Why the Fed must stand still on rates


Two weeks ago I  argued that a Federal Reserve decision to raise rates in September would be a serious mistake.  As I wrote my column, the market was assigning a 50 percent chance to a rate hike. The current chance is 34 percent. Having followed the debate among economists, Fed governors and bank presidents I believe the case against a rate increase has become somewhat more compelling even than it looked two weeks ago.

Five points are salient.

First, markets have already done the work of tightening.  The U.S. stock market is worth $700 billion less than it was 2 weeks ago and credit spreads have widened noticeably.  Financial conditions as measured by Goldman Sachs or the Chicago Fed index have tightened in the last 2 weeks by the impact equivalent of more than a 25 BP tightening.  So even if resisting inflation required a 25 BP tightening as of two weeks ago, this is no longer the case.

The figure below makes a crucial point.  It shows that even though the federal funds rate is very low (negative one and a half percent after adjusting for inflation), financial conditions are helping the economy less than in previous years when interest rates were much higher.


Second, the data flow suggests a slowing in the U.S. and global economies and reduced inflationary pressures.   Employment growth appears to have slowed down, commodity prices have fallen further, and the general data flow has been on the soft side.  Comprehensive measures of data surprises, such as the Bloomberg Economic Surprise Index, bear out this impression and the Atlanta Fed’s GDP Now model is currently predicting only 1.5% growth in Q3.

Third, the case for concern about inflation breaking out is very weak.  Market based expectations suggest that inflation over the next decade on the Fed’s preferred core pce basis is near record lows and well below 2 percent.  The observation that 5 year inflation, 5 years from now is expected to be below target calls into question arguments that current low inflation is somehow transitory.

The recent analysis presented by Fed Vice Chair Stanley Fischer asserting to the contrary relies on assumptions about exchange rates and inflation.  When actual empirical estimates are used his conclusions are substantially weakened.  Indeed as the figure below shows, there is no correlation of late between deceleration in inflation and import share looking across PCE components.InflationAndImportSharePCE.xlsx

Also on inflation, it bears emphasis that (i) we have some room for inflation acceleration (ii) prices are now fully 2 percent below a 2 percent inflation path taking off from 2010, (iii)  the Phillips curve is so unstable that it provides little basis for predicting inflation acceleration.  To take just two examples — first, unemployment among college graduates is 2.5 percent yet there is no evidence that their wages are accelerating. And unemployment in Nebraska has been below 4 percent for the last 3 years and growth in average hourly earnings has been basically constant at the national average level.

Fourth, arguments of the “one and done” variety or arguments that the Fed can safely raise rates by 25 BP as long as it’s clear that there is no commitment to a series of hikes are specious. If as some suggest a 25 BP increase won’t affect the economy much at all, what is the case for an increase? And when the same people argue that 25 BP will have little impact and that it is vital to get off the zero rate floor, my head spins a bit.

In a highly uncertain world, the Fed cannot be both data dependent and predictable with respect to its future actions. Much better that it stick with data dependence than that it put its credibility at risk by seeking to mitigate a current rash action by trying to reassure with respect to future steps.

I understand the argument that zero rates are a sign of pathology and the economy is no longer diseased so policymakers have to increase rates.  The problem is that the case for hitting the brakes in an economy with sub-target inflation, employment and output is not there; regardless of whether the brakes are to going to be pressed hard or softly, singly or multiple times.

From the Vietnam War to the Euro crisis, from the Iraq war to the lessons of the Depression we surely should learn that policymakers who elevate credibility over responding to clear realities make grave errors.  The best way the Fed can maintain and enhance its credibility is to support a fully employed American economy achieving its inflation target with stable financial conditions.  The greatest damage it could do to its credibility would be to embrace central banking shibboleth disconnected from current economic reality.

Fifth, I believe that conventional wisdom substantially underestimates the risks in the current moment.  It bears emphasis that not a single post war recession was a predicted a year in advance by the Fed, the Federal government, the IMF or a consensus of forecasters.  Most were not recognized till long after they started.  And if history teaches anything it is that financial interconnections are pervasive and not apparent till it’s too late.   Russia’s 1998 default, problems in subprime lending, and the Asian financial crisis were all moments when financial dislocations had far more pervasive effects than was generally expected.

We know that the world’s largest economy, China, is in its most uncertain state since it began economic reform in 1979 and may well be experiencing a larger volume of capital flight than any economy in history.  We know that the central banks  of Japan and Europe are likely to have to double down in the months ahead on already extraordinary quantitative easing.  We know that American households, firms and markets are processing what appears to a kind of “reverse 1990s” moment of sharply decelerating productivity growth.  We know that liquidity conditions in markets have worsened and there is at least some reason to believe that “positive feedback” trading strategies where investors sell when prices go down may well have become increasingly important.  We know the current U.S. recovery is in its 7th year and that confidence in public institutions is at a low ebb.

More likely than not, these fears are overblown and 2015 and 2016 will not go down in financial history.  If so, and the Fed does not act, inflation will start to accelerate, volatility will subside and policy can step in.  Regret may come in the form of inflation a few tens of basis points too high or a bit of euphoric relief in markets.  If on the other hand, some portion of these fears are warranted and the Fed tips towards tightening, it risks catastrophic error.

Now is the time for the Fed to do what is often hardest for policymakers.  Stand still.

September 9, 2015


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  • The Fed Funds rate reflects inter-bank borrowings, and inter-bank borrowings are at the lowest level in 35 years. So a Fed Funds rate will have very little effect. As for monetary tightening, it has been on since the beginning of 2014 as the attached graph shows. But the YoY growth rate is still more than 5% and history shows that nothing catastrophic happens when growth rates are so high. You can depend on the Fed to engineer the next recession, of course, but that probably won’t happen until 2016.

    • eli

      Completely agree on both points. However, i’ll add that regarding tightening, i think it will depend on where the IOER ends up as a result. If they hike IOER in conjunction with FF, i suspect we’ll see an impact. Whether or not it will be negative (lower growth/inflation) will depend on other things. Regarding the latent tightening, i noticed this a few weeks back. Real base money growth turned negative. This “tightening” has been going on since the end of QE3. Looking at the whole series, the dips have been coinciding with the sunsetting of each successive round of QE.

    • ADJMacro

      Hello Philip, may I ask what data you are using to derive the CMS or is this a trade secret?

  • TedSnider

    Here is article that looks at which asset class will suffer significant declines in value if/when the Fed actually raises interest rates:


    The Fed’s actions since 2008 have backed it into a corner from which there is no easy exit and stocks are not the only asset bubble that the Fed’s policies have created.

  • susupply

    Even more basic, the Fed should forget about interest rates altogether. That’s because, as Milton Friedman told Walter Heller (back in 1968 at their NYU debate) interest rates are not ‘the price of money’.

    The price of money is whatever good or service you have to give in exchange for money. And that price–which is currently stable–often moves in the opposite direction from the ‘prices of credit’ (interest rates). So interest rate(s) changes are not a reliable indicator of monetary policy.

  • Steve Robinson

    What about China and the petro-kingdoms converting their foreign exchange holdings held in USD denominated assets to defend their local currency, bail-out failing state-sponsored institutions, plug soaring budget deficits, etc? Conventional wisdom would say that there will be selling pressure on the USD and long term rates would would rise, regardless of what the Fed does on short term rates (a “reverse Greenspan’s Conundrum”). Part of me believes the Fed should begin to raise short-term rates to telegraph to the financial system that higher rates are coming and to shore up the currency in the event there is a race for the exits by large sovereign holders of USD denominated assets. As the poster below stated, with inter-bank lending as low as it is the real economic impact of the higher rates would be minimal, but it definitely would shift expectations.

    • UncleK

      Selling pressure on the USD?? Have you seen what it’s done the past 12 months?

  • dan berg

    “And if history teaches anything it is that financial interconnections are pervasive and not apparent till it’s too late.” Add to that the fact that interest rates have been lower, longer than at any time in the last 5000 years; add to that a (admittedly weak) foreign policy argument (who loses?) and the “stand still” argument is not a slam-dunk, as was said in another iffy decision making context.

  • Benjamin Cole

    Larry Summers can blog economics that way Mickey Mantle could hit the ball. Wow.

    I sure hope this is read at the Fed.

    I dare to peep that Summers consider not only no rate hike, but the case for QE as conventional policy, ala the Bank of Japan.

  • JKH

    Well done.
    The instability of the Philips curve, the futility of forced normalization, and data dependence do not support hiking.

    • Steve Robinson

      I agree the Phillips Curve is not a reliable indicator, but would argue it is because there was a labor supply-shock because of globalization which depressed U.S. wages and inflation.Today those large pools of labor previously inaccessible because of Communism and trade protectionism have largely been absorbed; as evidenced by the rapid increases in wages and decrease in competitiveness in China. I would argue that it stands to reason now that those macroeconomic trends that defined the 90’s have reversed, the head-winds the U.S. economy is facing today would reverse as well: higher inflation, lower productivity growth, and higher long-term interest rates.

  • billsimpson

    I’m always amused by the worry today about inflation. Globalization, facilitated by the inventions of the shipping contained and the Internet, took care of that threat. The days when union members could demand higher and higher wages, or they would shut the industry down, are long gone. Union membership, under which large portions of the manufacturing sector of the economy could work together as an effective bloc, no longer exists. Workers trying to demand higher wages will find their jobs moved to Vietnam. That tends to put a lid on inflation in a substantial part of the economy. Sure, it is largely a service economy today, but even some of that work can now be outsourced. Much of what remains are lesser skilled jobs, which can easily be filled with someone willing to work for low wages. When workers aren’t organized into large blocks that can shut things down, individuals are easy to replace.
    The Chinese government will have to dip into their vast hoard of savings accumulated over the last 20 years to stimulate their economy. They won’t run the risk of a recession bringing down a big part of their banking system. That new stimulus spending will keep the Chinese economy expanding for several more years. Eventually, trying to micromanage the economy of China will no longer work. It will be tough to close a lot of unneeded capacity. The transition from the world’s factory, to the world’s capital of consumption, will be tough. I’m not sure they can accomplish the transition under their current form of government.

  • Mike Johnson

    Hear, hear, reality is no longer what it once was and adherence to the policies of the past will be damaging. The economy should show that it can maintain the target rate of 2%+ for a year before rates are increased or credit substantially tightened by policy measures from the Fed or increasing regulatory restriction.

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