Should the Fed Hold or Should it Raise?

September 14, 2015

Editorials this past weekend in the Financial Times and The Economist argue that the U.S. central bank should leave the federal funds target range at 0-0.25% at this week’s FOMC meeting.  The FT makes the point that the Great Recession shook up economic structures sufficiently so as to cast doubt on how to interpret signs of diminishing capacity constraints especially “without evidence that inflationary buffers were actually being hit.”  A second point is that even without a nominal interest rate hike, credit conditions already are tightening due to global financial turmoil and the firm dollar.  The Economist also notes a lack of compelling evidence that U.S. inflation is about to climb past the central bank’s target.  If that does happen, the “Fed has unlimited capacity to raise rates” but that premature tightening “could turn inflation into deflation.”

For decades, a big fear existed that undue tightening delay would force central banks to deliver much stronger medicine, generating recessionary conditions and squandering the progress made over a very long time to restore price expectations to a 1-2% range.  However, the experience of many central banks in the post-2006 years has produced a bias toward the opposite timing error.  Several central banks raised rates when, with hindsight they should not have.  This group includes the European Central Bank, which in early July 2008 — a year after the subprime mortgage debt crisis began — hiked its refinancing rate by 25 basis points to 4.25%.  Since then, the eurozone has experienced in-and-out recession and massive disinflation bordering on deflation.  The refinancing rate is now at 0.05%, and strong quantitative stimulus has become necessary.  From July 2010 to June 2011, the Swedish Riksbank repo rate was lifted 175 basis points (bps) to 2.0%, aggravating disinflation, and now Sweden has a negative repo rate of -0.35%.  The Bank of Japan prematurely ended its first round of quantitative stimulus and in August 2000 lifted its money market target to 0.25% from zero.  It’s back at zero, enforced by more quantitative easing.  The Bank of Canada has cut its overnight interest rate target twice this year, having raised it three times in 2010.  Likewise, three cuts this year by the Reserve Bank of New Zealand bookend four hikes in 2014.  The Reserve Bank of Australia also has cut rates this year to a record low Official Cash Rate of 2.0%, having hiked by 175 bps from October 2009 to March 2010.  Norway, the first European Central Bank to tighten after the Great Recession, has most recently been easing.  In all these cases and more, feared higher inflation didn’t materialize, and dangerously low inflation instead ensued, spurred in part by ill-advised monetary restraint.

Another way of approaching the question of whether current conditions warrant the onset of Fed tightening is to compare those conditions to ones prevailing at the start of earlier significant interest rate-tightening cycles.

The last such cycle commenced in June 2004 from a level of 1.0%.  Nominal GDP had increased 7.1% over the previous year, compared to a 3.7% rise over the past reported year.  CPI inflation was at 3.3% then, versus 0.2% now.  Real GDP had climbed 4.2% on year, well above the present 2.7% increase.  The ten-year Treasury yield was at 4.64%, more than twice its present level.  Unemployment was a half percentage point above the present 5.1%.  But a big contrast lies in the recent movement of U.S. share prices (DJIA), which back then had risen 2.4% over the previous month and 2.0% over the previous two months but now which has fallen 6.4% and 9.4%, respectively over those time spans. 

The penultimate rate tightening cycle begun in June 1999 from 4.75% was preceded by growth of 6.3% in nominal GDP and 4.6% in real GDP over the prior year.  The jobless rate was 4.3%, the 10-year Treasury yield was 5.89%, CPI inflation was at 2.0%, and the DJIA had gained 2.4% in the prior month and 2.0% over the previous two months.

The most jarring tightening by the Fed in the last generation started in February 1994 and would double the then-3% federal funds rate within a year.  Nominal GDP had climbed 5.0%.  Real GDP had advanced 2.6% (but 3.7% annualized in the most recent half-year interval).  Unemployment was at 6.6%, CPI inflation was 2.5%, and the 10-year Treasury was at 5.77% but within several months would jump to around 8%.  The DJIA had gained 5.6% in the month before tightening began and 7.1% in the prior two months.

Then there was the tightening cycle that started in March 1988, less than a half year after the 22.6% DOW crash on October 19, 1987.  The Fed had eased in immediate response to that crash, but unlike 1929, a recession did not ensue.  By early 1988, Fed officials realized the economy needed restraint, not stimulus.  From a Federal funds rate low of 6.5%, a rate-tightening cycle resumed at end-March 1988 and did not end until 9-3/4%.  In the year to end-1987, nominal GDP climbed 7.6%, and real GDP rose 4.3%.  CPI inflation when tightening began was at 3.9%, and the jobless rate was at 5.7%.  The DJIA had fallen 3.5% in the prior month but was 2.1% higher than its two-month earlier level.  The 10-year Treasury was somewhat over 8.0%.

Generalizing the above experiences, nominal GDP now is expanding much more slowly than in any of the precedents.  Inflation is far lower this time, and this would be the only time in which stock market action is adverse immediately ahead of the first rate increase.  Bond yields are also much lower now.  Only unemployment is in range of the other precedents.  In three of the cases, the federal funds rate is far lower this time.  But in the most recent precedent, the funds rate was just 75 basis points above the current level, which is smaller than the inflation differentials. 

The inherent risk in tightening as soon as this week will depend greatly on what ensues in the dollar and oil prices.  Both have been strong disinflationary factors, and one doesn’t want to trigger a fresh round of sharp dollar appreciation and oil price debasement.  Ideally, one desires a better balance of inflation containment, with higher U.S. interest rates but a softer dollar, more elevated commodity prices, and a better prognosis for emerging market economies.  Alas, policymakers do not control this balance.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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