Janet Yellen’s flip-flop
In the last one month, things have begun to turn in the bond market globally. Yields have begun to rise. In its June monetary policy meeting, the Federal Reserve (Fed for short) raised the federal funds rate (FF rate) in June to a maximum of 1.25%. Not only that, the minutes of the meeting of the Federal Reserve Open Market Committee confirmed that the Fed stands ready to start shrinking its balance sheet in the next few months.
Some commentators think that the policy stance of the Fed is wrong (Martin Sandbu of Financial Times is an example). They feel that the move to raise the policy rate in baby steps risks an end to the economic expansion that is eight years old. Even if the inflation rate were below 2% and would stay that way, the FF rate in real terms is negative. Or, even if the inflation rate were to edge down to 1.5%, the real FF rate would be barely positive. When the unemployment rate is below 5%, supply of leveraged loans at a record high, stock indices at record high valuations and stock market volatility at record lows, that level of real policy rate is unacceptably low.
According to critics, invoking financial market conditions to justify rate hikes is flawed because it mixes both financial market and real economy objectives. One instrument can work with only one objective. That objective is inflation and that is below the (implicit) target of 2% and hence, interest rates should not be raised. Financial stability should be pursued through macroprudential measures.
However, this argument is wrong because interest rates affect both the real economy and financial markets. In fact, textbooks always inform students that interest rates transmission works through financial variables such as long-term interest rates and stock markets. Hence, the argument that the interest rate policy tool should be wielded only to achieve the inflation objective does not wash. Unfortunately, it seems to resonate with the Fed.
It was disappointing and yet unsurprising that Janet Yellen, the chairperson of the Fed, downplayed the market’s tightening expectations in her testimony to the US Congress on 12 July. She repeatedly referred to tame inflation and acknowledged that the Fed would take note of it. Frankly, I am unable to understand her rationale for soft-pedalling market expectations of future rate rises in America. It only confirms our fears that the Fed remains captive to asset markets.
Financial conditions in the US are looser than they were when the Fed first raised the interest rate in this cycle in December 2015. Indeed, they are looser than they were in 2007. Only in 2014, were financial conditions in the country looser than they are now. That clearly shows that the Fed should have begun tightening in 2014. They left it until the end of December 2015 and now, after financial conditions have become more expansionary in the last one-and-a-half years, Yellen has inexplicably softened her message to the market.
The Fed is well behind the curve and that’s why leverage picked up and stock market valuations are too high. Hence, what it has been doing in the last one-and-a-half years is to belatedly acknowledge the financial instability risks by normalizing monetary policy, even though inflation rate is below 2%.
The awkwardness of tightening monetary policy when the inflation rate is well behaved would not be necessary if the Fed had not left it too late to do too little. More specifically, if the Fed had incorporated financial stability into its mandate, it would not have waited this long to begin to normalize monetary policy and inconsistent and confusing statements would not have to be made.
If the Fed’s policy decisions diffused through financial variables and if it had not responded to the tightening efforts, then it is an open-and-shut case that the Fed needed to do more to make sure that financial conditions tighten. After all, that is the objective of raising policy interest rates. Hence, soothing words to financial markets on future interest rate increases is the opposite of what sensible monetary policy is.
This is a replay of what happened in 2004-06. Even as the Fed was increasing interest rates, yield on US Treasury instruments did not pick up commensurately, thus blunting the Fed’s rate increases. The Fed blamed it on Asian savers. It did not take any other action nor did it alter its policy trajectory or its policy transparency. We all know what happened in 2007-08. Nearly a decade later, Yellen risks repeating the same mistake.
Consequently, the risk of a stock market crash leading to an economic recession is not small. Of course, commentators such as Sandbu would blame the Fed for having normalized monetary policy a little too enthusiastically, precipitated a stock market crash and brought about an economic recession. We would, however, blame the Fed’s loose monetary policy for having created the stock market boom that inevitably bursts and culminates in a recession.
Since 2012, central banks in advanced countries have done enough to hurt the credibility and usefulness of monetary policy and central banking, in general. If another crisis or financial market meltdown struck—as is likely—they would stand discredited and be rendered powerless. Going by their overall record since 1997, that would be no bad thing.
V. Anantha Nageswaran is senior adjunct fellow (geoeconomics studies) at Gateway House: Indian Council on Global Relations, Mumbai. These are his personal views. Read Anantha’s Mint columns at www.livemint.com/baretalk
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