Today the FOMC committee meets to set monetary policy. Although markets expect no immediate change to the Fed Funds rate, they are pricing in roughly a 40% chance the Fed will raise rates at September’s meeting.
Recently the Federal Reserve committee members have been sending signals rates will rise sooner rather than later. Gavyn Davies from the FT wrote a great piece about the slight shift in stance:
The date of lift off is still a matter of contention. Recently, the IMF has argued that it should be delayed until next year, and Paul Krugman has said that the costs of wrongly acting too soon are much smaller than the costs of making the opposite mistake.
For a long while, Janet Yellen seemed sympathetic to this asymmetry of risks, but lately she seems to have shifted her stance. Her recent message has been clearly tilted towards a path for rate increases that is “early and gradual” rather than one that is “later and steep”.
Last week, she went as far as to say that “the economy cannot only tolerate but needs higher rates”. That is an unusually hawkish choice of words for a Fed Chairman who is usually viewed as a dove.
Ms Yellen has been supported in this shift by her main lieutenants, including Stanley Fischer, William Dudley and John Williams. Paul Krugman says that the reasons for this shift are “mysterious”, and certainly they were not fully spelled out in last week’s Congressional testimony, which focused on the usual debates about the labour market and inflation.
If the FOMC is intent on staying the course of their recent slight hawkish tilt, then today’s meeting will be an important opportunity to lay the ground work for a September hike. Yellen & Co. do not want the first rate hike in almost a decade to be a surprise for the market. Therefore it will be crucially important for the Fed to clearly prepare the markets for a September hike.
The more important question is whether there are any cold feet at the Fed. Gavyn Davies’ article was written mid July and the Federal Reserve committee members have been in a self imposed blackout period before today’s meeting. We do not know if the recent developments in China and the commodities collapse have influenced the Federal Reserve to delay lift off or not.
To some extent, the markets are confused about the Fed’s recent message. For the longest time the Fed made it clear that any rate hikes would be dependent on both an improving labour market and a return of inflation to the target rate. Although some pundits will claim the labour market is not nearly as healthy as the numbers indicate, let’s take the improving employment picture at face value. If the Fed was setting their monetary policy based on the labour market, then there is no doubt the time to hike has long past. But the labour market is usually only used as a tool to set monetary policy because a tightening labour situation has traditionally led to inflation. The Phillips curve predicts that as employment improves, inflation will rise. Yet most economists agree the Phillips curve no longer has much predicative value. Not only that, Yellen has made the plight of the average worker her raison d’être. She has stated helping Main street is her main objective (from a recent Yellen speech):
The Fed provides this help by influencing interest rates. Although we work through financial markets, our goal is to help Main Street, not Wall Street. By keeping interest rates low, we are trying to make homes more affordable and revive the housing market. We are trying to make it cheaper for businesses to build, expand, and hire. We are trying to lower the costs of buying a car that can carry a worker to a new job and kids to school, and our policies are also spurring the revival of the auto industry. We are trying to help families afford things they need so that greater spending can drive job creation and even more spending, thereby strengthening the recovery.
When the Federal Reserve’s policies are effective, they improve the welfare of everyone who benefits from a stronger economy, most of all those who have been hit hardest by the recession and the slow recovery.
Given her sympathy to the plight of the average American worker it is interesting she has suddenly become convinced the time to raise rates is upon us. There is still precious little wage inflation. American workers are not yet enjoying the fruits of the Fed’s largesse.
And the Fed’s favourite inflation gauge, the core PCE, is showing no signs of being anywhere near the Fed’s target.
In early 2012 Bernanke took all sorts of heat for not withdrawing liquidity when the PCE rate ticked above 2%. At the time the inflationistas were predicting the start of runaway inflation. Yet Ben held tough. Within a year inflation had collapsed and his decision not to panic seemed particularly astute.
Well, I guess some would say his decision not to panic seemed astute, others would argue he sowed the seeds for the inflated financial markets we are now experiencing. Bernanke firmly believed any policy mistake would be withdrawing liquidity too early, not the other way round.
Up until Yellen’s recent policy shift the current Fed shared a similar view. But it seems like Yellen has succumbed to the hawkish FOMC members who think “zero was an emergency rate, and the emergency has long past.” They want to raise rates just to get off the zero bound.
I am not judging what monetary policy is right or not, but the current policy stance is inconsistent. If the Federal Reserve was about to get religion and allow the business cycle to take its course, and allow the purging of bad debts through a credit destructive recession, then I would understand the Fed’s desire to raise rates. All the hard money guys would love this outcome.
We could purge the system of the bad debts, clean it all up and start again. But the pain would be worse than watching a Kevin James movie marathon. There is no way society would be willing to suffer through the years of restructuring.
Given the massive worldwide over indebtedness, there is only one way out – inflating it away. Pretending otherwise is just naive.
When the Fed mouthes words about raising rates, they are fooling themselves. They cannot raise rates in any meaningful way. The moment they do, the economy will collapse back in on itself. In fact, I contend they don’t even need to raise rates for this to happen. The recent commodity collapse and the worldwide economic slump is the result of the Fed stopping the expansion of their balance sheet, along with threat of higher rates.
The longer the Fed pretends it will execute relatively prudent monetary policy, the more likely a deflationary vicious cycle will take hold. We all know there is no way the Fed will stand tough as the unwind accelerates, so why even bother? Why does Yellen feel the need to raise rates with inflation running significantly below target? The Federal Reserve has never started a tightening cycle with inflation below their target rate, so why start now?
I can only surmise the Fed does not understand the full extent of the balance sheet recession they are facing. Bernanke did, but he is gone. The current Fed believes this cycle is no different than all the previous cycles. And maybe they are right, but I doubt it.
Ever since the 2008 credit crisis, every Central Bank mistake has been in raising rates too soon, not the other way round. The US does not understand the damage their slowing of liquidity is having on the rest of the world. The longer they remain oblivious to this fact, the uglier the ultimate unwind will be. The more the Fed traipses down this tightening road, the quicker they will be forced to come rushing back to the rescue with QE4.
If Yellen continues to kowtow to the hawkish wing of the FOMC, the market will panic and test her resolve. And then, in the midst of the selling, the FOMC will of course fire up the printing press. So if they aren’t going to have the stomach to sit through the pain, why bother raising rates in the first place?
Thanks for reading,