Fed redux: Making policy behind the curve
— John Kemp is a Reuters columnist. The opinions expressed are his own. —
With clear signs the U.S. and world economies have returned to growth, investors are trying to guess when the Federal Reserve will begin to raise interest rates again.
Voting to maintain the federal funds target at 0.00-0.25 percent at this week’s meeting, the rate-setting Federal Open Market Committee (FOMC) reiterated that low rates of capacity utilisation, subdued inflation trends and stable inflation expectations were “likely to warrant exceptionally low levels of the federal funds rates for an extended period”.
The language echoes almost exactly the phrasing the FOMC used throughout H2 2003, when it repeatedly noted that “the Committee believes that policy accommodation can be maintained for a considerable period” (Aug, Sep, Oct and Dec meetings). The formula was altered in January 2004 (“the Committee believes it can be patient”) (January and March meetings) but interest rates were not in fact raised until the end of June 2004.
Even then the Committee continued to damp down expectations of a sharp rise, employing the formula “policy accommodation can be removed at a pace that is likely to be measured”. The phrase was repeated throughout the remainder of 2004 (Jun, Aug, Sep, Nov and Dec meetings) and almost to the end of 2005 (Feb, Mar, May, Jun, Aug, Sep and Oct meetings) before the Fed switched to a full inflation alert at the end of the year (Dec 2005).
Federal Reserve Chairman Ben Bernanke was a member of the rate-setting Committee throughout almost all this period. He has passionately defended the Fed’s conduct of monetary policy throughout this period, most recently at the American Economic Association (AEA) conference earlier this month, where he rejected criticism it left rates too low too long, and was then too slow to increase them.
LESSONS FROM 2003-2006
Given the Fed believes it did nothing wrong, its conduct of monetary policy in the wake of the 1990-1991 and 2000-2001 recessions is likely to be a template for the months ahead.
Past experience suggests the first increase is at least six months away, but could be much further. It took the Fed another six months to begin raising interest rates after dropping the “considerable period” commitment in 2004. With the Committee still maintaining its “extended period” equivalent, the first rise is unlikely until H2 2010, and perhaps not into 2011.
But this time around the debate is likely to be much more rancorous and the course of policy attended by much greater uncertainty:
(1) While Bernanke refuses to admit the Fed make mistakes in monetary policy (as opposed to banking supervision), he has not convinced many economists, politicians or investors to accept the narrative. The Fed’s credibility has been badly dented. Moreover, confidence in its commitment to low inflation, and among foreign investors, has been weakened leaving the central bank less scope to chart a steady course and dismiss deviations in inflation as “temporary”.
(2) Federal Reserve Bank of Kansas City President Thomas Hoenig, a respected veteran, has already cast the first, rare dissenting vote, urging the Committee to drop its extended period language because economic and financial conditions had changed sufficiently that it was no longer warranted.
Hoenig’s dissent should be interpreted with care. It is unlikely he wants an imminent rate rise. Rather he probably wanted to give the Committee more flexibility and avoid becoming boxed in by a rhetorical promise to keep rates for much of the rest of the year. One criticism of the Fed’s approach in 2003-2006 was that it encouraged excessive risk-taking by inoculating investors against policy risks. Less certainty and predictability might have encouraged more caution.
POLICY BEHIND THE CURVE
The gradual pick up in manufacturing output and shipments around the globe is evident in a variety of real-world indicators. The number of containers handled at the West Coast ports of Los Angeles and Long Beach, as well as Asian trading hubs at Singapore and Hong Kong, has risen consistently in recent months from depressed levels in late 2008 and early 2009.
There has been a similar pick up in air freight, which is one proxy for higher-value added items. Volumes have started to recover at Memphis, Hong Kong and Frankfurt airports, the largest cargo hubs in North America, Asia and Europe respectively:
Policymakers nonetheless remain cautious about whether the recovery has enough momentum to be self-sustaining.
Much of the rebound has been driven by inventory-related changes along the supply chain. It could falter once production-consumption levels are rebalanced. The Fed will therefore remain inclined to keep rates low until the recovery has proven much more durable.
Past experience suggests monetary policy responds to the cycle with a much longer lag than most analysts assume. The attached chart shows changes in the Fed’s policy rate since 1972 and its estimate for capacity utilisation in the manufacturing sector. It is an informal graphical version of the “Taylor Rule” (often cited by the Fed itself) relating interest rates to the output gap:
Rates track capacity use but with a lag. After the last four recessions, capacity use began to rise in June 1975, Feb 1983, Apr 1991 and December 2001; but rates did not rise until Aug 1977, Jan 1987, Feb 1994 and Jul 2004, a lag of 27 months, 46 months, 34 months and 32 months respectively. A large overhang of excess capacity inherited from the previous downturn eased fears about inflation, allowing policymakers to focus on entrenching the recovery.
The average lag between growth resuming and the first rate increase has been 35 months. If the current recovery is dated back to July 2009, rates might not rise until end-2011.
A SUI GENERIS RECOVERY?
While there is a pronounced rhythm to the business cycle, every recovery is in some sense sui generis. There are reasons to think the present one and associated rate changes will differ even more than usual from the “norm”:
(1) Policymakers have produced a huge distortion in financial markets, with the lowest rates since World War Two coupled with massive liquidity injections, and an ultra-loose fiscal policy. While the distortion may have been justified, it leaves officials with a lot of heavy lifting to do in order to “normalise” conditions by the time the expansion becomes mature.
The longer the adjustments are postponed, the more abrupt and disruptive they will become, and the greater the risk of inflating another even bigger asset bubble.
In the early stages, the Fed may reduce liquidity rather than raise rates; the Committee has already voted to allow some extraordinary programmes to expire. But in the end the cost of borrowing must rise; whether the Committee focuses on reserve volumes, the discount rate or the fed funds target makes little practical difference.
Leaving rate rises until the end of 2011 would represent an enormous gamble. The Fed may start to guide rates to more normal levels before then. Early moves (starting in H2 2010) would enable it to maintain a relatively gentle trajectory.
(2) Epidemic default has only been averted by cutting borrowing costs sharply, enabling over-borrowed households and companies to cut their servicing costs and refinance, while allowing banks to fatten gross interest margins.
Given the underlying fragility of the loan book and household finances, raising rates too early would carry a significant risk. With the degree of overleveraging preceding the crisis, it could take several years to repair balance sheets to the point where they could withstand a significant tightening of conditions.
Even assuming the economy manages a sustained recovery in 2010, which seems likely, any changes this year are likely to be minor, and monetary conditions are unlikely to normalise significantly until well into 2011.