The Fed's first rate increase in nine years comes decidedly late. The economy is in its seventh consecutive year of expansion; the unemployment rate has fallen to 5 percent, commonly viewed as the long-run natural rate of unemployment (so-called "full employment"); and inflation is modestly below 2 percent. Moreover, the Fed's quantitative easing programs have generated over $2.5 trillion in excess banking reserves, and the Fed plans to reinvest the proceeds from maturing assets in its portfolio in order to maintain the excess liquidity, while raising rates very gradually.
“After five years, it's clear the Fed has been much more successful keeping rates artificially low and boosting asset prices than it has been stimulating the economy.”
The economy will continue to grow as the Fed raises rates; it always has in the past. But the Fed's policies involve high risks. These risks stem from the Fed having maintained an extremely accommodative policy long after the economy and financial markets started to behave normally following the financial crisis and deep recession. And by raising rates so gradually and keeping the federal funds rate below inflation, the Fed would be compounding potential risks.
It's critically important to understand that the Fed's quantitative easing and forward guidance have operated by purposely distorting financial markets in an attempt to keep interest rates and bond yields artificially low. This encourages risk-taking and boosts asset prices as a means to generate stronger consumer spending and business investment.
After five years, it's clear the Fed has been much more successful keeping rates artificially low and boosting asset prices than it has been stimulating the economy. Nominal GDP, the broadest measure of current dollar spending in the economy, has failed to accelerate in the past five years.
Household balance sheet adjustments and other private sector adjustments following the unsustainable housing and debt bubble have contributed to slower aggregate demand growth, but the real culprit of the constrained economic growth has been the government's economic policies. Among other growth inhibitors, the convoluted corporate tax system, the growing web of burdensome regulations and higher mandated operating costs have reduced business efficiencies, raised production costs and dulled their appetites for expansion and spending. Businesses and households are weary of the gray cloud hanging over Washington, and they brace themselves for more of the same.
Not surprisingly, the Fed's aggressive monetary accommodation has been ineffective in addressing these constraints. Instead, the Fed's excessively easy policies have resulted primarily in higher asset prices and more risk-taking as portfolio managers seek high returns in an artificially low-interest-rate environment, domestically and internationally. The Fed has seemed to understate the potential distortions while emphasizing that the benefits of the additional monetary stimulus on the economy outweighed the risks.
Meanwhile, the failure of aggregate demand to accelerate has been the primary constraint on wages and inflation. Even as labor markets tighten, businesses seeing only modest top-line revenue growth know their product pricing power is limited so they are reticent to grant higher wages. While prices of services are rising at an annual rate of about 2 percent, the Fed's long-run inflation target, technological innovations continue to push down prices of durable goods (they have been declining in each of the last 20 years) and the recent decline in oil prices has temporarily lowered inflation. Note that while these factors that have constrained inflation are beneficial to economic performance, the Fed continues to express concern that inflation is too low and perceives it as a reason to keep interest rates artificially low.
“The Fed now knows it must raise rates further to a more normal or neutral level, and it hopes that the unwinding of the distortions it has created are orderly.”
The Fed now knows it must raise rates further to a more normal or neutral level, and it hopes that the unwinding of the distortions it has created are orderly. There's no guarantee they will be. The recent disorderly selloff in the high-yield bond market reflects a confluence of factors, including the sharp decline in energy prices and worries about lack of liquidity held by corporate bond dealers, but it also reflects the beginning of an unwind of the "positive carry" investment strategies encouraged by the Fed's policies. This behavior is confirmation that the Fed should have begun normalizing rates much earlier.
The Fed is encouraged to proceed raising rates more quickly that it currently plans. Economic performance would adjust. Prolonging the normalization of interest rates would allow distortions to mount and does not necessarily lower the probability of jarring responses.
This piece originally appeared in U.S. News & World Report
This piece originally appeared in U.S. News and World Report