After more than six years of near zero interest rates, the U.S. Federal Reserve is pondering on the merits of a move towards policy normalization. Despite the turmoil in China’s economy, the ongoing uncertainties in Europe, tumbling commodities and volatile stock markets authorities express confidence that the American economy is getting close to equilibrium, and a rise in interest rate is warranted by the end of this year.
This urge to raise the benchmark federal fund rate started earlier this year when Fed deleted a forward guidance signal from its communique in order to indicate its intention for a mid-year rise in interest rates. The FOMC that had been saying it would be “patient” before the commencement of a tightening phase wiped out that qualifier in March, but indicated that it was looking for “further improvements in the labor market” before an increase in interest rates would be appropriate.
The FOMC had given some signals about its long-term goal following its meeting in January 2012, when issued a statement informing the market participants that the Committee judges that inflation at the rate of 2 percent (Based on the price index for personal consumption expenditures, PCE) is most consistent over the longer run with its mandate. By the end of 2012, the Committee signaled that low rates would be appropriate “at least as long as the unemployment rate remains above” a threshold of 6.5 percent, again reassuring the markets that this guidance was consistent with low rates persisting at least until mid-2015. Finally, in the FOMC's June 2015 Summary of Economic Projections, its estimates of the longer-run normal rate of unemployment had a central tendency of 5.0 to 5.2 percent, and in August, the unemployment rate fell to 5.1 %.
In his recent Jackson Hole speech Stanley Fischer, the Fed Vice Chairman, stated:
Although the economy has continued to recover and the labor market is approaching our maximum employment objective, inflation has been persistently below 2 percent.In this note I argue that the Fed's estimate of longer-run normal rate of unemployment is not consistent with the US investment in capital formation, The appearance of a gradual decline in the US economy's slack is attributable to a greater use of contingent labour and contingent capital, due to the prevailing global uncertainty. The economy is being distorted by the zero-interest rate policy and is not getting closer to its long-term equilibrium. The use of contingent production factors has generated a quasi-closing of the gap in reference to a quasi-potential output growth, which corresponds to Klein (1960) and Berndt and Morrison (1981) definitions of capacity. This is why this quasi-closing of the gap has not exerted an upward pressure on the US inflation rate. The exploration of these issues would help us to understand where the US economy is headed for?
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Of course, ongoing economic slack is one reason core inflation has been low. Although the economy has made great progress, we started seven years ago from an unemployment rate of 10 percent, which guaranteed a lengthy period of high unemployment. Even so, with inflation expectations apparently stable, we would have expected the gradual reduction of slack to be associated with less downward price pressure.
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In making our monetary policy decisions, we are interested more in where the U.S. economy is heading than in knowing whence it has come. That is why we need to consider the overall state of the U.S. economy as well as the influence of foreign economies on the U.S. economy as we reach our judgment on whether and how to change monetary policy.
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With inflation low, we can probably remove accommodation at a gradual pace. Yet, because monetary policy influences real activity with a substantial lag, we should not wait until inflation is back to 2 percent to begin tightening. Should we judge at some point in time that the economy is threatening to overheat, we will have to move appropriately rapidly to deal with that threat.
Following the financial crisis, the Fed lowered its benchmark federal-funds rate to near zero in December 2008, communicating its assessment that exceptionally low interest rates would be appropriate “for some time,” and then for “an extended period.” In August 2011, the “forward guidance” language was modified to calm market anxieties by signaling a date before which an increase in the federal funds rate was unlikely. As the economy’s performance was disappointing, that date was moved forward several times thereafter, settling eventually at the mid-2015.
Those economists who still believe in the legislative power of market warned from the start that these kinds of interventionist policies will only distort the economy. Long period of ultra-loose monetary policy has triggered global mispricing in financial and goods and services markets, discouraging capital formation and adversely impacting the potential output, Larry Summers’ secular downward trend was basically Central-bank-made stagnation policy which has prevented the equilibrating market forces to do their jobs. As the classical theory suggests the very low or negative “natural rate of interest” reflects the very low or negative expected growth in potential output, and this is the main driver of the increased demand for the safety of U.S. Treasury securities, which would raise longer-term interest rates.
Of course, globalization implies that these distortions are also globalized, thus in the absence of a global coordinated policy domestic monetary policy cannot mitigate this predicament. Global economic dynamics are contaminated by distorted global linkages through commodities, trade and finance. The overriding risk of uncoordinated policy is to the downside — a risk that would be aggravated by a groping normalization policy.
What is the evidence?
The unemployment rate, which peaked at 10 percent in October 2009, has fallen quite rapidly. For many analysts this has been the evidence that labour markets are getting closer to equilibrium. However, economic theory suggests that a balanced growth requires a contribution from all production factors in the production process -- particularly from tangible fixed capital. As the following chart shows the US investment has been quite weak in the post-recession era.
How can the labour markets move to equilibrium with such a weak capital formation? It is quite clear that this fragile capital formation is due to the prolonged period in which businesses have postponed investment as a result of the prevailing global uncertainties which have been exacerbated by the authorities suppression of equilibrating market dynamics . Investment spending has grown more slowly than usual for a business-cycle expansion and this is the main reason for the observed decline of the US productivity.
The global uncertainty and ultra-loose monetary policies have encouraged businesses to follow strategies of incremental reductions in costs that are not accompanied by investment in new technology. This has undermined the longer-term growth of potential output, which appears to have caused a distorted and artificial decline in real interest rate, by which authorities hope to encourage entrepreneurs to assume more risk. The economic theory suggests that lack of capital formation would cause a shrinkage in production possibilities frontier, resulting in a decline in labour productivity growth as we have observed in the US (see the following chart).
The fact that U.S. businesses are hesitant to invest is also evident from the labour market data. It is clear, both from theory and empirical data that when uncertainty is on the rise businesses would be reluctant to invest in irreversible capital. They would try to meet an increased demand by employing contingent workers, this appears to be a key reason for a rapid decline in the unemployment rate. In such conditions, businesses may lease equipment instead of purchasing, or may upgrade an existing production line with used equipment. This increased reliance on contingent labour and capital is frequently the reason why firms report difficulties in finding labour.
In a slow growth environment, workers prefer to work through contingent labour agencies instead of accepting temporary jobs directly offered by firms, simply because by doing so they would enhance their working relationships with those agencies, whose repeated offering of temporary jobs to trusted workers could be regarded as reasonable substitutes for permanent jobs. This is also why participation rate has declined (roughly 3 percentage points since the end of the recession, a steep drop by historical standards), why the number of people per job openings has dropped and why the labour share of income has remained so low (see charts below). It is of note in this regard that a broader measure of unemployment that includes part-time workers, plus people who have recently left the labor force but would like to be working, was 10.4 percent in July, well above the official unemployment rate of 5.3 percent.
If economy is to move to a normal phase, and potential output together with labour markets are to be at their long-term sustainable equilibria, then strategic investment must be restored to a normal level adequate for a balanced growth.
It is stunning that how little attention is being paid to the postponement of private investment projects, and a general lack of entrepreneurial risk taking in today's investment climate. As I have argued before:
I am not of course a fan of current zero interest rate policies, and I believe these policies have distorted not only the US and European economies, but also the global economy. The Fed indeed has created a catch 22 situation; as higher rates are needed badly, but any action towards raising rates would be extremely destabilizing.The only solution at this time is a coordinated global rebalancing of financial structure and eliminating all moral hazards of guaranteeing too-big-to-fail financial institutions.
