August 23, 2015
Raising rates this year will threaten all of the central bank’s major objectives
Will the Federal Reserve’s September meeting see US interest rates go up for the first time since 2006? Officials have held out the prospect that it might, and have suggested that — barring major unforeseen developments — rates will probably be increased by the end of the year. Conditions could change, and the Fed has been careful to avoid outright commitments. But a reasonable assessment of current conditions suggest that raising rates in the near future would be a serious error that would threaten all three of the Fed’s major objectives — price stability, full employment and financial stability.
Like most major central banks, the Fed has put its price stability objective into practice by adopting a 2 per cent inflation target. The biggest risk is that inflation will be lower than this — a risk that would be exacerbated by tightening policy. More than half the components of the consumer price index have declined in the past six months — the first time this has happened in more than a decade. CPI inflation, which excludes volatile energy and food prices and difficult-to-measure housing, is less than 1 per cent. Market-based measures of expectations suggest that, over the next 10 years, inflation will be well under 2 per cent. If the currencies of China and other emerging markets depreciate further, US inflation will be even more subdued.
Tightening policy will adversely affect employment levels because higher interest rates make holding on to cash more attractive than investing it. Higher interest rates will also increase the value of the dollar, making US producers less competitive and pressuring the economies of our trading partners.
This is especially troubling at a time of rising inequality. Studies of periods of tight labour markets like the late 1990s and 1960s make it clear that the best social programme for disadvantaged workers is an economy where employers are struggling to fill vacancies.
There may have been a financial stability case for raising rates six or nine months ago, as low interest rates were encouraging investors to take more risks and businesses to borrow money and engage in financial engineering. At the time, I believed that the economic costs of a rate increase exceeded the financial stability benefits, but there were grounds for concern. That debate is now moot. With credit becoming more expensive, the outlook for the Chinese economy clouded at best, emerging markets submerging, the US stock market in a correction, widespread concerns about liquidity, and expected volatility having increased at a near-record rate, markets are themselves dampening any euphoria or overconfidence. The Fed does not have to do the job. At this moment of fragility, raising rates risks tipping some part of the financial system into crisis, with unpredictable and dangerous results.
Why, then, do so many believe that a rate increase is necessary? I doubt that, if rates were now 4 per cent, there would be much pressure to raise them. That pressure comes from a sense that the economy has substantially normalised during six years of recovery, and so the extraordinary stimulus of zero interest rates should be withdrawn. There has been much talk of “headwinds” that require low interest rates now but this will abate before long, allowing for normal growth and normal interest rates.
Whatever merit this view had a few years ago, it is much less plausible as we approach the seventh anniversary of the collapse of Lehman Brothers. It is no longer easy to think of economic conditions that can plausibly be seen as temporary headwinds. Fiscal drag is over. Banks are well capitalised. Corporations are flush with cash. Household balance sheets are substantially repaired.
Much more plausible is the view that, for reasons rooted in technological and demographic change and reinforced by greater regulation of the financial sector, the global economy has difficulty generating demand for all that can be produced. This is the “secular stagnation” diagnosis, or the very similar idea that Ben Bernanke, former Fed chairman, has urged of a “savings glut”. Satisfactory growth, if it can be achieved, requires very low interest rates that historically we have only seen during economic crises. This is why long term bond markets are telling us that real interest rates are expected to be close to zero in the industrialised world over the next decade.
New conditions require new policies. There is much that should be done, such as steps to promote public and private investment so as to raise the level of real interest rates consistent with full employment. Unless these new policies are implemented, inflation sharply accelerates, or euphoria in markets breaks out, there is no case for the Fed to adjust policy interest rates.
The writer is the Charles W Eliot university professor at Harvard and a former US Treasury secretary