17 December 2015

The Fed’s first small, belated step toward rate normalization

By Mickey D. Levy

The US Federal Reserve’s first rate increase since mid-2006 is its initial small step away from its emergency monetary policies, which began in the depths of the financial crisis.  It is truly a small first step, however, and the Fed’s torturous debate and angst about such a minor rise in rates is worrisome.  Remember, the Federal funds rate is well below inflation and monetary policy remains extremely easy.

There is much debate about what the “new normal” rate will be.  Diminished growth expectations have lowered estimates of the so-called natural rate of interest—the inflation-adjusted rate consistent with potential growth and stable, low inflation.  The Fed’s own forecast of a 3.5 percent Federal funds rate consistent with its 2 percent long-run inflation target, implies a natural real rate of 1.5 percent.

One thing is clear, the Fed must raise rates significantly further to normalize monetary policy and achieve healthier and more sustainable economic and financial market performance.

For now, this initial rate increase will have negligible impact on the economy.  Monetary policy remains easy and it always affect the economy with a lag.

After previous Fed rate increases—there have been five since the early 1980s–economic growth was sustained or accelerated. But during these periods consumer or business credit continued to grow and the US stock market either sustained prior gains or appreciated as rising profits offset downward pressure on price/earnings multiples.

In 2016, with the stronger US dollar putting pressure on profits of multi-national firms, a modest pickup in economic growth is required for profit increases to support stock valuations.

Earlier Fed rate increases haven’t had a specific impact on the US dollar, but given the divergence between the Fed’s monetary policy and those of other global central banks, which are expected to maintain zero interest rates and quantitative easing, along with the US’s higher inflation-adjusted bond yields, expect a firm dollar.

The Fed’s policies have been more successful keeping interest rates low than stimulating the economy:  nominal GDP has not accelerated above four percent growth during the last five years, despite all of the Fed’s efforts.  Since inflation is ultimately generated by excess demand relative to capacity, it’s no surprise that inflation has stayed low. The modest rise in aggregate spending has been the primary factor influencing wages and prices, and has constrained both wage increases (despite lower unemployment) and inflation. In addition, the recent sharp declines in energy prices mean that inflation is below the Fed’s long-run target. As a result, the dovish Fed has had been able to maintain its extremely accommodative policy.

The excess liquidity sloshing around financial markets seeking high returns in a low interest rate world has encouraged excess risk-taking.  The Fed has been warned that maintaining zero interest rates and a bloated balance sheet long after economic and financial performance returned to normal would raise the risks and potential costs of its exit strategy. And the recent disorderly selloff in the high yield bond market is confirmation that the Fed should have begun normalizing rates much earlier.

The Fed now knows it must raise rates further to a more normal or neutral level, with the Fed funds rate around 3.5%. And economic and financial behavior must eventually adjust to more normal monetary policy.  Time and more rate increases will tell whether the transition is smooth or jarring.

Mickey D. Levy is Chief Economist of the Amercias and Asia for Berenberg Capital Markets and a member of the Shadow Open Market Committee sponsored by the Manhattan Institute.