Sunday, September 13, 2015

Fed Policy: Do Two Wrongs Make A Right?

Deciding on monetary policy is not an easy task.  It requires an acute sense of economic wisdom in reading the signs that the economic data throws out, and also an actor's skill and sense of timing to ensure that the words are delivered in exactly the right form at the right time. The Fed has a monumental decision to take this week - whether to raise rates for the first time since July of 2006. That is over 9 years ago, and reflects how serious the last recession (or "great recession" as it's now called) was, not only in terms of it's initial depth, but also because of the way the recession was initiated (through the housing and financial sectors), through the consequent sluggish recovery.

But I think some in the media are under certain misconceptions about monetary policy.  Monetary policy is undoubtedly "abnormal" at the moment, with no real ability to lower rates if we go into another recession, and righting this "abnormality" is probably the strongest argument for lifting rates right now, as there doesn't appear to be any inflationary pressures on the horizon.  At least that is the official line I hear in the media, but more on this later.
Source: New York Times

The two strongest reasons I hear that the Fed shouldn't raise rates (see Larry Summers's FT blog outlining why he thinks the Fed should not raise rates now) are that US inflation rate (measured by CPI or PCE measures) is still under the Fed's 2% target, and that although the US labour market has recovered, the lower participation rate and stagnant wages still point to persistent weakness.  Add to this the new "emerging markets" Quantitative tightening argument made yesterday quite forcibly by Gavyn Davies in the FT (see here)

But when I read both Larry Summers's and Gavyn Davies's arguments, they seem rather weak to me, and for the following reasons:

i) "Normalization" is important.  As a central bank, the main instrument that the Fed has is interest rates. Using QE was an experiment, an experiment that other central banks are now using, but where there is considerable and continuing discussion regarding the effectiveness of this relatively new policy.  As we are now nearing the end of the current business cycle ( - business cycles typically have length of 4 to 10 years), the Fed needs to put some real teeth back into it's monetary policy instruments so that it has the ability to effectively ease if and when another sizable downturn occurs.

ii) Inflation.  Inflation is currently low basically because of the role of lower oil prices in bringing down input prices throughout most of the economy.  But once crude oil prices begin to rise again, which they inevitably will, the distortion of such a large fall in oil prices will work in the opposite direction - it will tend to bias inflation upwards rather than downwards.  Now although we do not know the full effect of lower oil prices on inflation, the Fed is using the measure of prices minus food and energy, which only takes out the direct effect of volatile energy prices, and not the further effect of energy prices as an input into the production of other goods and services.  So my point here is that inflation, even measured without food and energy prices, is still downwardly biased. A better indicator is probably wages, and they are increasing now at a 2.5% year over year rate (average weekly earnings on private nonfarm payrolls).  That implies that indeed we now are looking at some inflation in the system with the likelihood that even if current inflation levels are subdued, the actual future inflation rate is likely to incorporate these cost increases, and so inflation should be on an upward medium term trajectory.

iii) External factors.  The Fed does not set monetary policy on the basis of economic conditions external to the US.  Nevertheless, that has not stopped institutions like the IMF, the central bank of India, and other central banks from weighing in to urge the Fed not to raise rates in September.  Indeed, the sales of dollar reserves in the form of US government bonds has led to a tightening of interest rates which, as Gavyn Davies has pointed out in the FT, is an implicit tightening of policy in the medium term bond yields (around 10 years).  The figure on the right shows this trend, and indeed from a global perspective this trend is sufficiently large as to potentially swamp injections of liguidity through QE from both the ECB and the Bank of Japan. But I would argue that this is not relevant to the US - the US has to set monetary policy according to the economic and financial conditions in the US, and not elsewhere.  If the Fed starts to take these kinds of factors into account, then the Fed will no longer be setting US monetary policy - instead it will be setting global monetary policy, and this is not in it's mandate.

So to end this blog posting I want to make the case that 2 "wrongs" don't make a "right".  The Fed was wrong not to go in 2014 when it clearly had the chance to start the "normalization" process earlier in the growth phase of the business cycle.  For the reasons I have outlined above it would also be wrong not to increase rates now at the September meeting as well.  And yet there are still some commentators who suggest that it would be right not to raise rates this week.  My own assessment of the situation would be that the Fed would be falling seriously "behind the curve" on normalization of monetary policy, which could have extremely negative effects in 2016 or 2017 if and when the next recession arrives. Now the response to the points outlined here would undoubtedly be "but we could always do a QE4" - but no central bank really wants to extend the exceptional circumstances further unless absolutely necessary, and it would be a massive mistake if the Fed were to assume that the US economy could be effectively protected solely by a QE4. That would be like waging a battle with only air cover, and no infantry!

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