The Marriner S. Eccles Building in Washington, D.C., the headquarters of the Federal Reserve System
Last week, Federal Reserve officials gathered in a meeting of the Federal Open Market Committee to assess U.S. economic health and decide the course of U.S. monetary policy. In a controversial decision, the officials voted 11-1 to keep the target federal funds rate near zero, maintaining the extremely accommodative stance they have taken since the 2008 financial crisis.
Over the past few months, strong U.S. economic data (and Fed officials themselves) supported an interest rate “liftoff” and a normalization of monetary policy. Many economists and investors expected this process to begin with a rate increase at the September 16-17 FOMC meeting. However, recent turbulence in financial markets and slowing Chinese economic growth complicated the conversation and clearly influenced the Fed’s choice to hold the federal funds rate near zero. Regrettably, this may not have been the appropriate decision.
Approaching Liftoff
The argument in favor of raising rates is fairly simple. The American economy has grown robustly over the past several years and substantial GDP growth in the second quarter of 2015 indicates that this trend will continue. In addition, the U.S. labor market is strengthening along with the domestic housing market. Housing starts have grown impressively, and the nation’s unemployment rate has dropped to 5.1%, a seven-year low and a level that the Fed considers “full employment.” These conditions are characteristic of a healthy economy, one that certainly does not require an “emergency” federal funds rate near zero.
Further, postponing liftoff involves serious risks. With interest rates approaching the zero bound, the Fed at present has few monetary policy tools available to combat any new economic shocks. Should the U.S. economy experience difficulty in the short-term, the Fed would be forced to pursue experimental policies such as quantitative easing (“QE”) or negative interest rates to combat recession. However, it isn’t certain that a fourth round of QE would effectively stimulate the economy, and European central banks have not had much success with negative rates.
The act of postponing an increase also introduces uncertainty into the economy and financial markets. For several months prior to the September FOMC meeting, Fed officials indicated their confidence in the U.S. economic recovery and their intentions to raise rates in late 2015. By maintaining a near-zero federal funds rate in September, Fed officials acted counter to their own predictions and the expectations of the markets. In this manner, Fed officials obscured their thinking on monetary policy and produced uncertainty among investors and economists. This has contributed to volatility in financial markets that may negatively affect world economic growth in the short term.
Perhaps most alarming is the prospect of a U.S. financial asset bubble. In a low-interest rate environment, traditionally “safe” investments such as U.S. government bonds and CDs offer very small returns to asset holders. In search of profit, many investors favor riskier assets including stocks and derivatives. Persistently low interest rates may induce an unwarranted expansion in the prices of these risky assets, creating a “bubble.” When this asset bubble “pops,” a rapid sell-off of these assets occurs that may detrimentally affect the economy and the financial system. Beginning a period of gradual interest rate increases would make safer assets more attractive to investors and check the growth of risky asset prices.
Holding at Zero
Those opposed to liftoff cite a variety of reasons for leaving the federal funds rate near zero, though their primary concerns are inflation, unemployment, and international instability. U.S. inflation, as measured by Headline CPI, has remained stagnant during the economic recovery. Year-over-year inflation figures released each month have generally hovered just above 0%, well below the Fed’s 2% target rate. This would seem to indicate little upward pressure on prices and favor holding interest rates near zero to spur lending and inflation. However, energy prices significantly impact Headline CPI, so these figures are skewed by the recent plunge in oil prices. Core CPI, which strips out energy and food prices, has seen persistent growth of around 1.8% year-over-year in recent months, a figure much closer to the Fed’s 2% target (and indicative of economic expansion). In addition, lower energy prices may spur discretionary consumer spending and actually benefit price level and output growth.
Closely related to inflation are the issues of unemployment and wage growth. Many Fed officials and economists have cautioned against raising rates because of implicit slack in the labor market and its adverse effect on wage growth. It is worth noting that the unemployment rate may exaggerate the health of the U.S. labor market because it excludes marginally attached workers from the labor force and does not distinguish full-time workers from part-time workers. A more telling labor metric involves the total number of unemployed workers, marginally attached workers, and part-time workers as a percentage of the labor force. In August, this figure reached a seven-year low of 10.3% and continues to trend downward. Although this measure has not yet returned to its pre-recession levels of 8-8.5%, it has certainly improved significantly from its peak of 17.1% and is likely to fall further with U.S. economic growth. This tightening in the labor market will eventually provide upward pressure to wages, and an incremental increase of 0.25% in the federal funds rate would not likely reverse this trend.
Although inflation and labor market conditions surely influenced Fed discussions, international financial instability is likely the proximate cause for the rate hold. The recent collapse in Chinese equities’ prices and the concurrent slowing of Chinese economic growth has provoked volatility and pessimism in world financial markets. U.S. equity markets entered a period of correction in recent weeks and currency markets were roiled by China’s surprising devaluation of the yuan. In response to the latter, emerging market currencies have depreciated, accelerating capital outflows from several Asian and South American countries. These developments have dampened world economic growth forecasts and contributed to a strengthening U.S. dollar. They certainly dissuaded Fed officials from hiking interest rates for the first time in nine years.
However, some of these factors should not weigh too heavily on U.S. monetary policy. The correction in Chinese equities was necessary to reduce the massive leverage in Chinese markets and return asset values to reasonable levels. In addition, slowing growth in China should not come as a surprise given the size of its economy and the pace at which it has expanded in recent years. A cooling Chinese economy presents less of a threat to global economic health than does a Chinese economy reliant on government stimulus for artificial growth.
Nonetheless, the devaluation of the yuan should be considered in interest rate deliberations. A substantial increase in U.S. interest rates following this development would prompt further strengthening of the dollar relative to most emerging market currencies. This would encourage capital outflows from these countries and introduce more financial volatility. However, a modest increase in the federal funds rate would probably not induce calamitous outflows that would significantly threaten global stability.
Economic Risk
The arguments for and against raising the federal funds rate both have merit. The rate decision thus hinges on risk: Which alternative presents less risk to U.S. economic health and financial stability? Raising the federal funds rate incrementally (by 0.25%) may produce minor short-term difficulties in emerging markets, but is unlikely to derail the U.S. labor market or cause deflation. In addition, this move would trigger the normalization of monetary policy, a process appropriate for a healthy domestic economy. Alternatively, holding the rate steady introduces uncertainty and leaves the Fed poorly equipped to deal with future economic shocks. The potential for a severe economic decline is evidently higher if near-zero rates are maintained. If the FOMC had raised rates at its September meeting, uncertainty surrounding liftoff would have been resolved and the Fed would be in a better position to confront future stresses.
The FOMC’s inaction in September renders its October and December meetings all the more important. Either Fed officials heed the data and their own calls for a 2015 liftoff, or they again hesitate in the face of new and transitory economic challenges.
Todd Lensman is a freshman in the College of Arts & Sciences at Cornell University, majoring in Mathematics and Economics.
Image Attribution: “Marriner S. Eccles Federal Reserve Board Building” by AgnosticPreachersKid, licensed under CC BY-SA 3.0
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