Draining the monetary policy swamp
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Just before the first quarter ended, the US released March data for its most comprehensive (excluding the GDP deflator, of course) inflation indicator—the Personal Consumption Expenditure Chain-Type Price Index. The annual percentage change (PCE inflation rate) in the headline index had crossed 2.0%. It read 2.1% when rounded off. Between January and September 2015, it hovered at around 0.2%. The last time it was above 2.0% was in April 2012. The core index reflected an annual percentage change of 1.8%. Is inflation about to raise its head in the US in a big way?
It is well known that the Federal Funds rate hovered at around 0% to 0.25% since December 2008 until the Federal Reserve hiked the rate in December 2015. The next one followed a year later in December 2016. Is the Fed behind the curve? Alternatively, has it done too little, too late?
We have posed three questions and it is possible to answer the questions independently. In other words, a nasty resurgence of inflation in the US is not inevitable because monetary policy has been too loose for too long. Indeed, inflation is unlikely to pose a big problem for the economy despite the monetary policy mistakes because policy played no role in its secular decline. Other forces did and they are still active. We will examine it more closely on another occasion. This time, the focus is on the Fed.
The reason why the Fed ends up creating bubbles and busts is that it is too slow to begin tightening and when it does, it overdoes it because it is already late in doing so for the cycle and the strains and fault lines of the preceding boom have begun to manifest in any case, especially in asset markets and in risk-taking. That was the case in 1987, in 1999-2000 and in 2004-07. The only exception was in 1994 when it moved to raise rates aggressively before asset prices had entered bubble territory. That is why the US economy narrowly avoided a recession and there was no bubble to prick, then. But that was the exception and not the rule. Those were the days when Alan Greenspan actually worried about irrational exuberance in the stock markets.
But, this time around, the Fed has stuck to the script of the last three decades. It has begun normalizing (note, it is not the same as “tightening”) monetary policy very slowly. Indeed, it has moved from being “recklessly ultra-loose” to being “somewhat recklessly loose” in the last two years.
That said, the Fed is right to make an attempt to catch up with the economic cycle. It is better late than never. The consequences of remaining recklessly ultra-loose would be worse. Yes, the cycle is about eight years old. But, look at the cyclical indicators:
(a) Personal Consumption Expenditure (PCE) growth is accelerating.
(b) Change in the Labor Market Conditions Index is now positive. It showed weakness in the early part of 2016. That phase has passed.
(c) The Manufacturers’ New Orders (non-defence capital goods excluding aircraft) is now showing positive change in the last three months (year-on-year) after a long spell in negative territory.
(d) The Chicago Fed National Activity Index is accelerating now.
So, from a real economy standpoint, there is momentum.
Indeed, one should not discount the possibility that the belated normalization of monetary policy by the Fed and the prospect of the stultifying regulations imposed by the Barack Obama administration being lifted are lifting the mood among households and business enterprises in the country. Persistently low interest rates reinforce deflationary mindsets and thwart capital formation by businesses. It is well documented now. If only the nanoscope and the laser-like focus that commentators had brought to bear on the new administration in the US had been deployed with the previous regime too, who knows things might have turned out differently and for the better, for the American economy.
So, the Fed is right to make hawkish noises now. Further, there is clear talk of fiscal policy becoming looser. It has not done so yet. But the signal is for a regime shift in fiscal policy and that does call for a less accommodative monetary policy.
Where the Fed has always erred—including in this cycle—is in allowing asset prices to get way ahead of fundamentals, as they have done in the last several years. So, by the time fundamentals actually begin to turn, asset prices are way out of alignment already. There is no more good news to be priced in. The Fed tightens at the first sign of strength in the real economy. Even if it is gradual, it is enough to stop the economy in its tracks because by then too much risk has been accumulated in financial markets.
One risk that the steady diet of low and lower rates could have spawned needs to be acknowledged here. That is the emaciation of the strength of the economy to withstand even remotely normal interest rates because the Fed had gotten “economic agents” accustomed to gradually lower and, finally, exceptionally low rates for too long a period. This has been the monetary policy script for the last three decades with just one exception, as noted earlier.
For America to maintain its economic dominance and the global hegemony of the US dollar, both the institution and its monetary policy framework are in need of a drastic overhaul. That is one swamp that has to be drained, for sure.
V. Anantha Nageswaran is the co-author of Economics Of Derivatives and Can India Grow?