Fed mulls shift in monetary policy

The US central bank didn’t have to follow ultra relaxed monetary policies for an extended period after the financial crisis/recession of 2007-2008 (aka Great Recession); this was an innovative and aggressive policy choice. Now a return to normalcy is deemed desirable, but many questions are arising as to the side effects and appropriate timing of the transition.

Moral: It’s far easier to block questionable policies initially than it is to reverse them after they have been in effect for a while.

A. Where things stand - The Federal Reserve has been holding short-term interest rates at nearly zero since 2009 (aftermath of the Great Recession). It has also run “quantitative easing” programs (basically buying longer-term securities with the aim of holding down longer-term interest rates), most recently QE3 (launched in September 2012; phased out by the fall of 2014).

As a result of the issuance of emergency credits during the financial crisis and subsequent quantitative easing, total assets on the Fed balance sheet have quintupled and then some since 2008.

FED Balance Sheet

The Fed is now the largest single holder of US Treasury debt (roundly $2.5T versus $1.3T for China); the Fed’s interest income is returned to the US Treasury so debt held by the Fed is essentially interest-free for the government. Federal Reserve, August 2015 (download PDF).

These policies were intended to promote economic recovery after the Great Recession; it was generally understood that they would not be continued indefinitely. The downside risks are investment market distortions, e.g., asset bubbles, and rampant inflation (according to the Fed, an inflation rate of 2% per year would be ideal).

There have been investment market distortions aplenty, but the rate of inflation has remained relatively low. The Fed seems in no rush to apply the monetary brakes, and it’s unclear how long a return to “normal” monetary policies will take. For reasons to be discussed, we believe this process should be expedited.

B. Is monetary stimulus needed? - Not only have the past seven years been an era of ultra relaxed monetary policy (call it monetary stimulus), but the government has been running eye-popping budget deficits as well. Thus, total federal debt grew from $10.0T at 9/30/08 to $18T+ currently, an 80%+ increase in a mere 7 years. The deficit has been reduced of late, but it is still running at an annual rate of some $400-500 billion.

With so much stimulus, one might think the US economy would be soaring (and probably overheating) by now. The actual situation is an anemic recovery.

Despite an encouraging second quarter, Gross Domestic Product is expected to grow about 2.0% for the full year – clearly subpar for what is supposed to be a period of economic recovery. Second quarter economic growth revised up to 3.7 percent, Joseph Lawler, Washington Examiner,
8/27/15.

•The second quarter was a significant improvement over the first, when output grew by a meager 0.6 percent.

•A model maintained by the Federal Reserve Bank of Atlanta based on the most current economic data shows third-quarter growth checking in at 1.4 percent. In their most recently released projections, members of the Federal Reserve expected growth for the year to total 1.8 percent to 2 percent.


Also, inflation is running well below the Fed’s 2% rate target, which has been repeatedly cited as a reason not to start raising interest rates just yet. Fed’s [Vice Chair Stanley] Fischer: Inflation too low to justify rate hikes, Joseph Lawler, Washington Examiner,
8/10/15.

Inflation was just 0.3 percent in June, in the measure most closely watched by the Fed, well below the Fed's longer-term 2 percent goal. *** even stripping out the effects of energy and food prices, core inflation was 1.3 percent in June. *** "The concern about this situation is not to move before we see inflation as well as employment returning to more normal levels," Fischer said, explaining in part why the Fed did not raise its interest rate target at its June meeting. *** Fischer, Fed Chairwoman Janet Yellen, and other officials at the central bank have said they will rely on incoming economic data to decide when to begin tightening money by raising interest rates.

So why hasn’t the combination of monetary and fiscal stimulus worked as expected? Surely Americans have not grown tired of spending money. Perhaps other government policies are counteracting the stimulus and thereby choking off the hoped-for recovery. GovCare – Dodd/Frank financial regulations – the EPA’s war on coal (and soon all fossil fuels) – etc. Federal regulations cost US economy more than $2 trillion annually, Business Council,
9/10/14.

Take a current annual budget deficit of roundly $0.5T, subtract the estimated cost of regulations, and the indicated net effect would be a governmental withdrawal of $1.5T from the economy every year. No wonder massive monetary stimulus has been seen as necessary to keep the economy sputtering along despite the risks involved.

C. Recent developments – After completing the phase-out of quantitative easing (ending purchases of additional securities, but not selling the securities already acquired) last fall, Fed officials began talking about raising short-term interest rates (currently near zero) by say 0.25% percentage points – maybe in September. Additional increases would follow until short-term rates reached normal market levels. The new Fed buzzword for interest rates: “crawl,” Joseph Lawler, Washington Examiner, 6/3/15.

"I think it will be appropriate at some point this year to take the initial step to raise" interest rates, [Fed Chair Janet] Yellen said in Providence, R.I., in late May. After the first increase, she said, "The pace of normalization is likely to be gradual."

China’s devaluation of the Yuan on August 11 (reflecting apparent weakness in the world’s second largest economy) and subsequent volatility in global stock prices complicated matters, reinforcing concerns that an interest rate increase might be premature. Thus, for example, the Dow Jones Industrial Average fell nearly 10% between August 19 (closing value 17,348) and August 25 (closing value 15,666). It has since staged a partial recovery, closing at 16,102 on Sept. 4. Historical DJIA prices,
yahoo.com.

Recent statements indicate that an interest rate increase remains under consideration, with a decision to be made at the Fed's Sept. 16-17 meeting. Reading between the lines, however, the sentiment for a rate increase in September has cooled. Fed appears to hold line on rate plan, Jon Hilsenrath & Ben Leubsdorf, Wall Street Journal,
8/30/15.

JACKSON HOLE, Wyo.—Federal Reserve officials emerged from a week of head-spinning financial turbulence largely sticking to their plan to raise U.S. interest rates before the end of the year. *** Officials will continue to keep a close watch on markets and China. But they hope U.S. consumer-price inflation will start inching toward their 2% annual target as the economy’s untapped capacity gets used up, leaving them in position to start raising rates after several months of forewarning. *** “I will not, and indeed cannot, tell you what decision the Fed will reach by Sept. 17,” [Vice Chair Stanley] Fischer said.

Some observers foresee further market turbulence, which could force the Fed to drop the idea of raising interest rates any time soon. [Peter] Schiff [CEO, Euro Pacific Capital]: US Dollar bubble is going to burst, F. J. McGuire, newsmax.com,
8/11/15.

Our economy is in much worse shape than the Chinese economy. The Fed is going to be forced to admit this. They're not going to be raising interest rates, they're going to be doing QE4," [Schiff] said, referring to a fourth round of quantitative easing.

Other central banks are currently easing their monetary policies, and there have been pointed suggestions that the Fed should rethink its position. China exclaims “we were wronged” – demands Fed delay rate hike, Tyler Durden, zerohedge.com,
8/27/15.

With all mainstream media blame fingers pointing at China - because a market crash could never be America's fault - Chinese authorities are not best pleased with the rhetoric. As we noted earlier in the week, China's central bank blames The Fed for the market rout, and now, as Reuters reports, “The PBOC has reiterated that a Fed rate hike will push EM [emerging market countries] into crisis and Yuan devaluation is not responsible for global market turmoil.”

There was a lot of talk about the August jobs report, which was released last Friday. The official unemployment rate fell to 5.1%, which is clearly regarded as within the Fed’s “full employment” range. Other measures of unemployment, however, continue to suggest a substantial overhang of idled or underemployed workers. Alternate math puts unemployment at 10.3 percent, Sean Higgins, Washington Examiner,
9/4/15.

Bottom line, the jobs report didn’t settle anything and, as the saying goes, “the market hates uncertainty.” The DJIA was down 1.7% for the day (3.2% for the week). Stocks decline after mixed labor-market report, Corrie Driesbusch, Wall Street Journal,
9/4/15.

The report provided little new clarity for investors. Those who heading into the August jobs report thought the Fed would raise rates in September saw the data as confirming their projection, traders said, while those who believed the Fed would wait until December felt the miss validated their prediction.

D. Assessment - SAFE has followed the Fed’s policies in recent years with growing skepticism. While drastic action was surely necessitated by the financial crisis in 2008, we would have favored a return to more traditional policies once the crisis was over – and so recommended at the time. Time to reset the central bank, 4/16/12.

While the rate of inflation has been running below the Fed’s 2% per year target rate, this does not justify a delay in raising interest rates because the target is basically arbitrary. Why is 2% inflation necessarily better than, say, 2% deflation? The real point is not the maximization of economic output, but rather whether the interests of borrowers or savers will be favored. And in the spirit of fairness, we would suggest that the most appropriate goal would be general price stability, i.e., neither class should be favored over the other.

Some might dismiss a 2% rate of inflation as trivial, but this rate compounds to 22% over a decade; that may not seem like a minor matter for retirees and others living on a fixed income. Also note that (a) the impact of inflation will vary with an individual’s consumption pattern (so the experienced rate of inflation for an individual might be, say, 5% instead of 2%), and (b) there is evidence of the officially reported inflation rate being understated. US Economic Survey,
August 2013 (inflation section).

Then there’s mission creep, with the Fed increasingly viewing itself as responsible for the overall economy instead of simply trying to keep the monetary system running smoothly. Who elected the Fed officials? Wouldn’t it be better to hold the nation’s political leaders accountable for economic results (a matter of considerable interest to voters) instead of expecting the Fed to handle matters? Federal Reserve launches another monetary policy experiment [QE3],
9/17/12.

. . . there is something deeply troubling about the Federal Reserve chairman coming to be seen as our economic godfather, who stands ready to “save the day” if the president and Congress cannot come to terms. The result is to remove accountability from the political process, making it ever more difficult to take the steps (e.g., the SAFE agenda) needed to rejuvenate the US economy over the longer term.

Although central bankers like Ben Bernanke, Janet Yellen and Europe's Mario Draghi "have all said monetary policy can't be the sole fix for the Western world's slow-growth malaise," they have nevertheless acted as enablers for the irresponsibility of political leaders. A better way to bring "elites" into line, Holman Jenkins, Jr., Wall Street Journal,
9/5/15.

Monetary policy has become our era’s great crutch so leaders everywhere can go on catering to the same old organized interests instead of undertaking necessary reforms.

Given current economic conditions, this is arguably not the best time to start raising interest rates. The Fed flirts with the right move at wrong time, Gerald O’Driscoll, Cato Institute,
8/24/15.

The global economy is weakening. Emerging-market growth has largely been driven by commodity exports, especially energy. There is weakness in almost all commodity markets, and sustained increases in interest rates would likely exacerbate that weakness. It is not just commodity exports, however, but global trade generally that is at risk. Economic sentiment in Germany, a notable European Union exporter, has turned negative, according to the ZEW Financial Market Survey. If one truly believes the world is economically integrated, it is dangerous to dismiss the global consequences of U.S. monetary policy.

While we would agree with O’Driscoll that the Fed isn’t operating in a vacuum, ultra relaxed monetary policies haven’t worked better elsewhere than they have in the US. Perhaps it would make sense for the Fed to lead by example, raising interest rates here and encouraging similar changes elsewhere. Clear conclusions concerning QE, Michael Pento, affluentinvestor.com,
8/26/15.

It is now becoming empirically obvious to any objective observer that the philosophy of money printing to generate growth is a complete failure. That bankrupt philosophy led to the biggest bubble of all: the QE-induced faith in central banks' ability to save the world. The collapse of this deluded fantasy will be the most devastating reality check of all.

Bear in mind that a 0.25% rate increase is hardly a radical initial move, and that all the interested parties realize that a return to normal monetary policies will be necessary at some point. If problems develop as interest rates rise, moreover, there will be other ways to address them. The Fed’s stock-price correction, Martin Feldstein, Wall Street Journal,
8/24/15.

. . . if the asset-price corrections have serious adverse macroeconomic effects, the task of stimulating the economy should shift from the Federal Reserve to the Obama administration and Congress. There is no shortage of tax and budget policy prescriptions that could stimulate output without increasing national debt.

Moreover, according to former Fed Chairman Alan Greenspan, the debate about the Fed’s actions is just serving as a distraction from the real problem that must be addressed (fixing the fiscal problem). In a TV interview, he pronounced himself “baffled” [by perceptions] that a 25 basis point hike by the Fed would have a major impact on economic conditions around the world. Greenspan: The Fed can’t solve every problem, Matthew Belvedere, cnbc.com,
9/4/15.

All things considered, we think the Fed should stop agonizing about all the potential implications and get on with an interest rate increase in September.

**********COMMENTS*********

#We've lived with abnormally low rates for far too long. It seems Fed officials are hyper-sensitive to (a) what they perceive is a fragile U.S. economy (latest growth of 3.5% looks pretty good to me), (b) concern about the under-employed (some of the jobs lost are not returning because of improved technology/productivity, which is healthy), and (c) perhaps (I hope not) declines in the market (which have been overdue). - Retired financial executive

##The rate change is modest, but it will reduce prices of bonds sooner or later. Now, the thumper: with rates very low in the 'West,' which includes Japan now, this will force shifts of capital from those places back to the US as the interest rate is essentially 'the price of money' and that price will just rise. We will damage emerging Asian economies. The debt service of the US will also rise, and I don't see much hope for cutting back on government spending.

When you smash the metric limits of an economy [debt too high, interest rates too low, unemployment too low, wages too high, GDP lower than it should be, dollar too high] you push the boundaries of that economy into unknown territory in fiscal terms of the historical set. Nobody knows what will happen next. The only mystery to me is how our dollar rises in spite of the M2 supply and such. It must mean the other currencies are weaker than we thought. - SAFE director

We'd argue that the risks of not raising rates are even bigger.
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