Life After Fed Lift-Off

January 2, 2016 0 Comments

Once upon a time, small changes in interest rates were seen as a small tool on its ability to fine-tune the economy. Those days seem to be a distant memory; hikes in the Fed Funds Rate are now a testament to our economy’s ability to move past the worst financial crisis in a generation.

Of course, if the Fed decided NOT to increase rates, it would have surprised no one. It seems as if Janet Yellen is under pressure to keep her word. The alternative could have resulted in the Fed losing its credibility, along with its ability to fine-tune financial markets. However, it’s a very poor rationale for implementing monetary policy.

This is because the decision to increase rates has come at an unusual time. The first Fed increase usually happens when the economy appears to be rebounding. Since the end of the recession in 2009, real GDP growth has remained around 2.0% annually. Weakness in China and Japan continues to persist. With the strength of the U.S. Dollar still emerging, an interest rate hike is more likely to exacerbate the sluggish growth in emerging markets, which use the low-cost dollar to increase their finances. We must also consider the fact that corporate profits are growing at the slowest rates they’ve experienced… ever.

Still, financial markets seemed very optimistic about the Fed finally getting rates off the ground. That is, until the possibility of having to deal with not one, but more “gradual” rate increases in the future; which will hopefully set the Fed Funds rate at 1.38% by the end of 2016. This means an average of at least four rate increases per quarter.

Not exactly what the markets was expecting:

Under normal market conditions, the Fed is able to increase rates when the economy is growing and the markets don’t have to worry about the adverse effects of miscalculated monetary policy. Perhaps the markets are trying to tell the Fed that it is much too early to have a tightening of this magnitude.

Of course, employment still remains very strong; however, outside of these metrics, the U.S. economy is failing to pick up steam. Industrial production has consistency fallen and continues to fall for more than three straight months. Also the US Flash Manufacturing PMI released by Markit fell to 51.3 from 52.8 in the previous month, the lowest level in more than a year.

In a world where interest rates theoretically cannot fall far below zero, changes can still be made to give policymakers more leg room to accommodate changes in monetary policy. Arguments can be made (by some people, in general) that tightening gives them much more room to control runaway inflation. Other arguments can also be made that rate increases can give the Fed greater room to cut rates, if it needs to, in the future; however, therein lies the problem.

This can all be explained with the Wicksellian equilibrium rate (trigger warning: slightly wonkish). Let’s pretend that the only thing that really matters in monetary policy is the ratio between the Fed Funds rate and the real rate of interest, also known as the Wicksellian Equilibrium Rate. This differential produces macroeconomic stability in the form of nominal GDP growth, currently running at 3.3%.

As discussed earlier, interest rates are tools central banks use to fine-tune the economy; it cut rates when the economy is growing too slowly and tightens when the economy is growing too quickly. Now let’s say that the Fed decides to tighten (which it just did). The tightening reduces the Wicksellian Equilibrium interest rate; this, in turn, results in a wider gap between the Fed Funds Rate and the real rate of interests. As a result, monetary policy becomes tighter than it should be, thus, having adverse effects in economic growth and activity.

When this happens, there are times when central banks are able to discover this and start to reverse course on monetary policy. Unfortunately, central banks are unable to close the gap between their main benchmark rate and the wicksellian equilibrium interest rate.

An example of this occurred in 2011, as the European Central Bank increased its deposit facility interest rates, twice, after keeping them at 0.25% for more than two years. A year later, the ECB was forced to reverse course and has cut rates in the negative territory since then. The same happened to the Riksbank of Sweden, as their main interest rates peaked at 2% in 2011 after keeping rates so low for two years. The bank ultimately was sent rates marching back down again. Currently, their interest rates stand at -0.35%. Other central banks (Denmark, Canada, just to name a few) have also experienced similar reversals.

Policymakers still argue that a 25bps increase in rates is unlikely to halt economic growth. The effect of interest rate changes often varies. The effect depends on what is happening with the Wicksellian equilibrium rate; however, because it is difficult to observe, it can be difficult to understand the effect a quarter point change in rates can have on the economy. What we do know, with much recent examples, that the changes can be quite severe.

Because the effect of monetary policy operates with a lag, policymakers need to be forward looking. Perhaps, instead of deciding if more rate increases are warranted, policymakers should asset the effects of the first.

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