According to a Wall Street Journal survey, 97% of business and academic economists expect the increase is inevitable, as some 80% of respondents believe the Fed's credibility would be damaged if it doesn't finally act. Earlier this month, in her congressional appearance, the Chair Janet Yellen testified that the U.S. economy “is doing well and that is the reason that it is a live option for us in our December meeting to discuss…whether or not it’s appropriate to raise rates.”
It is interesting that Fed’s October minutes stated that:
“The U.S. financial system appeared to have weathered the turbulence in global financial markets without any sign of systemic stress. Most participants saw the downside risks arising from economic and financial developments abroad as having diminished and judged the risks to the outlook for domestic economic activity and the labor market to be nearly balanced.”As an aside, one must say that such claims appear ill-considered and surprising particularly since they remain unchallenged by the media and experts. It must be quite clear that they cannot be factually correct, as nobody can claim to have a model that can realistically measure all the possible risks and their directions. This is not a Black Swan argument. We know that the macro models are not very well specified, simply because there have not been enough observations that would allow for control of the impacts of various QEs, zero- and-negative interest rates, global shocks and behavioral and policy changes – just to name a few (and assuming that we have a right theoretical model- which is a big assumption). Furthermore, we do not know what are the distribution shape of various arguments in our risk functions and so on. A more careful statement would have read: “most participants ‘felt’ or ‘hoped for’ …”, which of course would be a psychological statement.
For start, let me be clear that in my view the rate increase is necessary, because the low rates have been distorting the economy and have created dangerous imbalances, particularly unsustainable level of debts. However, to raise the policy rate by 25 basis point at this time would not send any useful signal and, for the reasons that I would elaborate later, could be a wrong move. A policy normalization would only make sense when the markets know what the normal level is and how fast is the speed of adjustment toward that level. If the Fed moves 25 basis point this coming Wednesday and then remains inactive in 2016, or even if it undertakes two other moves by the end of the next year to level of 1.25 per cent (assuming that it would be possible) one cannot claim that the policy would be normalized and the harmful impact of imbalances on saving, investment and productivity will be healed. In fact, the October minutes of the FOMC implicitly agrees with the above reasoning.
The minutes report that participants
“indicated that the expected path of policy, rather than the timing of the initial increase, would be the more important influence on financial conditions and thus on the outlook for the economy and inflation, and they noted the importance of underscoring this view at the time of liftoff. “This point then was later emphasized by Ms. Yellen in her remarks at the Economic Club of Washington, on December 2nd, when she stated:
“what matters for the economic outlook are the public's expectations concerning the path of the federal funds rate over time: It is those expectations that affect financial conditions and thereby influence spending and investment decisions.”
And yet, the Fed has not provided any clue about the likely path of the policy rate. The FOMC minutes vaguely reported that:
“During their discussion of the likely path for the federal funds rate after the time of the first increase in the target range, participants generally agreed that it would probably be appropriate to remove policy accommodation gradually.”However, when one sifts through the qualifiers such as ‘generally agreed’, ‘probably be appropriate’ and ‘gradual’ removal of the policy accommodation, the statement about the path becomes a totally vague statement of intention. Even this level of vagueness has been nuanced even more in the next sentence to render it even somewhat less clear:
“It was also emphasized that, while participants' most recent economic projections suggested that a gradual increase in the target range for the federal funds rate will likely be appropriate to support progress toward the Committee's dual objectives, monetary policy adjustments ultimately would be dependent on economic and financial developments. These adjustments thus could be either more or less gradual than the Committee currently anticipates”.On this point Ms. Yellen was at least a bit more forthcoming in her speech informing the public that:
“In this regard, the Committee anticipates that even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run. Fed should raise the rate when it can be reasonably confident that the pass toward normalization and subsequent rate rises is open – this is not so at the present time.”Note that, according to her the target rate would be below the ‘normal’ by some unspecified amount and for some indeterminate time. This clearly shows that the upcoming 25 basis point increase on December 16th does not contain any information about the likely path of normalization. Indeed, in this juncture with the benchmark crude oil price below $36 a barrel, mounting pressures in the U.S. high-yield bonds and the signs of the likely burst of stock price bubbles, what could be the a likely path toward equilibrium interest rate? The answer -- any path would be a possibility.
The Fed’s chair has informed us that:
“With respect to longer-run trends, the staff noted that multiyear averages of short-term real interest rates had been declining not only in the United States, but also in many other large economies for the past quarter-century and stood near zero in most of those economies.”Unfortunately , this statement appears somewhat confused, since the equilibrium real rate of interest is a long-term concept, relating to the rate of growth of potential output. It is hard to believe that the the potential output growth is now close to zero in the U.S. and many other large economies. Let’s assume, a la Friedman, that over the longer term there is no reason for the velocity of money to be unsettled, then the Wicksellian equilibrium real rate of interest would be exactly equal to the rate of growth of potential output. It is noteworthy that the concepts such as short-term or long-term rates of interests are usually related to the concept of yield curve. In other words, once we find out the Wicksellian rate of interest we can apply various theories of the term structure of interest rate to specify the yield curve. However, as far as the monetary policy is concerned we only need to find out what the long term equilibrium level of the policy rate is (i.e., Fed funds rate, which of course is at the very short end of the term structure).
Thus, when Ms. Yellen continues in her remarks to say that
“Moreover, economic theory indicates that the equilibrium level of short-term real interest rates would likely remain low relative to estimates of its level before the financial crisis if trend growth of total factor productivity does not pick up and if demographic projections for slow growth in working-age populations are borne out.”She is simply suggesting that the rate of growth of potential output is expected to remain low, because of the low growth rates of total factor productivity and population growth. So assuming a potential growth of about 2% and an inflation target of 2% the Wicksellian equilibrium interest rate would be about 4 per cent. Let’s assume that for a number of special factors the equilibrium rate is 100 basis points lower, i.e., 3 per cent. Thus, the Fed fund must reach 3 per cent for the economy to be considered as normalized. Note that in this regard the equilibrium yield curve must shift upward in a parallel fashion by 275 basis point, assuming all other things remain the same of course.
Thus, it is hard to believe that an extra 25 basis point move, that would raise the policy rate to 0.5 per cent, will provide any signal about the path of normalisation, particularly when the situation in Europe and China is so precarious and the global equity markets have become more volatile losing about $2.5 trillion in the last two weeks. The more likely scenario is a heightened level of uncertainty and a possible financial crisis when this season's holidays are over. Such developments will produce a diametrically opposing path for the policy rate -- towards negative rates.
Yet as I have argued before there is a need to normalize the market and remedy the distortive impacts of the zero interest rate policies. To do this the authorities need to realize that we are living in the proverbial global village and we need a coordinated global effort to correct this mess. This is a positive-sum game for every region, so there is a realistic chance of success in any such negotiation. The only group that may suffer the cosequences would be those large financial entities that have lent imprudently and contributed to the creation of the current imbalances
