Everyone, and I mean everyone, has an opinion on what the Federal Reserve should do, will do and why when the policy-setting committee meets this week to consider an increase in its benchmark rate. We have been inundated with advice from Fed officials — former, current and wannabes — Nobel laureates, Wall Street economists, academics, bankers, bloggers, and pundits.
Under the circumstances, it seemed worthwhile to try to synthesize the major arguments for and against a 25-basis-point increase in the federal funds rate, which has been at 0% to 0.25% for almost seven years, and hopefully clarify the issues in the process. Here goes.
Here are 5 reasons to raise rates:
1) Crisis rate, normal times
When the Fed lowered the funds rate to near zero in December 2008, the U.S. economy was in freefall. Real gross domestic product contracted by 8.1% annualized in the fourth quarter of that year, the biggest decline in a half-century. Almost 2 million jobs vanished during the quarter. The housing market was in tatters. Some major money-center banks were insolvent, requiring a government rescue. And stocks were imploding.
While the ensuing expansion has been unspectacular by most metrics — average real GDP growth of 2.1% since the end of the recession in June 2009 — the crisis is over. Monthly job growth has exceeded 200,000 for the last three years. Mortgage delinquency and foreclosure rates have fallen to 2007 levels. Banks have recapitalized. Except for some day-to-day volatility in financial markets, the crisis is history. For that reason, the crisis rate should be history, too.
2) Long and variable lags
Trite as it may sound, monetary policy operates with long and variable lags. Inflation may be low today, but waiting to act until it is testing the Fed’s 2% target is inadvisable.
Just last month, at the Fed’s annual Jackson Hole symposium, central bankers admitted that inflation dynamics during and after the Great Recession remain something of a mystery. Buying a little insurance against the unknown sounds like a good idea.
3) No time like the present
The Fed has talked ad nauseam about raising rates “later this year.” The expected June liftoff was pushed back to September. Then last month, signs of a slowdown in China sent global stock markets on a roller-coaster ride. Fed funds futures pared the probability of a September rate hike to 25%.
Policy makers have been waiting for the planets to be in perfect alignment before taking the first incremental step to normalize rates. Something — data, markets, “uncertainty” — keeps interfering with the Fed’s best-laid plans. To which I say, carpe diem!
4) Zero intolerance
Fed policy makers really, really want to put some distance between the funds rate and zero. And no, this isn’t an argument about raising rates in order to lower them again. It’s about their comfort with, and preference for, an interest-rate target to conduct monetary policy rather than experimental and untested tools to absorb excess bank reserves totaling $2.6 trillion.
5) Just do it
Get it over with already! Think about all the words spilled over a lousy one-quarter percentage point. Just do it so we can all move on.
And here are 5 reasons not to raise rates
1) What inflation?
The Fed has undershot its 2% inflation target for over three years and doesn’t expect to hit 2% until 2017, according to the Fed’s policy makers’ central tendency forecast from June. The board staff projects sub-2% inflation through 2020.
I have no idea how anyone can project accurately beyond the next quarter. Worth noting is that some economists, including Harvard’s Carmen Reinhart, are warning about global deflationary forces. If inflation dynamics are a big question mark, it might be better to get a sense of which direction inflation is heading before pulling the trigger.
2) Minding Mr Market
Financial markets have an uncanny ability to describe the current situation and hint at future developments. And right now that message is: look before you leap.
A strong dollar DXY, +0.02% , falling commodity prices and a yield curve that continues to flatten (long rates falling) are not exactly crying out for monetary restraint. The Fed prefers its econometric models, but my money would be on Mr. Market.
3) Headwinds
Central bankers love to talk about headwinds. Anything and everything that might slow the ship of state falls into this amorphous category.
The latest headwind is China. China’s state-managed economy is slowing, its stock market SHCOMP, -2.10% slumping, as Communist Party bureaucrats struggle to steady the ship. Even China’s unreliable economic data are pointing to a period of slower growth.
For years we’ve heard talk of China’s property bubble and seen photos of “ghost towns”: entire cities pre-planned to attract the next wave of industrial workers. Finally the excess capacity seems to have put a halt to rapid industrial development.
4) Data dependency
The Fed reminds us every chance it gets that its policy decisions are data dependent. Given the bank’s dual mandate — full employment and price stability — one wonders which data point is trumpeting a rate increase. The Fed’s preferred inflation measure, the personal consumption expenditures price index, is barely positive on a year-over-year basis. (See No. 1 above.) Commodity prices are tanking as demand from China dries up.
The unemployment rate has fallen to 5.1%, a level historically associated with full employment. But where are the signs of tightness in the labor market? Not in wages, which are stagnant. Not in the number of underemployed. And not in the number of persons who have dropped out of the labor force. At 62.6%, the participation rate sits at a three-decade low. Data dependency is arguing against a rate hike.
5) Financial instability
Volatility VIX, +1.83% soared in the latter half of August as financial markets responded to China’s devaluation. Stock markets plummeted worldwide. There may be no perfect time to raise rates, but you have to wonder why the Fed feels the need to initiate the first rate hike in nine years during a period of heightened instability.
By now it should be apparent that some of the pros and cons of a rate hike are mirror images of one another. The difference lies with a policy maker’s attitude toward inflation, for example, or the relative importance she places on the timing of a first step.
The outcome of the Fed meeting on Wednesday and Thursday has been described as a “cliffhanger.” I’m more curious about how the Fed explains its action/inaction than in what it does. After all, “later this year” is becoming calendar-challenged. Maybe it’s time for new assurances on “one and done?”
Source: By Caroline Baum @ http://www.marketwatch.com/
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