Fear could lead Fed into a much more fearsome trap

September 18, 2015

Delaying its first rate hike in nearly a decade after taking a pass in June and July means the U.S. central bank may have stepped further away from an escape from zero rates and $3.7 trillion of asset purchases bloating its balance sheet.

No central bank in post-War history has ever successfully made this escape. All four of the developed world’s biggest central banks — the Fed, the European Central Bank, the Bank of Japan and the Bank of England — are in different stages of the same situation: near-zero rates and holding huge piles of financial assets.

If Fed Chief Janet Yellen can’t get interest rates up above zero before the end of the business cycle, she won’t be able to lower them when the next recession hits. After more than half a decade of expansion and full employment nearly reached, it’s a race against time.

Taking a pass this month doesn’t necessarily mean the Fed is already stuck in a liquidity trap, where a central bank’s ability to effectively steer the economy through monetary policy becomes severely impaired.

Rates and balance sheets

However, as with most momentous decisions in business, when a window of opportunity presents itself, sometimes it’s best to act.

The problem is the Fed has just lowered the sash even further on its own escape window.

Blaming her hesitation in part because of the global economy, particularly China, as well as turmoil in global financial markets, Fed chief Janet Yellen has made it even more difficult to satisfy her own conditions to get out, no matter how well the U.S. economy performs.

By all accounts other than the official one from Beijing, China’s economy is slowing. Its central bank has cut interest rates five times since late last year and it has just recently devalued its currency.

Even if these policies succeed, we won’t have evidence of that for some time, and certainly not in time for the Fed’s next few meetings.

As for financial markets, they are in turmoil in large part because of the Fed’s own indecision.

Marc Ostwald, FX, rates and emerging markets strategist at ADM Investor Services, summed up the Federal Open Market Committee’s choice this way:

If the FOMC’s objective was to convey confusion, it has succeeded, thereby ploughing a deep furrow of instability and destabilization, and shining a very bright light on the large debt and liquidity trap it and other G7 central banks have spent 7 years crafting.

Joel Naroff, from Naroff Economic Advisors, was even more blunt:

All they succeeded in doing was confusing the heck out of everybody. They introduced financial concerns, third-world countries, China, Canada.  What the hell does that have to do with the U.S. economy? I’m totally baffled by it.

Citing markets as an explanation for pausing on a rate rise is a short-term solution and is highly unlikely to create the calm backdrop the Fed supposedly is looking for. It’s targeting the symptom of the problem, not the cause.

And as Yellen herself said at the news conference, it’s not the Fed’s job to follow the ups and downs of the markets.

Fear, as markets know very well, is a powerful thing. You can be afraid of the unknown and of repeating a mistake, only to find that the fear creates more fear and eventually, paralysis.

The BOJ, which like the Fed seeks to run a 2 percent inflation rate, has been stuck in a trap for 15 years, since it first ran out of interest rate to cut and began a programme of quantitative easing (QE).

After several years, it saw a window of escape around the last time the Fed hiked rates and raised rates twice, to half a percent. But that inflation threat turned out to be a mirage, with the BOJ eventually having to cut back to zero and then scrap its overnight call interest rate.

Since then, it has conducted an exponential amount of additional QE, with an aggressive escalation about 2-1/2 years ago, but to no avail. Inflation is still doggedly below target and deflation comes and goes but never goes away for good. It is likely to conduct even more QE in the months ahead.

This Japanese rate mistake that led to a deeper liquidity trap – and other recent failed attempts to raise rates, particularly by the European Central Bank, which twice mistakenly chased inflation pressures that never materialised – likely played a big part in stopping the Fed from gunning for a rate rise now.

After all, it’s not as if Yellen couldn’t have found explanations for raising rates that even the staunchest of opponents would have accepted. And the difference between 0-0.25 percent and 0.25-0.50 percent should not be enough to choke off the world’s biggest and most powerful economy, with core inflation running not far below 2 percent.

Many business leaders – although not the chief executives of J.P. Morgan and Goldman Sachs just before the decision – have recommended she get on with it.

Even a clutch of central bankers from emerging markets, whose currencies have been pummeled to multi-year or record lows as the dollar has surged in anticipation of such a move, have very bluntly recommended the Fed get on with the job.

As with so much of central bank policy which pretends to be a lot more complicated than it really is, the reason it hasn’t done so appears to be rather simple. It seems afraid.

— Siddharth Iyer contributed to this post

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