Why the Federal Reserve is timid on rates
One broad guide for evaluating central-bank decisions is this: when the case for a course of action is clear cut, central banks should have already acted. That may explain the irritation of Reserve Bank of Australia Governor Glenn Stevens at his US counterpart Janet Yellen for keeping the US cash rate at zero long after the circumstances have set in that the Federal Reserve said would herald a rate increase.
Stevens, appearing before a House of Representatives committee hours after the Fed’s policy-setting board on September 17 decided against raising the US cash rate, more or less rebuked the Fed for its timidity. There will always be certain market moves, some weak economic data or an argument to say "don't do it just yet," Stevens said. "One day you are just going to have to do it … they need to (go up) for the US’ sake."
Stevens’ frustration is understandable considering the US economy is in its sixth year of expansion, brisk consumer spending has helped the economy grow at a near-4% annual pace and as far back as 2012 the Fed indicated it would raise the US cash rate when the jobless rate slid to 6.5%. This first marker of when a vibrant labour market could boost inflation was reached in April 2014. The jobless rate has subsequently dropped to a seven-year low of 5.1% in August this year. Thus the unemployment rate sits within the revised 4.9%-to-5.2% range the Fed now says will lead to wage-driven inflation.
Yet the Fed’s policy-setting board in September decided by nine votes to one to keep the US cash rate at the 0% to 0.25% (effectively zero) band it has sat since 2008. The majority voted for more time to judge whether developments in China and other emerging economies could jeopardise the US recovery. (The Fed is blasé about what higher US rates might do to the rest of the world.) In a perverse outcome, the Fed’s hesitation on rates made investors fret that the Fed can see troubles ahead that are not obvious to others.
Why is the Fed so nervous about raising the US cash rate when keeping it at emergency levels carries risks? The answer could well boil down to a number that haunts US policymakers. That number, which stands for a year, is 1937. That’s when US policymakers crushed the US post-Depression recovery by tightening fiscal and monetary policy. The Fed seems concerned that rate increases could set up a similar, even if less dramatic, crunch today. The Fed is right to be wary of the most-likely mistake it could make in today’s circumstances because the majority of its counterparts have so blundered. There are three reasons, though, why the Fed is likely to overcome its timidity before too long. The first two reasons are grounded within the Fed, while the other is political.
There is, it must be said, a case for keeping rates on hold. Hidden unemployment is suppressing wages growth, investment is weak, higher rates could snuff out the housing recovery while inflation is well below the Fed’s 2% target. Lower import prices thanks to a 15% trade-weighted jump in the US dollar over the past year and the bursting of the commodities bubble are suppressing inflationary pressures. The Fed’s preferred inflation gauge, the personal consumption expenditure index, only rose 0.3% in the 12 months to July and the Fed doesn’t expect consumer prices to touch 2% until 2018. But the fact that the Fed went against its own “forward guidance” in keeping rates on hold in September smacks more of timidity than a data-based decision. The Fed’s nervousness highlights how central banking has its own biases. One of them is that under today’s prevailing conditions – where deflation and a renewed slumped are at least as menacing as inflation – history has taught central bankers to be wary about tightening policy.
Premature victories
In the first few months of 1937 when Franklin D. Roosevelt had just begun his second term as president, US production rose above pre-Depression levels for the first time. As Jean Edward Smith recounts in his biography, FDR, steel production was at 80% capacity and the true unemployment rate had plunged to 4%, down from one-third of the workforce in 1933.
Roosevelt assumed economic victory. Accordingly, he slashed government spending to wipe out the federal budget deficit within two years, while the Fed raised reserve requirements by 50% to restrict lending. “Such massive contraction was more than the recovering economy could sustain,” Smith writes. “Industrial activity declined more abruptly than at any other time in the nation’s history.” Four million people had lost their jobs within 12 months. By the end of 1937, the steel industry was at 19% capacity.
The “Depression within a Depression” prompted the most embarrassing U-turn of all for policymakers – when they are forced to recover from their own mistakes. In April 1938, Roosevelt pleaded to and won from Congress a stimulus program that resulted in the US economy regaining by year end half the output lost due to his over-hasty clamp on fiscal and monetary policy. Nonetheless, Roosevelt’s premature tightening has served as a warning to US policymakers ever since.
If the Yellen Fed needed any more reminders what damage such mistakes can do, it only need tally the number of central banks that made the same error in recent years. At least six of the 10 most prominent central banks in advanced countries have raised interest rates since 2009 only to reverse their decision, often within months. These are the central banks of Australia, Canada, Denmark, the Eurozone, Norway and Sweden. Central banks in Chile, Iceland, Israel, New Zealand, which has twice raised and cut rates from post-crisis lows, and South Korea could be added to this list. All up, 15 of the 36 OECD members have made the mistake.
The most unnecessary and the most damaging tightening belongs to the European Central Bank under Jean-Claude Trichet. The ECB raised its key rate in 2011 in two steps from 1% to 1.5%, even though inflation was benign (2.7% and falling) and member countries were in recession. Many commentators date the start of the Eurozone debt crisis (as distinct from the Greek debt crisis) from the first increase in April 2011 because it signalled the ECB was so inflation-obsessed it would provide no help to solve the crisis. So harmful were the rate increases Mario Draghi overturned them within about seven weeks of becoming ECB president in November 2011 – to give a four-month gap between the last increase and the first cut. As the Eurozone economy is yet to emerge from depression, Draghi has subsequently pruned the benchmark rate in five steps to 0.05% and launched a quantitative-easing program.
Sweden’s central bank was as overanxious as the ECB about non-existent inflation but at least it only damaged one country, namely Sweden. In 2010 when inflation was 1.2%, the Sveriges Riksbank decided to curb a surging housing market, record household debt and (tame) inflation by raising its key rate seven times from 0.25% to 2% in the 12 months to July 2011. The result was a recession. Within five months after the last increase, the world’s oldest central bank was forced to cut rates. It has since trimmed them so many times since that in February this year the Riksbank became the first central bank to reduce its main policy rate to a negative number (minus 0.1%). To combat deflation, the Riksbank has since cut this rate to minus 0.35% and embarked on quantitative easing.
Australia and Norway never inflicted too much self-harm with rate increases as the pair implemented rate cuts in time to (so far) avoid recessions. The RBA lifted the cash rate in seven steps from 3% in 2009 to a post-crisis high of 4.75% in 2010 only to start trimming one year later. Stevens’ error was to misjudge the durability and inflation danger posed by the promised boom in mining investment, which fizzled anyway when commodity prices tanked. In 10 steps since November 2011, the RBA has lopped the cash rate to a record low 2%.
Norway’s central bank raised its key rate in four steps from 1.25% in 2009 to 2.25% in May 2011 only for Norges Bank to cut rates seven months later when the Eurozone crisis intensified. After four more rate reductions, Norway’s key rate is at a historic low of 0.75%.
The Bank of Canada took until 2015 to cut interest rates (twice) after raising them three times from post-crisis lows in 2010, a sufficient lapse of time to avoid staining its reputation. Denmark’s central bank adjusts its benchmark rate in line with the ECB because its main policy goal is the stability of the krone. The rate increases of Danmarks Nationalbank in 2011 and subsequent cuts in the lending rate can be blamed on the ECB. Central banks in Japan, Switzerland, the UK and the US are the only central banks in advanced countries yet to raise their key rates from post-crisis lows.
Self-made traps
The dilemma for analysts trying to anticipate the first US rate increase since 2006 is that the timidity of the Fed’s policy-makers contradicts their expectations for interest rates. The Fed’s so-called dot plot of policymaker projections for the US cash rate in September showed that 13 of the 17 policy-board members still expect a cash-rate increase in 2015 (even if one board member put a negative dot in the graphic for the first time). There is no logic to this. For what difference can a couple of months make to the issues surrounding the decision?
All the warnings the Fed receives about the damage a US rate increase would do will still apply come 2016. These dooms-dayers caution that higher US interest rates will harm emerging countries tottering under excessive US-dollar debt. These debts won’t be under control by year end, nor will the inflation and other damage associated with drops in emerging currencies triggered by talk of higher US interest rates. China’s financial stability and economy won’t suddenly improve by year end – the most likely noticeable change would be deterioration. On the domestic front, US inflation will still be under target and deflationary forces still loitering. Wages growth will still be sluggish, hidden unemployment just as prevalent and business investment below par. The incentive will remain for the Fed to keep interest rates at zero to allow the US economy to heal more.
Fed decision-makers, of course, hear reasons why they should lift the US cash rate. The most convincing arguments are that zero interest rates are fanning imbalances and channelling too much money into borderline endeavours. Others are that rates need to be raised so the Fed will have an ability to respond to the next downturn and that a gradual increase in rates now will prevent a sudden spate of hikes in 2016 if wages growth accelerates. None of these arguments are likely to be stronger in coming weeks.
The Fed claims its decisions are data dependent. But if the Fed were to raise the US cash rate before year end – as Yellen flagged again on September 24 – the timing would perhaps be based more on three untechnical reasons rather than the latest data, especially after a weak jobs report for September was released on October 2. The first is that the Fed wouldn’t want to add to the uncertainty created by its September postponement. The second is that Fed policymakers for so long have signalled that the first increase would occur in 2015 that their credibility is at stake. Central bankers are no less image conscious than politicians and the Fed needs to ensure its actions match its excessive talk. The other is that the Fed would like to get its rate increase over well ahead of the US elections next November to avoid injecting itself into the final campaign season.
Whenever the Fed presses ahead with its first rate increase – and investors are now pricing in a 2016 kickoff – at least the ghosts of 1937 make one thing clear cut; that any overall increase in US rates will be modest.
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