The U.S. Fed and the Seven-Year Itch
The peculiar logic of raising interest rates because you pre-announced it
December 21, 2015
On November 16, Janet Yellen, the Chair of the Board of Governors of the Federal Reserve System, finally ended the Fed’s own suspense drama after 18 months of public agony. She announced that the U.S. Fed had just raised the country’s so-called federal funds rate to a range between 0.25 and 0.5%.
This decision also came exactly seven years to the day after the Fed had lowered rates to near zero at the height of the Great Recession.
This seven-year itch or the eagerness begins what economists like to refer to as the process of “normalization” of U.S. monetary policy. Pressure in the markets to move in that direction became too strong to withstand.
However, an increase in interest rates is premature for structural and cyclical reasons. First, let me address the structural reasons:
1. As I have pointed out before, the world economy is facing a paradigm shift.
Inflation is caused either by a cost push and/or a demand pull. However, our world today is faced with a “cost crash” and a “demand lull.” Inflation is structurally subdued.
2. The role and structure of the U.S. economy has completely changed over the last 35 years. In 1980, U.S. GDP accounted for 30.4% of global output. By 2014, that share had shrunk by a quarter and now reaches only 22.4%.
At the same time, the U.S. middle class is diminishing in size. In 1981, it accounted for 59% of the population. By 2015, the share of the U.S. middle class had fallen to just 50% of the country’s population.
Both the diminished role of the U.S. economy in global output and the country’s shrinking middle class have a material impact on U.S. growth, inflation and, therefore, the country’s monetary policy.
In other words, U.S. growth is much more affected today by economic developments outside the U.S. than it was in the past.
3. The previous point requires that U.S. monetary policy must be far more global-minded today than it was 35 years ago. It is unquestionably the mandate of the U.S. Federal Reserve to preserve price stability within the United States.
However, interconnectedness and global interlinkages make it far more likely today that the “side effects” of U.S. monetary policy abroad will be fed back into the U.S. economy itself.
4. For all those asset bubble worriers, there is no proof that U.S. interest rate policy can effectively prevent bubbles. In fact, most recent experience seems to suggest that it cannot.
The Fed raised interest rates very aggressively between 2004 and 2006 from 1.25% in June 2004 to 5.25% in June 2006. This did nothing to keep the American people from buying ever-more expensive and overpriced homes, only to flip them shortly thereafter.
No cyclical reasons either
But the Fed really does not acknowledge these structural issues and it happily moves along as if this were just a normal business cycle decision. So, let us examine, then, the narrowly focused reasons for the Fed’s decision to raise rates.
1. Full employment: The Fed justifies the rate increase with the fact that unemployment has fallen dramatically from 10.0% in October 2009 to just 5.0% in November 2015, a number equivalent to the magical number of “full employment.” Yet, no economist can really give proof of what defines such magical number.
What we do know about unemployment is our own historical experience. During the last year of the Clinton Administration, U.S. unemployment bottomed out at 3.8% in April of 2000.
More astonishingly, this low unemployment rate was achieved against a labor force participation (LFP) rate of 67.1%.
This November, LFP stood at a miserable 62.5%. In other words, the employment gap between April 2000 and November 2015 (gap in unemployment rate + gap in LFP) amounted to a whopping 5.8 percentage points.
Of course, LFP shrinks as the U.S. population ages, but even at the height of the crisis in 2009, LFP still stood at 65.0%.
No matter how you look at the employment picture, the U.S. is miles away from full employment. Consequently, there are also no wage pressures which could ultimately lead to inflation.
2. Janet Yellen also pointed out that headline inflation is kept “artificially” low due to low oil prices. This is true.
However, it has been the Fed’s policy for a long time to use core inflation instead of headline inflation. Core inflation excludes volatile energy and food prices. Since mid-2011, core inflation has barely budged and fluctuated just below or at 2% year-over-year.
3. The Fed Chair also suggested that a very gradual increase was much better than a sudden and sharp increase of interest rates once that inflation popped up.
Again, she is correct in principle. However, as there is no inflationary pressure on the horizon, any increase in interest rates is superfluous.
It could be ignored, were it not for global market volatility and depressed growth in emerging markets, that the rate increase is harmful, ultimately to the U.S. economy as well.
Even if we stipulate material increases in prices within the next three years, the gradual approach now chosen would fail. This is so because interest rates are being raised from near zero and they would have no effect.
Therefore, containing inflation would then require “an abrupt tightening” that “could increase the risk of pushing the economy into recession.”
In a perverse sense, the much desired transparency at the Fed which was one of the trademark achievements of Ms. Yellen’s predecessor, Ben Bernanke, may also have backfired. It is simply not a good idea for the Fed to create an 18-month long cliffhanger over rate increases.
As this year drew to an end, the Fed may have felt compelled to finally meet the expectations it had raised so long ago, even if the fundamentals were less than convincing.
In the end, central bankers should all be sworn in not so much with their promise to uphold the constitution, but in an analogy to the Hippocratic Oath: “First, do no harm.”
This seven-year itch begins the process of “normalization” of US monetary policy.
US growth is now more affected by economic developments outside of the US than it was in the past.
US monetary policy must be far more global-minded today than it was 35 years ago.
The “side effects” of US monetary policy abroad will be fed back into the US economy itself.
There is no proof that US interest rate policy can effectively prevent bubbles.
As there is no inflationary pressure on the horizon, any increase in interest rates is superfluous.