No Reason to Fear Fed Rate Hikes
How often have we heard the phrase “if the Fed hikes rates too early, the economic recovery will be derailed”? It is ingrained into the Fed’s mindset and similar statements appear frequently.
Yet the history of Fed rate hikes during prior economic expansions suggests that such fears are unwarranted, and the current five-year old expansion would fare just fine and even be enhanced if the Fed began hiking rates. Normalizing interest rates should be welcomed, not feared by the Fed.
In many key aspects the economy has characteristics typical of early-middle stage expansions, and prospects for sustained growth are very favorable. The types of excesses in the real sectors or financial markets that have preceded prior recessions are absent, and monetary policy is aggressively stimulative. Wage and unit labor costs increases are low and inflation is moderate. The stock of capital and the level of employment are not excessive relative to output. Inventories are low. Private sector finances have improved. Households are deleveraging and debt service costs are low. Household net worth is near an all-time high. Profit margins are healthy and business balance sheets are strong. Banks have increased capital and reduced leverage. Virtually all indicators suggest the probability of recession is very low.
The Fed’s misplaced fears that any rate hike will upset the economy underlies its protracted and increasingly ineffective forward guidance. The Fed’s efforts to be transparent and clear have been muddled because the Fed’s monetary policy is misguided. The time is appropriate for the Fed to set out a clear and positive strategy for hiking rates, normalizing monetary policy and streamlining its forward guidance.
Observations on the US economy. Economic growth has been inhibited by real factors and negative influences of government economic policies and related uncertainties that are beyond the influence of monetary policy. Similarly, lingering labor market weaknesses largely reflect structural factors that will persist even when the unemployment rate falls to “full employment.” Monetary policy should not be targeting the labor force participation rate or trying to address high unemployment stemming from insufficient education or skills. Other policy tools clearly would have been more efficient in addressing specific obstacles to growth (reform of the mortgage market and corporate taxes, for starters).
Quantitative easing and anchoring the Federal funds rate to zero were emergency policies designed for an economic and/or financial crisis, not current conditions.
Beginning to raise rates consistent with the rise in the natural rate associated with healthy economic expansion and higher expected rates of return on capital would simply maintain the current posture of monetary policy and would not constitute a tightening that constrains aggregate demand and economic growth. That is particularly true now with $2.7 trillion of excess reserves and extraordinarily low bond yields, and the market anticipating rate hikes.
Historic episodes of Fed rate hikes during expansion. Recent US cycles provide ample support that Fed rate hikes—even aggressive monetary tightening—during early-to-middle stages of economic expansions have little if any short-term economic effect and actually improve the foundations for sustained expansion.
In 1994, in response to stronger economic growth, the Fed raised the funds rate from 3 percent to 6 percent while inflation remained stable around 3 percent. Real bond yields exceeded 4.5 percent and the US dollar was strengthening. Growth slowed for two quarters, but then reaccelerated, led by the interest sensitive sectors, and remained strong through the remainder of the decade.
During the next expansion, the Fed didn’t want to upset bond markets so it raised rates very gradually, from 1 percent to 5.5 percent from mid-2004 to mid-2006. Real bond yields hovered between 2.5-3.0 percent and the US dollar weakened. Real GDP growth remained strong through early 2006 and then decelerated as the debt-financed housing bubble began to collapse.
In mid-1983, when the economy was only two quarters into recovery from the severe back-to-back recessions of 1980-1982 and the unemployment rate was 10 percent, the Fed began tightening from an already very high real funds rate. The real funds rate rose from 6.5 percent in June 1983 to 6.9 percent in July 1984 and real bond yields averaged 8.4 percent, and the US dollar strengthened. Real growth remained robust through the first quarter of 1984, and then decelerated, but still grew 4.25 percent in 1984 and 1985.
Fed rate hikes in earlier expansions tell a similar story. The current perceived costs of raising rates are dramatically overblown.
Current concerns about the negative effects of the moderately stronger US dollar and weak global economies are overstated, and they ignore the positive boost from lower oil and energy prices. During each prior Fed rate increase, the US net export deficit widened, but strong domestic final sales sustained solid growth.
Failing to raise rates appropriately during prior expansions has proved costly in different and unforeseen ways. In the late 1970s, inflation rose “unexpectedly.” During the 2002 to 2007 expansion, financial and real distortions resulting from artificially low real rates—including higher housing and asset prices—were understated because initially they felt good. Higher real interest rates would have resulted in a better balanced economy with fewer financial distortions and long-run costs.
The Fed is ignoring these lessons from history. It seems to have lost sight of the basic issue: Is economic performance best served by the current monetary policy of anchoring the Federal funds rate to zero and maintaining massive excess bank reserves?
Even on this basic issue, the Fed gives mixed messages: while it forecasts stronger economic growth in 2015-2016 as it gradually raises rates (along the path it currently deems appropriate), its forward guidance and public statements convey the image of a very fragile economy—one that may not be able to withstand a hike in rates, even if real rates remain negative. This conveys a distinctly negative tone to nonfinancial businesses and households suggesting that this may not be the right time to spend, invest or take risks. This harms confidence.
Data dependence and recent trends. If the Fed were truly data dependent, it would have already begun raising rates or be very close to doing so. The rapid decline in the unemployment rate, even as the Fed has lowered its longer-run potential growth, suggests the Fed is quickly approaching its objective. And core inflation has edged up toward the Fed’s 2 percent long-run target.
But the Fed urges patience and stretches out its zero interest rate policy. This is very risky. Adjusting policy to the latest high-frequency data assumes no lags between monetary policy, economic performance and inflation. This is absolutely inconsistent with historical experience.
As the unemployment rate has fallen rapidly, the Fed’s shift to emphasizing wages as a measure of labor market conditions is even more problematic. Wages lag economic conditions and in some instances wages lag inflation. Basing monetary policy on a notoriously long cyclical laggard is backward–looking and prone to policy mistakes. In light of the Fed’s long-run unreliable forecasting track record, moving up its rate hikes would be wise and prudent.
Mickey Levy is a member of the Shadow Open Market Committee.
For more, see Mickey Levy’s full paper, “Rate Hike Fears Are Unwarranted.”
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