Will the Fed raise rates this September? A question of fixed rule and method.

  

'' o ere, quae res nec modum habet neque consilium, ratione modoque tractari non volt, in amore haec sunt mala, bellum, pax rursum : haec si quis tempestatis prope ritu mobilia et caeca fluitantia sorte laboret reddere certa sibi, nihilo plus explicet ac si insanire paret certa ratione modoque."

 ' My master, a thing that admits of neither method nor sense cannot be handled by rule and method. In love inhere these evils—first war, then peace : things almost as fickle as the weather, shifting about by blind chance, and if one were to try to reduce them to fixed rule for himself, he would no more set them right than if he aimed at going mad by fixed rule and method.'  --     Horace, Satires

Global economic growth has been rapidly approaching a stagflation state with the inflationary pressures being concentrated on the asset prices. There are some staggering  $11.4 trillion of global sovereign debt, primarily in Europe and Japan, carrying negative yields, while in the U.S. yields are also getting very low. The market has become quite jittery, as we saw on September 9th, when participants reacted to some hawkish comments from the FOMC members and downloaded their positions causing a half trillion dollars decline in the value of equities.

Fears of an imminent rate rise were eased three days later after  Lael Brainard, a member of the Board of Governors of the Fed, urged “prudence” in removing the central bank’s accommodative policies. Reportedly, market had anxiously expected the usually dovish Ms. Brainard might deliver a hawkish speech recommending a rise in the Fed funds rate, that has been held in a range between 0.25 to 0.5 per cent  since December.

Overall, some FOMC members appear to feel little sense of urgency about raising rates because of the low inflation, while others seem to reckon that with the labor market gap being closed the extremely accommodative policy rate is no longer warranted. The truth is that both groups are looking at irrelevant indicators and the fact that inflation is holding below the Fed’s 2 per cent target or the unemployment rate  is at 4.9 per cent are disconnected from today's globally imbalanced economic conditions that have drastically altered the transmission mechanism of monetary policy in all the major advanced countries.

In her Jackson Hole lecture, Ms. Yellen  referred to the updated estimates from the model developed by Laubach and Williams (2003) that indicate that the real long-run neutral or "equilibrium" short-term interest rate in the United States is currently about 2-1/2 percentage points lower than it was on average in the 1980s and 1990. She also referenced to a papers by Holston, Laubach, and Williams (2016) that find similar declines in equilibrium rates for the euro area, Canada, and the United Kingdom  and attributed  these declines to factors like slower growth in the working-age populations of many countries, smaller productivity gains in the advanced economies, a decreased propensity to spend in the wake of the financial crises around the world since the late 1990s, and perhaps a paucity of attractive capital projects worldwide. As we have argued in the past the  neutral rate is a long-run equilibrium concept that cannot be applied to a short-run disequilibrium situation like today's.

Theoretically the neutral rate should be equal to the rate of growth of potential output, associated with the efficient production possibility frontier, and given the incredible technological advances it is hard to believe that the potential growth rate has declined because of slower growth in working -age population which on the supply side can easily be offset by the advances of robotics and AI technologies, and on the demand side by increased demand for a wide spectrum of new smart goods and services.  All other factors in her list are stemming from a shrinkage in the production possibility frontier due to the global financial imbalances that have generated a prolong and deep uncertainty and has adversely affected the global capital formation.  

Of course, the main reason for her  focusing on the neutral rate as Ms.Yellen has articulated is to answer the following question:

 Would an average federal funds rate of about 3 percent impair the Fed's ability to fight recessions? Based on the FOMC's behavior in past recessions, one might think that such a low interest rate could substantially impair policy effectiveness. 

Then, looking at the experiences of the past nine recessions, Ms. Yellen notes that:

the FOMC cut the federal funds rate by amounts ranging from about 3 percentage points to more than 10 percentage points. On average, the FOMC reduced rates by about 5-1/2 percentage points, which seems to suggest that the FOMC would face a shortfall of about 2-1/2 percentage points for dealing with an average-sized recession. 

However, she finds this simple comparison exaggerates the limitations on policy, since  a large portion of the rate cuts that subsequently occurred during these recessions represented the undoing of the earlier tight stance of monetary policy.  Thus she maintains that:

Of course, this situation could occur again in the future. But if it did, the federal funds rate at the onset of the recession would be well above its normal level, and the FOMC would be able to cut short-term interest rates by substantially more than 3 percentage points. 

So the main reason for the Fed's urge to raise the policy rate would be to push it above the normal level (that is supposed to be very low in the present time), so that in the event of the next recession the FOMC would be having enough room to respond by reducing it. Given that the next recession is almost upon us this introduces a bizarre and volatile policy response.Of course, if the transmission mechanism is broken then declines in the policy rate, no matter by what magnitude, would be ineffective as is witnessed in Japan and eurozone.

In August last year asking the same question about the possibility of Fed raising rates in September 2015 I wrote:

In my estimation Fed cannot risk raising rates in such  critical times and therefore it won't. A rising rate at current market conditions one month before October, that historically is associated with a stock market correction, could be the psychological trigger that would disturb the current fragile local equilibrium, pushing the US and the whole global system along a path towards instability and a full-fledged financial crisis exhibiting a collapse of investment, debt deflation, and thus leading to insolvent debtors and a weaker banking system – that would be 1937 all over again!

Had it not been for a marked  increase in  the prevailing uncertainty that has rendered  the decision of the Fed " almost as fickle as the weather, shifting about by blind chance",  as evinced by a lack of consensus among various FOMC's participants I  would have also reached for the very same conclusion again, i.e., the possibility of a September inaction this year.

Ms. Yellen, like Mr. Draghi, in her Jackson Hole lecture  implicitly maintained that the transmission mechanism of monetary policy has been working  well and that Fed's new unconventional policy tools have been effective. She maintained that the reason for the disappointingly slow growth rates has been related to various headwinds the economy faced in recent times. She stated:

In light of the slowness of the economic recovery, some have questioned the effectiveness of asset purchases and extended forward rate guidance. But this criticism fails to consider the unusual headwinds the economy faced after the crisis. Those headwinds included substantial household and business deleveraging, unfavorable demand shocks from abroad, a period of contractionary fiscal policy, and unusually tight credit, especially for housing.

Apart from the the fact that those headwinds should have been and could have been predicted by any decent model,  she did not mention the lack of capital formation, low productivity growth and a greater use of contingent capacity that have arose from the global financial imbalances.  Referencing  a study by Engen,  Laubach, and Reifschneider (2015)  Ms. Yellen argued that the Federal Reserve's forward guidance and asset purchase policies "have put appreciable downward pressure on long-term interest rates and, as a result, helped spur growth in demand for goods and services, lower the unemployment rate, and prevent inflation from falling further below our 2 percent objective." Obviously, if the model underlying the transmission mechanism have been outdated then one cannot rely on the inferences derived from a wrong model.

Nevertheless, many FOMC members, like Mr Kaplan the president  of the Dallas Fed, have acknowledged the fact that the world has become much more interconnected over the past several decades, and  global trade and financial markets  have expanded such that an economic deterioration  in one country can have  greater adverse effects on other economies. In other words, the parameters and the functional forms of economic models with regard to the trade of goods and services, capital flows,  labor market dynamics,  asset allocations  and global investment demand for “safe” assets have changed.  `In Mr Kaplan words:

Because financial markets trade in real time, market strains or other challenges in one market now have the potential to rapidly affect currency, debt and equity markets globally. We certainly saw the effects of this interconnectedness during the 2008–09 financial crisis. More recently, and on a much smaller scale, we saw how turmoil in currencies and local markets in certain countries in early 2016 helped lead to global market volatility and a rapid tightening of overall financial conditions.

Moreover, as we have argued in our previous post it is very hard to maintain the hypothesis that the transmission mechanism is still working

 in a market which agents,  in the optimization of their objective  functions, are able to take account of the possible policy actions.  In fact, the transmission mechanism has been disrupted at various critical connections precisely because of this ability and this is why the forecasting models that  central banks are using  are persistently overpredicting the economy's growth rates and why investors are reluctant to invest. 

A rise in interest rate will put upward pressures on the US dollar, reducing the American competitiveness in the global market, when many regions are engaged in currency wars to support their exports. Last year I was proved correct in my call that the Fed will not raise the interest rate in its September meetings. I also was correct in predicting that a December rise will destabilize markets after the new year's holidays. This year the case is even stronger because of the Brexit and because of the presidential election.  As I argued last year:

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. This is why I have been calling for an emergency global finance conference similar to the Brussels conference that took place   between the 24th of September and the 8th of October 1920.  That international conference was called

“with a view to  studying the financial crisis and looking for the means of remedying it and mitigating the dangerous  consequences arising from it.”

In such a conference 3 key issues must be on the agenda (1.) a halt in the currency wars and  a move toward rationalizing  currency relationships based on the law of one price. (2.) A restructuring of the current unsustainable levels of debt  and (3.) a coordinated global fiscal policy to improve the international trade infrastructure .