The Federal Reserve announced on Wednesday (December 16) that it would raise policy interest rates by ¼ to ½ of 1 percent, ending the seven year policy of keeping Fed interest rates near zero, and would embark on a path of “gradual” interest rate increases in order to “normalize” interest rates. This announcement had been long expected by pundits, economists and the financial markets, and, more to the point, had long been pushed by Wall Street and their supporters. It was telling that the first question asked by a reporter in Fed Chair’s Janet Yellen’s press conference following the announcement was not a question at all. The reporter blurted out a sigh of relief: “Finally!” he exalted. The Financial Times’ Lex Column headline: “U.S. Monetary Policy At Last.”
In fact, the financial media have been huge cheerleaders for a rate hike. In the months leading up to this announcement, much of the business press had been pushing for an increase. In September, when the Fed did not raise rates, much of the financial press ran headlines like the this Wall Street Journal headline: “The FED Blinks.” The Journal was not alone with phrases like: “the open market committee sat on its hands.” Blinking and hands sitting: these suggest lack of courage, weakness and worse. Neil Irwin of the New York Times, personalized it to Janet Yellen with a headline on September 17: “Why Yellen Blinked on Interest Rates.”
Well, yesterday, Yellen did not blink and the financial press and many economists and pundits were clearly pleased. Yet, as the thoughtful members of the press and economists pointed out, economic conditions are not much better, and in some ways are worse, in December, than they had been in September. Dean Baker of the Center for Economic Policy Research (CEPR) wrote almost immediately after the decision multiple reasons why data do not support a decision to raise rates: He points out that while the official unemployment of 5% is not particularly high, “most other measures of the labor market are near recession levels.” The percentage of the workforce working part time but who really want full time jobs is near the highs reached after the 2001 recession. The percentage of workers willing to quit their jobs to look for a better job is also at near recession highs. “If we look at employment rates, the percentage of prime-age workers (ages 25-54) with jobs is still down by almost three full percentage points from the pre-recession peak.” Finally, wage stagnation is still significant, even despite some recent low gains.
The signs of weakness and uncertainty globally are also still strong. John Authers of the Financial Times shows in a series of graphs that market participants expect inflation to fall further, NOT rise to the 2% level expected by the Fed. Oil prices continue tumbling, which could be a source of demand for consumers, but like other aspects of deflation put a downward pressure on important sectors and, if they interact with excessive debt, can contribute to pressures for a debt deflation spiral. Global equities have fallen along with oil and other commodity prices, perhaps a sign of weakening profit expectations. And, importantly, the value of dollar continues to rise, which might help foreign exporters, but serves a drag on U.S. economic production by making it less competitive. This problem is exacerbated by the fact that the European Central Bank is moving in the opposite direction by lowering interest rates—even into negative territory.
All of this raises the obvious question of how did Janet Yellen and the Federal Reserve justify their rate increase now, despite strong signs that there is little economic basis for doing so?
Call this the Fed’s “New Operation Twist“: an exercise not in twisting the term structure of interest rates to lower long rates and raise short rates as in earlier times, but in twisted logic, plain and simple.
This was apparent in the Federal Reserve’s press release, and even more in Janet Yellen’s press conference following the Federal Open Market Operations (FMOC) meeting. Her justification for raising rates rested on several questionable, and even strange, twists of logic.
The first, and most important, is the confidence the Fed has that inflation will continue to rise toward its 2% target, even though, by raising rates, the Fed will be putting downward pressure on the economy. They are thus creating an additional “headwind” to join the other global forces in the domestic and global economies—weak demand in China, commodity market gluts, and uncertainty over terrorism and global security—that all suggest that inflation will remain weak.
Part of the reason they believe inflation will rise despite the increase in interest rates and other negative forces, is that they believe that, with lower unemployment, workers will achieve the bargaining power to raise their real wages. But in the current context of weak bargaining rights, globalization by U.S. multinational corporations, and the continued weakness in the labor market domestically, worker real wages are likely to continue doing what they have done for decades now: remain relatively stagnant.
These odd examples of twisted logic seem minor, though, compared to some of the more bizarre arguments made by Yellen and the Fed.
In her statement and answers to questions after her remarks, Yellen said several times that the increase in interest rates is a strong sign of the Federal Reserve’s confidence in the strength of the American Economy. Because, after all, if the U.S. economy were not doing well, then of course, the Fed would not be raising rates, right?
Here is an example of the Fed trying to play the classic game of the “confidence fairy”—we will raise your confidence by pretending we are confident. But it is rather more like “whistling past the graveyard”: with the data out there for everyone to see, most are unlikely to be fooled. It is also a little like saying: we are going to get in our truck and run you over because we are confident that you are strong enough to take it.
And here is, perhaps the strangest twisted logic of all: Yellen said that they want to raise rates now, because they are worried that if there is a downward shock to the economy, with interest rates at the zero bound they will have fewer tools (less ammunition) to counteract the shock.
Doesn’t this sound like she is saying: we are going to create a downward shock, so later it is easier to counteract it?
The final example is the argument that they want to raise rates preemptively now, before there is any clear sign of excessive inflation, because lags in monetary policy mean that if they wait they might be too late and then they will have to raise rates more abruptly and this will be even more disruptive.
We must ask the question: who do more rapid increases disrupt? The answer is likely to be the speculative financial markets, and the banks who might find that the speculative positions they take have been mistaken. So here, in paying excessive concern for the speculative financial markets, the Fed is willing to raise interest rates before the labor market is really ready.
This also begs the question: where does this 2% inflation target come from? It is completely arbitrary, which even Ben Bernanke, the architect of the new inflation targeting at the Fed, admits. Would it be better to allow a shallow rate increase trajectory at the appropriate time, and let inflation over-shoot its arbitrary 2% target, than risk prematurely nipping the recovery in the bud?
To be sure, Yellen repeatedly said that the increase in rates will be gradual. But projections by the Fed Policy Makers suggest anything but a gradual rate increase. These projections of the expectations of the policy makers (not their plans, to be clear) show interest rates rising to between 2 and 3% by the time the new President is inaugurated.
Why is it that Janet Yellen, clearly a very smart economist who is committed—like, perhaps, no Fed Chair before her—to try to achieve full employment and reduce inequality would engage in such questionable arguments and problematic actions?
The most likely answer is probably that Yellen faces enormous pressure from her own committee and outside forces to raise rates sooner rather than later. These outside forces are the banks. A series of papers have shown that in general, bank profits increase with higher interest rates. Economists at the Bank for International Settlements (BIS) have done empirical work that suggests that higher interest rates improve bank profits; and others at the IMF have done careful empirical work suggesting that in the U.S. higher interest rates raise income inequality.
But in the time of the Great Financial crisis and quantitative easing, the relationship between monetary policy, bank profits and inequality is actually more complicated than this. In a series of papers at the Institute for New Economic Thinking (INET), Juan Montecino and I show that Quantitative Easing by the Fed initially improved bank profitability and helped corporate profits in other sectors as well, such as automobiles and construction. It did also raise employment and helped workers and the middle class, but at the same time QE worsened income inequality by delivering large asset price gains to the wealthiest Americans.
By the later phases of QE, though, most banks in the U.S. did not continue benefiting from loose monetary policy and then the attitude of Wall Street toward expansionary policy likely faded. As Tom Ferguson and I showed in the case of prematurely aborted expansionary monetary policy in the 1930s, the banks began to lose more from lower interest rates than they gained in asset price appreciation and expanded demand.
The result is that the more standard pattern identified by the IMF and BIS economists of lower interest rates hurting bank profits has likely returned. And with it has been the blistering pressure to raise rates.
Facing this pressure, Janet Yellen has most likely decided play a strategic game: give in to the demands from her colleagues for a move toward higher rates, while expecting to be able to drag her feet in the future on raising too rapidly, in the hope of keeping monetary policy “accommodative” along the way.
Will this gambit—which has caused her to twist her logic like a pretzel—work? It seems like a long shot. Finance has its long knives drawn and it has plenty of allies on its side. At the same time, though, the fragility of the global economy will weigh in on her side.
The tragedy, of course, is that this is not the game she should be playing. First, fiscal policy needs to be much more aggressive in promoting needed investment. Moreover, rather than beating a strategic retreat, Yellen and allies should be engaging in much more creative, direct job promotion and direct promotion of local infrastructure investment, as proposed by groups like QE for the People in the UK, associated with Jeremy Corbyn, and the Fedup Campaign, here in the U.S. To make that happen, we need to keep pushing. And fast.
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