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The Fed’s Dilemma, Explained

ten dollar billThe Federal Open Market Committee’s decision at its September meeting of whether to raise interest rates will come down to one question: how Fed officials weigh the long-term trend of economic growth versus short-term market fluctuations.

As the latest labor market report came out on September 4th, the Fed has now received all the important data that had been scheduled to come out before the FOMC’s September meeting. These economic data provide only mixed signals, calling into question the first rate increase occurring in September.

In the labor market, the latest job report shows nonfarm employers only added 173,000 jobs in August, lower than estimated, compared with 245,000 jobs added in July, 245,000 in June and 260,000 in May. The disappointing August payrolls growth could serve as a  headwind to the Fed policy firming. But this is only a one-month slowdown in hiring, and the data could be revised higher in the next month’s job report.  On the other hand, the unemployment rate fell to 5.1 percent, reflecting a healthy labor market condition in a longer-term perspective.

Another indication that the Fed weighs heavily in its policy firming is inflation. Recently, several indicators point to downward pressure on inflation, such as a strong U.S. dollar and the decline in oil prices. In the long run, however, some believe that the low unemployment rate will lead to higher prices, and additionally, the $2.5 trillion excess reserves sitting in the banking system are creating a threat of a runaway inflation in the future.

The global economy is another factor that the Fed will take into consideration. In response to the concern about economic slowdown in emerging markets, the European Central Bank on September 3rd expressed its willingness to expand the stimulus programs. This put pressure on the Fed to decide whether it should take the opposite approach — tightening policy or raising interest rates.

In the short term, global market fluctuations usually quickly spread over to the United States. Chinese currency, for instance, suddenly depreciated in the middle of August, causing large swings in the U.S. stock market. The Dow Jones Industrial Average fell about 10 percent within a week. But in the longer run, how the global economy would impact the U.S. economy is still up for debate. Since 2009, the U.S. economy has been steadily growing and gaining momentum while other economies were having difficulties.

If Fed officials believe that in the environment of short-term market turmoil, raising interest rates could magnify the market fluctuations and even cause market distortions, then the rate liftoff in September will be put on hold. But given the Fed’s longstanding commitment to raising interest rates by the end of this year, if it doesn’t take an action in September, October or December is likely to be chosen for the initial rate increase.

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  1. Excellent analysis by Dr. Jia Liu.

    One big wild card is whether the European Union member countries will try to pay for the near-term public costs of funding the new immigration wave with higher taxes or increased borrowing/sales of public debt. Most likely, the latter course will be chosen, for a year or two at least, and under current policy announcements, the European Central Bank may be expected to purchase a large part of that new public debt. Those purchases will cause expansion in the quantity of euros in circulation, which should lead to a further depreciation of the euro (currently about $1.11) against the dollar. A rate increase by the Fed would merely widen the exchange rate gap, with predictable effects on prices of traded goods and services, even inside the United States. In this environment, as long as the Fed succeeds in holding back its own excess reserves from monetary circulation, it is hard to see how inflationary pressures in the USA could increase. The Fed could find itself in the position of raising rates (or attempting to do so) while well short of its 2.0 pct. inflation goal (I’m glad that they are well short) and in a declining jobs creation environment.

    Notwithstanding my analysis here, it still might make sense for the Fed to raise rates sooner rather than later but if (and only if) the increase were part of an openly stated and credible plan to “normalize” monetary policy operations overall, with, say, a 2.0 pct. rate target over time. To be fully credible, such a plan would have to involve shrinkage of the Fed’s balance sheet (primarily, reduction of excess reserves and termination of the currently open-ended foreign exchange swap lines). The Fed could let the mortgage-backed securities component of its assets shrink passively over seven years or so simply by not rolling over (renewing) purchases of such securities as they mature or are paid off. Unfortunately, as Dr. Liu has pointed out before in public presentations, the Fed transformed the maturity profile of its Treasury securities holdings in recent years by purchasing a disproportionate share of long-term securities for its portfolio. A reasonable path for shrinkage of that part of the Fed’s balance sheet would be to stop intervening in financial markets to hold rates in positive territory when market trends would be negative. In negative territory, the Fed can sell long-term Treasury securities paying a positive yield at a profit and use the proceeds to extinguish the corresponding liabilities on its balance sheet. With enough such sales, the market-clearing rate of interest should rise back above zero and enable the Fed to resume the path of policy normalization with fewer market distortions. As for the foreign exchange swap lines, capping them or even terminating them in the current environment poses fewer obstacles than one might think because, at present, no or next to no swap line drawings are outstanding (in recent weeks, the only persistent borrowing has been about $140 million for a single European bank, probably Greek).

    As a former Federal Reserve Bank friend of mine put it to me recently, it is a shame that the Fed did not pursue balance sheet shrinkage before attempting monetary policy normalization because that failure causes greater market turbulence than really is necessary.

    In short, the Fed could raise rates sooner rather than later if it credibly committed to a course of monetary policy normalization like that described above. But the Fed cannot justify a rate increase now if officially measured inflation is weaker than the stated target (2.0 pct.) and the overall trend of jobs creation is downward. Instead, the Fed increasingly appears to be pursuing a single policy objective, the unemployment rate. — Walker Todd, Chagrin Falls, Ohio


    September 9, 2015

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