international analysis and commentary

The outsized role of the Fed and the uncertain road to normalcy


When the United States Federal Reserve (Fed) pulled the trigger in mid-December on its first interest rate hike in nine years, its decision was a long-time coming. In the face of a steadily improving domestic economy, the American central bank had been looking for the right opportunity to tighten for months. It held back only because of a series of negative international developments, from Greece’s reignited debt crisis in the spring to China’s economic turmoil in the summer.

The rationale behind the Fed’s latest move and its consequences are now hotly debated at home and abroad. In all likelihood, they will continue to be so for the foreseeable future given the scope and depth of the effort the Fed undertook since 2008 (in combination with other central banks in the developed world) to help pull the American, and global, economy out of the Great Recession. What is clear, however, is that Chair Janet Yellen and her fellow monetary policymakers in the US have now reached the end of the line in terms of their willingness to push the envelop and embrace an unconventional approach to easing of such historic proportions. This begs the question of who is going to pick up the slack and drive the economy forward as the Fed gradually moves back into its comfort zone and as monetary policy, at least in the US, begins to recede from the headlines into the background where it has traditionally belonged. 

Because the December interest rate hike was minimal and had been long in the works, its impact had been largely priced in the market already and therefore it did not cause any immediate disruption. The fact is that, by the end of 2015, the pressure on the Fed to start raising rates, albeit gradually, had built up enough that yet another delay would have been the real surprise. “I think it was roughly just about the right time,” says David Stockton, Senior Fellow at the Peterson Institute for International Economics in Washington DC. “Perhaps they could have waited and gathered even more evidence, but overall I don’t think this will turn out to have been a mistake as long as they move slowly and are attentive to the economic and inflation outlook.”

According to Stockton, the Fed’s decision will have a measured impact on both financial markets and the real economy in the US. Markets are likely to be “in a state of heightened anxiety” and experience “more volatility” over the next year, as investors try to anticipate if and when the Fed may follow up with more rate increases and what else might be in the cards. As for the real economy, this new less accommodative cycle may restrain the future pace of growth and cut into job creation, at least to some extent. But, for now, this is no reason to panic. “We’ve been adding some 200,000 jobs each month on average for some time and only about 100,000 are needed to stabilize the employment picture,” Stockton says. “The Fed is looking to slow things down so unemployment doesn’t fall too much too quickly.”

Stockton is the first to admit that, as always when monetary policy shifts direction after a long period of time, these downside risks could turn out to be a bigger blow than expected. “I don’t think that’s going to be the case,” he says, “but it is a possibility”. After all, the American economy is improving but it is still far from where it should be considering there are still many people who, by necessity, are forced to work part-time though they need full-time employment and that a large chunk of the labor force has dropped out of the job market altogether. Additionally, by some measures the Fed is still falling far short of its 2% inflation target.

This context gives some economists, particularly on the left, pause. They are convinced that the central bank’s latest action is premature, especially as it is expected to be not a one-off event but the opening salvo in a new, increasingly tighter monetary cycle. “The overall effect of the interest rate rise is that it substantially increases the risks to the US economy without any measurable benefits,” says Christian Weller, Professor in the Department of Public Policy and Public Affairs at the McCormack Graduate School of the University of Massachusetts, Boston.

According to Weller, higher interest rates throughout 2016 will strengthen the US dollar thereby hampering American exports, which have already been suffering due to the global slowdown and lower oil prices. Secondly, they will threaten American households, which remain heavily indebted from the past and continue to borrow anew, especially risky student and car loans. “As interest rates go up, there are two possibilities that are not necessarily mutually exclusive,” says Weller, who is a Senior Fellow at American Progress in Washington. “People will borrow less for their education and to buy new cars, thus slowing domestic demand, and people with variable interest rate and costly credit may start to become delinquent and default on those loans.”

Taken together, these developments could increasingly chill economic growth in the US, all for the sake of negligible rewards for savers and for the Fed, who is said to want to get out of the corner of near-zero rates in order to give itself more room to maneuver. “Retirement savings accounts have done pretty well in the last few years and there is little reason to believe that they will do much better,” says Weller. “The benefits with respect to more wiggle room for the Fed’s policymaking tool are limited, unless the Federal Reserve is willing to raise interest rates a lot. That seems neither their intent nor particularly logical – raise interest rates that destroy the economy, so that the Fed can use interest rate cuts to save the struggling economy that they helped create.”

In the meantime, a starkly different breed of criticism is coming to the Fed from the opposite side. Economists in more conservative circles have never approved of the central bank’s reliance on unconventional tools for such a prolonged period of time and view the December rate hike as long overdue, decidedly insufficient and generally irrelevant. “A 25 basis point hike in and of itself has zero impact on the real economy,” says Alex Pollock, Resident Fellow at the American Enterprise Institute (AEI) in Washington. “Interest rates continue to be exceptionally low, it is silly to even talk about this as a significant increase.” Pollock sees the Fed as having spent the last seven years manipulating interest rates downward so much that the whole process has turned into the expropriation of the money of savers to the advantage of borrowers, in particular the “highly leveraged professional” kind like investment funds. It has also artificially inflated asset prices across classes. These have been tumbling down for commodities with other sectors to follow. “If the market believes, which it probably does, that there will be a series of such increases, asset prices will deflate, losing some of their previous inflation in the coming year,” Pollock says. He judges this course correction as potentially healthy, the opportunity for markets in the US to come out of the unnatural state they have been kept in by the long arm of the country’s central bank.

For Pollock, the only argument that could be made for the suppression of rates, and generally for an interventionist monetary policy, is of a strictly temporary nature. “But this has not been temporary, it’s been six years since end of financial crisis in the US,” he says. “The Fed should go back to the original idea that spurred its creation in 1913, that it should be there for financial crises. As soon as a crisis is over, it should get out of the way and leave the market to set interest rates.”

Whether the Fed is wrong now, was wrong before or has been right or wrong all along, the passionate debate that has surrounded its every move in the last few years is a testament to its increased centrality in the economic life of the US. For better or worse, its outsized role was always bound to come to a close sooner or later. Bar major unforeseen geopolitical events in the next few months, which could convince the Fed to backtrack on its latest decision, this trend is likely to continue. As Yellen & co. leave center stage, the economic failures of the political leadership of the country, and not only, and the absence of a forward-looking fiscal policy, both of which have been partially masked by low interest rates and Quantitative Easing (QE) over the last few years, will come into even starker focus. A clear opening for Congress to start doing its job again will follow. “The Federal Reserve under both Ben Bernanke and Janet Yellen have long argued that monetary policy cannot be the only policy game in town and that fiscal policy will have to step up to strengthen the economy,” concludes Weller. “Raising interest rates and ending quantitative easing sends a clear signal that the Fed is slowly withdrawing from supporting the sluggish recovery. This puts more pressure on fiscal policymakers to address the remaining weaknesses in the economy.” Will Congress heed the warning?