How the Federal Reserve will normalize the benchmark interest rate after its FOMC meeting of July 26-27

Despite the low probability that markets attached to a July rise of the target range for the benchmark federal funds rate, there was a good chance that Fed would have used the July window to raise the range to 50-75 basis points from its current 25-50 level. Given the ongoing presidential electoral campaign, Brexit-negotiation uncertainties, and the economic outlook in China and Japan; July meetings offered the only window for policy action in contrast to September or December schedules, that notwithstanding the high probabilities that markets attaches to them, appear quite problematic. In fact, with apparent improvements in the inflation rates and some economic data since late-June including the non-manufacturing ISM, employment, retail sales, industrial & manufacturing output, and existing home sales Fed appears to have been in a good position to send a serious message about its resolve to move toward policy normalization.

After seven years at the zero lower bound, the target range for Fed funds rate was raised by 25 basis points in December 2015. At the time the data were exhibiting similar improvements and yet the increase triggered some global market volatility earlier this year that could have been predicted.

In fact, last September we wrote;

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 reason for the needed higher rates as we have stated in the past was that:

[T]he low rates have been distorting the economy and have created dangerous imbalances, particularly unsustainable level of debts.

We have argued that:

Unfortunately under today’s “currency wars” conditions, with the slowdown in China, and Europe’s debt crisis, as well as huge debt build up by consumers and states the normalization of monetary supply in any single country, as an isolated and uncoordinated action, would be a recipe for disaster,

and in particular have emphasized that:

Policy makers should realize how important the role of capital formation in the supply side is. They should realize that for a successful working of international trade currency values, like any other price signals, must be informative about their relative purchasing power, and these can only be discovered in transparent markets, where the fundamental relationships between financial assets and the real sectors are respected -- where the banks are healthy and tax payers are not on the hook for the rescue of Too-Big-to-Fail zombie banks.

Last September we argued that;

[T]o raise the policy rate by 25 basis point at this time would not send any useful signal and (...) 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.

On May 19 the Federal Reserve Bank of New York has introduced a data product entitled  U.S. Economy in a Snapshot ,  that in the words of its president William Dudley is supposed "to provide information that helps households and businesses follow the data along with the Fed." Unfortunately. the package is silent about how to organize these data so that one can follow the Fed. One may argue that Fed itself is still struggling with the challenge of calculating the unobservable neutral rate. Mr. Dudley has explained that:

Conventional U.S. monetary policy is conducted by targeting the level of the federal funds rate—an overnight interest rate on bank reserves. Few participants in our economy have any direct interaction with this interest rate. How, then, is controlling this interest rate such an important part of setting monetary policy and steering an 18 trillion dollar economy toward the Federal Reserve’s dual mandate objectives of maximum sustainable employment and price stability? (...)

When asked about the trajectory for the monetary policy stance, I always point out that it is data dependent. The FOMC calibrates the stance of monetary policy to best achieve our twin objectives of price stability and maximum sustainable employment, taking into account our forecast for how the economy is evolving. This forecast reflects the ongoing flow of the data. Data releases that are close to our expectations have little additional impact on the forecast, while data releases that deviate significantly from our expectations can lead to more significant revisions of the forecast. It is, therefore, important for market participants and households to be able to follow the data along with the FOMC and to understand how we are likely to interpret and react to incoming data.

What does it mean to say that the monetary policy stance is data dependent? Simply put, it means that the Fed funds overnight interest rate, as the main policy instrument of the monetary authority, is determined in relation to the interactions among a whole set of data. It is the movement of the key macroeconomics variables and their impacts on each other that determines the equilibrium neutral rate.

In fact, a quick glance at the New York Fed's aforementioned and very useful publication reveals that it contains about 60 time series data depicting movements of various macroeconomics variables. How then one should look at these data, and how can one interpret their seemingly inconsistent movements at certain times in order to project the likely direction of the Fed funds rate?

How to project the likely direction of the Fed funds rate?

There are a number of ways that one could organize the key macroeconomics data. The most familiar way is to specify and estimate a small structural model. However, as we have argued before, in the aftermath of the financial crisis:

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.

Thus, an alternative way would be to use Bayesian priors and specify a calibrated structural model, that can be updated in a Bayesian learning process. Finally, one may choose a small subset of perhaps about 10 variables in a Bayesian Vector Autoregressive (BVar) model, or one of its variants that would determine with some probability how much the policy instrument is needed to be changed in order for the model to stabilize at a certain inflation target range and output growth level.

With this in mind, it is surprising that most often the discussions of the likely trajectory of interest rates setting by Fed is presented in various types of partial equilibrium analysis. Typically, many analysts employ a Wicksellian paradigm of natural rate of interest, which as we will argue later is totally irrelevant for analyzing a severely imbalanced economy, such as those of many advanced countries in North America, Europe and Asia. Moreover, at times the monitoring of various variables are presented outside any structural or time series model in an ad hoc fashion. For example Esther George, the president of the Federal Reserve Bank of Kansas City, in a May 12th speech in Albuquerque, N.M., reporting a decline to 5 % in the unemployment rate, from 10% in the aftermath of the financial crisis in 2009 has stated:

Of course, the unemployment rate is an imperfect measure of the labor market, so I also pay close attention to other data. For example, one development I find promising is that many individuals who had dropped out of the workforce are finding jobs. After the crisis, the percentage of people participating in the labor market fell sharply. Some of this is because our population is aging, so people naturally work less as they get older. However, some of the decline in labor force participation was due to workers being discouraged about their job prospects. More recently, however, we have seen an upswing in people finding jobs who had previously stopped looking for one. For example, close to 2 million workers returned to the labor force over the past six months. This pace of re-entry is close to the fastest pace in more than 15 years. Despite these positive developments, wage growth has remained sluggish and many people still feel like they have limited options in the labor market.

She then goes on to describe two business perspectives in the labour market,

One perspective is of a booming labor market, rising wages and an abundance of opportunity. The other perspective is of stagnant wage growth, limited upward mobility and job insecurity.

Relating the second perspective to a sharp decline in the share of workers in middle-skill jobs she argues that

As the Federal Reserve considers these and other economic trends, it must weigh a number of crosscurrents to determine the appropriate interest rate policy. In the shortrun, I continue to monitor how the energy, agricultural and manufacturing sectors are adjusting relative to the national economy. And over the longer-run, I evaluate what trends like job polarization mean for monetary policy.

Nevertheless, without specifying what would be the prevailing equilibrium long-run Fed funds rate, she concludes by stating that:

The current setting for the federal funds rate is well below what the FOMC expects will prevail in the longer term. The plan is to move gradually and in a way that is responsive to economic developments. I support a gradual adjustment of short-term interest rates toward a more normal level, but I view the current level as too low for today’s economic conditions.

The problem with this type of analysis is that if businesses are shifting towards intensive margin mode of the production due to uncertainty, using more labour intensive techniques in their short-term capacity planning, for example by introducing additional labour shifts or hiring contingent workers instead of investing in irreversible fixed capital, then the fact that many of the dropped out workers from the labour force are finding jobs would not be that promising.

Ideally of course the impacts labour participation rate, discouraged workers, or wage growth could be incorporated in a structural model, or alternatively the Fed can run small satellite models to estimate and inform the market of their likely impacts. These variables would affect the other key macroeconomic variables such as capital formation, capacity utilization, productivity, terms of trade; to name just a few. A partial equilibrium analysis ignores many of these impacts when the trajectory of these omitted variables under various scenarios can drastically alter the nature of analysis and the outlook.

As a result of ignoring the situation of uncertainty as well as not taking into account the impact of the businesses' shift to intensive margin mode of production as well as delays in investment plans President George in her speech in Oklahoma city of July 9th, 2015 had been too optimistic about the capital expenditure outlook, stating that:

Moreover, as the economy continues to heal and domestic demand continues to strengthen, businesses should have more incentives to increase capital expenditures.

As we know, this prediction of course has not come to pass as according to the most recent New York Fed's snapshot of the US Economy in July:

Over the four quarters ending in 2016 Q1, real business investment in new equipment was down 0.3%, continuing a slowing trend in place since 2010. (...) A key reason for the overall slow pace of growth of investment in new equipment is relatively low level of the manufacturing capacity utilization rate. This rate which had been slightly above 75% for over a year, dipped below 75% in May. Historically, robust growth of investment in new equipment is associated with a capacity utilization rate of 80% or higher.

As we have argued in September last year 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.

This structural approach would reveal that the question of capacity utilization rate needs to be carefully reevaluated. The nature of full capacity under contingent capital and intensive margin would result in a shift of the full capacity potential to the left along the economy's long-term average cost curve. The resulting short-run equilibrium would be different from the long-term equilibrium capacity. Furthermore we specifically stated that:

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

Unfortunately in spite of recognizing that the long-run level of the neutral rate is highly uncertain many analysts, including some of the FOMC members, still focus on it. It appears that some even focus the highly volatile short-term rate. For example, the FOMC's minutes of the June 14-15 meeting reports that:

Many participants commented that the level of the federal funds rate consistent with maintaining trend economic growth—the so-called neutral rate—appeared to be lower currently or was likely to be lower in the longer run than they had estimated earlier. While recognizing that the longer-run neutral rate was highly uncertain, many judged that it would likely remain low relative to historical standards, held down by factors such as slow productivity growth and demographic trends.

It should be clear that it is not slow productivity growth that is holding back (the long-run) neutral rate. The direction of causality is the other way around. The prevailing low interest rate gives the impression that the neutral rate has declined, and at the same time they cause a delay in capital information, via a rise in uncertainty that low rates are causing. Low capital formation reduces the trend productivity, although due to intensive margin operation we may observe some transitory short-term productivity increase. As we have argued in the past, the neutral or natural rate of interest derived from the Wicksellian theory is only valid in the long run general equilibrium conditions. We stated that:

[T]he Wicksellian theory is a general equilibrium theory in which the financial rate of interest that borrowers actually pay must be equalized to the natural rate of interest that is determined by the marginal return on the fully employed real capital. If the financial rate is below the natural rate the demand for investment will rise as businesses can borrow at the lower financial rates and invest the funds into high-returning projects. However, the information signals that a Wicksellian paradigm could emit are not meant for a disequilibrium environment in which the real capital is underutilized and businesses are postponing investment in irreversible fixed capital and opt for waiting.
When due to the prevailing uncertainty businesses refrain from investment and when in their capacity planning they resort to utilizing contingent labour and capital instead of moving towards their long term minimum average cost capacity the Wicksellian equilibrium theory would be an inappropriate analytical framework. In fact, the concept of the natural rate of interest in a disequilibrium environment would be an oxymoron.

-- The introduction to this piece is slightly modified to take into account the Fed's inaction on July 27th.

The UK's Low Corporate Tax Rate; Will it Attract Investment?

What are the merits of George Osborne’s slashing of the UK’s corporation tax rate? In the previous coalition government he reduced both the main corporation tax rate (from 28% in 2010) and the small profits rate (from 21% in 2010) to 20% in 2015–16. After the Brexit vote the chancellor has argued for a drastic reduction of the rate to below 15 per cent in order to demonstrate that Britain is “open for business” to international investment? In an Opinion piece published on the Wall Street Journal , on July 10, Mr. Osborne wrote:

Now we intend to offer even more competitive taxes, and to become a home to more, not less, international business. To signal our intent, we will cut our corporate tax rate still further. It was already set to reach 17% from the 28% rate I inherited six years ago; now I want it to fall to 15% and preferably lower. What stronger message could we send that Britain is open to business?

 Will the lowering corporate tax policy improves British industry's competitiveness and enhance its productivity? Or would it likely exacerbate a zero-sum international race to the bottom between governments on tax rates as some have argued it would?


There has been a tendency throughout the advanced countries to reduce corporation tax rates since the stagflation of 1970s as the policy makers have tried to improve competitiveness and expand export markets. This tendency has been the most striking in the UK, where since 2010, it has cut tax rates deeper and at a greater speed than her competitors,  to the extent that as the following chart shows the rate is now among the lowest in the G20, and as we saw earlier may become the lowest if other countries do not respond.

Corporate Tax Rates Across G20

Source: IFS

As we have argued last August, the British economy is plaggued with underinvestment which is hampering its productivity growth and its competitiveness. Corporate tax rate reductions that are not being tied to the companies' investment in innovation and agility will just deteriorate the fiscal stance of the country and will add to uncertainty which would discourage capital expenditures.

Sources of Growth in the UK economy 

(year-over-year growth rate)

Source: Hover

The above chart indicates that UK investment has been decelerating at an alarming pace since the first quarter of 2015. As we have argued before, because of businesses’ utilization of contingent capacity the UK productivity has been misleadingly signaling some artificial improvements.  We argued:

This is because in planning for capacity during uncertain times businesses usually postpone their irreversible component of investment and utilize intensive margin production processes. As a result of this focus on short-term capacity corresponding to existing cost structure the longer-term capacity signals will be hidden. (...)

We argued that consistent with Ben Bernanke’s option price of waiting it would be quite rational for businesses to postpone their strategic investment plans at uncertain times and focus instead on their contingent capacity limits, which would result in transmission of inconsistent and misleading signals on capacity utilization rate and productivity improvement. A misinterpretation of these signals by policymakers would deepen and prolong uncertainty.

A corporate tax reductions cannot eliminate or mitigate such uncertainties and in contrast it may just add to them if other countries would retaliate by lowering their tax rates. In the meantime productivity growth — defined as the rate of change of output minus rate of change of hour worked — may continue to send false rising signals misinterpreted by policymakers as the indication that markets have agreed that the economy is open for the business and that the businesses are investing in innovation and competitiveness to expand the production possibility frontier. Whereas in reality because of postponement of real investment and utilizing contingent capacity the economy is falling behind.

Corporation Tax Rate In Selected Countries. Source: KPMG

UK's Corporation Tax Rate, 1981-2016

Germany's  Corporation Tax Rate, 1996-2016

US' Corporation Tax Rate, 2001-16

Why Interest Rates Are So Inconceivably Low?

In a recent article in the Washington Post professor Larry Summers has argued that the fact that the U.S. 10- and 30-year interest rates reached all-time lows of 1.32 percent and 2.10 percent on July 6th this year, as well as the record-low 10-year interest rates in Germany, France, Switzerland and Australia reflect a heightened recognition of the importance of the “Secular Stagnation” risks. He wrote:

There is a growing sense that the world is demand-short — that the real interest rates necessary to equate investment and saving at full employment are very low and often may be unattainable given the bounds on nominal interest rate reductions. The result is very low long-term real rates, sluggish growth expectations, concerns about the ability even over the fairly long term to get inflation to average 2 percent, and a sense that the Fed and the world’s major central banks will not be able to normalize financial conditions in the foreseeable future.

Thus, theoretically speaking, according to professor Summers the configurations of the supply and demand functions for investment funds now suggest a very low real interest rate  (most probably implying a negative rate at the full-employment level) which is unattainable due to the close-to-zero lower bound nominal rate. This argument as previously laid out by him and his co-authors Eggertsson and Mehrotra in Secular Stagnation in the Open Economy (NBER Working Paper No. 22172, April 2016) is based on Alvin Hansen’s idea of secular stagnation suggesting that:

the industrial world is plagued by an increasing propensity to save and a declining propensity to invest. The result is a declining equilibrium real interest rate, a tendency for lower bounds on interest rates to constrain their ability to find equilibrium levels, and a consequent persistence of inadequate demand leading to slow growth, sub-target inflation, and excessive non-employment.

Believing that the sluggish growth and low inflationary expectations are consequences of these low long-term real interest rates, Summers expresses concern that:

policymakers still have not made sufficiently radical adjustments in their worldview to reflect this new reality of a world where generating adequate nominal GDP growth is likely to be the primary macroeconomic policy challenge for the next decade.

But why there is an increase in global propensity to save? Are the interest rates providing relevant signals about the global saving propensity at the current sluggish economic environment? Moreover, what is the rationality for this bizarre economic agents' inter-temporal choice in such uncertain times? We note that Professor Summers' argument is grounded on the Swedish economist Knut Wicksell's thory of "Natural Interest Rate". Substituting the term "neutral rate" for the Wicksellian "natural rate" concept, he writes:

Secular stagnation occurs when neutral real interest rates are sufficiently low that they cannot be achieved through conventional central-bank policies. At that point, desired levels of saving exceed desired levels of investment, leading to shortfalls in demand and stunted growth.

We note that the Wicksellian theory is a general equilibrium theory in which the financial rate of interest that borrowers actually pay must be equalized to the natural rate of interest that is determined by the marginal return on the fully employed real capital. If the financial rate is below the natural rate the demand for investment will rise as businesses can borrow at the lower financial rates and invest the funds into high-returning projects. However, the information signals that a Wicksellian paradigm could emit are not meant for a disequilibrium environment in which the real capital is underutilized and businesses are postponing investment in irreversible fixed capital and opt for waiting.

When due to the prevailing uncertainty businesses refrain from investment and when in their capacity planning they resort to utilizing contingent labour and capital instead of moving towards their long term minimum average cost capacity the Wicksellian equilibrium theory would be an inappropriate analytical framework.  In fact, the concept of the natural rate of interest in a disequilibrium environment would be an oxymoron. The low and negative interest rates, are the prices savers are willing to pay to have access to a relatively less risky liquidity in these uncertain times. The factors influencing such inter-temporal preference is derived from a risk aversion motive.

As we have argued in the past, the economic agents are concerned about the precarious state of the global finance, the banking frailties, the high levels of various global debts, and a fast spread of political uncertainty. The sluggish growth and lack of demand are the consequences of a very disorderly structural adjustment in a perilous financial environment in which the old rules of the game have been abandoned and no new rules have yet been established.

The low interest rate thus is an indication of market assessment of the growth rate of potential output. As the following chart from Quartz show we have been in this situation also in the depression of 1930's.

This blog has referred in the past:

 “ to the suggestions of the prominent Swedish economist Gustav Cassel who in Brussels conference had recommended a re-balancing of the world flow of funds based on Purchasing Power Parity. A Cassel type of PPP adjustment does not necessarily require a gold-standard regime. A return to a Purchasing Price Parity can be grounded on a composite index of industrial materials. This process would create a realistic correspondence between the nominal world of finance and the real world of goods and services. A global annual GDP of 75 trillion dollars does not need to be lubricated by 600 trillion dollars of toxic assets."

We have also emphasized a need for restructuring of global debt and a need for a new global Marshall-type plan.  We also reminded the readers that:

in the eve of the London conference of 1933, the British Prime Minister Ramsay Macdonald, who understood the significance of the need for a global restructuring to establish a global financial balance, opined that the conference might possibly save democracy from the world’s economic challenges.”

Will the Global Economy Survive the Brexit

  Pavel Constantin,  Romania, June 22, 2016 Caglecartoons.com,

UK's vote to become the first country to leave the EU, has the potential to start a motion that could unravel the post-war global financial structure and with it a deep plunging of the global growth. To be clear, the Brexit itself is not the culprit as we have argued before the global financial system has been in an extremely perilous situation over the past decade.

It is unfortunate that Brexit has happened in such  uncertain times when the US political situation is in such a precarious state  with the two highly  divisive presidential candidates; of whom one   is so out of touch with the global economic fundamentals that he constantly adds to the prevailing uncertainty by his uniformed and misguided policy statements and the other’s “extremely careless” use of a private email address and server has been mischievously exploited to render her as a completely ineffective leader, should she win the election. Meanwhile, the US economy is slowing down and a significantly higher dollar, partially reflecting the increased global risk, is exacerbating the global economic disorder.

In Asia, both China and Japan's economic and political situations leave a lot to be desired. A tepid global demand is intensifying the adverse impact of Brexit on Chinese exports at the time when the rise of dollar, vis-à-vis Europe’s currencies, may force China to react yet again by allowing a more rapid depreciation of its renminbi, which is scheduled to be included in the IMF’s basket of currencies making up the Special Drawing Right (SDR) effective October 1, 2016.  The country’s growth, after averaging almost 10 percent between 2006 and 2014, slowed to 6.8 percent in 2015 and it may slow to about 5.8 percent this year.   The  promised economic restructuring and the consolidation of inefficient state enterprises with chronic oversupply now appear of remote possibility, while the probabilities of political and social unrest should not be underestimated.

Japan’s economic malaise is also worsening and Abenomics appears dead after the Brexit.  A frightening fiscal debt level, a stagnant economy and an ineffective monetary policy with a damaging negative interest rate must now deal with the consequences of an appreciating yen against several currencies which will reduce its exports,   weigh heavily on its industrial sector’s earnings and undermine the country’s domestic investment prospects.

Of course, the brunt of the Brexit mishap will be felt mainly in Europe, and particularly in the UK where British pound has plunged to hit a record low of $1.28 since June 1985. The pound also fell to a near three-year low against the euro at €1.17. On the stock market, shares in domestic companies, such as supermarkets, housebuilders and banks, took the biggest hit on July 6^th after the Bank of England unveiled a four-point plan to cope with the Brexit crisis. With the economy dependent on his ability to act quickly, decisively and with full access to information, governor Carney provided a timely reassurance that “The bank can be expected to take whatever action is needed to promote monetary and financial stability, and as a consequence, support the real economy.” This was a reminiscent of the 2012 Mario Draghi’s pledge to do “whatever it takes” to save the euro, which has only been successful as far as it has postponed the day of reckoning for euro.   The bank of England has eased special capital requirements for banks, providing an estimated extra £150bn for lending, which would not be nearly enough to prevent the risk of a global contagion.

Of course, the answer to Brexit cannot be monetary policy.  The limits of central banking in Japan, Eurozone, and the US have already been observed. The answer to Brexit is not even in the hands of Europeans ( the UK included). The world global financial disorder requires an urgent restructuring to get rid of the global toxic debts, establishment of a purchasing-power-parity-based exchange rate system, and a Marshall-type plan to invest on global digital infrastructure, renewable energy, and eradication of poverty and diseases. Unfortunately, the world is faced with lack of credible and visionary leaders to push for such an agenda.