At the end of its two-day policy meeting on January 25th, the Federal Reserve revealed its new communication strategy. It will now share with us all the forecasts made by all of the voting members of the Federal Open Market Committee (FOMC) and more on interest rates. It has a formal medium-term inflation target of 2% based on the price index for personal consumption expenditure (PCE). It does not have an employment target or unemployment rate. It has concluded, for better or worse, that it has more influence over inflation outcomes than over employment outcomes. It thinks that the natural rate of unemployment in the US is between 5.2% and 6.0%.
FOMC in December 2011
In addition to all of the above, what else did the FOMC decide on January 24-25? It decided that interest rates would stay low up to late 2014. The last time the FOMC met was on December 13th. The FOMC decided the following at that time:
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 per cent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
What was the economy doing then? This is what they said:
Information received since the Federal Open Market Committee met in November suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth.
Now, what did the FOMC decide on Jan. 25th?
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 per cent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.
That is a 15-18 month extension of the zero interest rate policy, pre-committed. What does the Federal Reserve need monetary policy autonomy and independence for, if they are going to chain themselves more and more? At least, is there any incremental logic in what they did between December 2011 and now? They repeated the same assessment of the economy:
Information received since the Federal Open Market Committee met in December suggests that the economy has been expanding moderately, notwithstanding some slowing in global growth.
There was no incremental deterioration in their assessment. It was identical to the December statement, in fact.
In terms of actual economic data, the housing market index has improved beyond what they could have imagined. The unemployment rate has declined and so have did the initial jobless claims. Purchasing Managers’ indices in various Federal Reserve regions have shown first order or second order improvement. As usual, the US stock market is defying gravity.
Now, let us make one thing clear. We do not think these are lasting signs of economic recovery. We may even venture to add that some of the improvements do not pass the test of rigour. However, from a rational decision-making angle, what matters is the change; what happens at the margin. At the margin, things have certainly not deteriorated but got better.
Lastly, if we examined the forecasts developed by the Federal Reserve Board members and Federal Reserve Bank Presidents, it is hard to discern a case for extending the zero rate (or, low rate) pledge until late 2014. If anything, their unemployment rate projections are more optimistic now than the ones they made in November 2011!
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Medium-term inflation target – case for tightening
If the natural rate of unemployment is now estimated at between 5.2% and 6.0%, then it is logical that the output gap is not as negative as is deemed. When the excess capacity is not as large as thought of earlier, then it further weakens the case for extending the period of exceptional policy setting.
The Federal Reserve has now announced a medium-term inflation target of 2% measured by the annual change in the price index for PCE. The average annual inflation rate measured by the PCE Price Index is 3.2%. If we are somewhat more charitable to the Federal Reserve, omit the early years of the 1980s when the inflation rate was in double-digits and calculate the average inflation rate from the 1990s, the rate is 2.2% – still above the Federal Reserve target of 2.0%. The annual inflation rate in the last two quarters (June and September 2011) has been 2.5% and 2.9% respectively.
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In other words, there is nothing in the data to warrant the Federal Reserve extending its zero interest rate policy by another 18 months.
Lastly, empirical evidence over the last three decades has shown that inflation targeting is useless in helping central banks avoid or contain systemic crises. If anything, inflation at or below target lulls central banks into policy complacency. Central banks need to look at a wide variety of indicators to identify and eliminate risks before they become too big to handle. In a well-functioning market economy, prices of goods and services would automatically adjust as both demand and supply respond to price signals. There is really nothing for central banks to do except to oversee prudent money supply and credit growth.
Forsaking policy independence is irrational
What did the last episode of pre-commitment under Greenspan achieve? He kept the Federal Funds rate at 1.0% from 2003 until 2004 (he need not have brought it down to 1.0% in the first place) and then increased them gradually at a pre-announced pace of 25 basis points per meeting? Did it cause market participants to taper off their risk-exposure gradually? No. It made them take on more risk because he had removed monetary policy unpredictability and uncertainty, which are legitimate weapons in the policy arsenal.
So, what was the logic in extending the zero per cent interest rate commitment by another 15 to 18 months when mid-2013 is already some 18 months away? Is there something that they know that we do not know about the underlying economy? Are all the recent improvements in the data fabricated? If they do expect the economy to remain as sluggish as to warrant zero per cent interest rate for almost another three years, then why are they not simultaneously warning of irrational exuberance in the stock market?
With his excessively loose monetary policy in 2001-2004 and with his gradual tightening from 2004 to 2006, Greenspan played a major role in precipitating the global financial crisis of 2008. His successor has exceeded him in many ways. It should not surprise us if the consequences too are far worse.
So, why is the Federal Reserve doing this?
There are many reasons. First, they suffer from intellectual paralysis. All policymakers (and economists) work with dogmas and not with open minds. If they are lucky, the dogmas do not lead to disasters. Otherwise, it does. That is what happened in 2008. They do not learn from errors. They are human beings, after all.
Second, to be charitable to them, American policymakers see deflation and depression in every corner. Every other risk is worth taking to avoid that one risk. To be uncharitable and honest, their true goal is monetary debasement and inflation. That is how one takes care of the mountain of present, future and contingent debt. Savers, pensioners and creditors – domestic or foreign – be damned.
Third, given that they are worried about deflation, they could have considered another round of money printing as they did in 2009 and in 2010. Republican Presidential hopefuls have set their face against it. Hence, Bernanke has to resort to this subterfuge.
Fourth, the Federal Reserve was smug with confidence that they were the only one in the race to debase money. Now, they have a rival who has either already closed the gap or raced ahead of the Federal Reserve. The expansion of the European Central Bank (ECB) balance-sheet in recent months has been astounding. It does not even require high-school mathematics to estimate that the growth rate of the ECB balance-sheet has been just under 50% in the last seven months.
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Economists would argue that this would not cause inflation immediately because either (a) the money multiplier is weak or that (b) these are temporary expansions of the balance-sheet or (c) that the market believes them to be temporary and hence, they would not influence expectations. May be, all of it is true although we are sceptical of all the claims made above.
Even if they were true, the distortions it causes to human behaviour (encouraging speculation in contrast to investment), to asset prices (bubble-creation), to competitiveness of developing countries (their currencies appreciate too much too soon for them to adjust) and to social equality (asset price gains do not accrue to the majority of the population) are too serious to be intellectualised or dismissed with a wave of hand.
The actions of the Federal Reserve are irresponsible and hence, indefensible. Their putative gains, if any, outweigh both local and global costs.
Investors react like flies drawn to fire
In response to this decision, stock markets went up in the US and in Asia. May be, that pleases the FOMC. After all, they measure their success in terms of the reaction in stock markets. Previous episodes of excessive and prolonged loose monetary policy have shown that such gains are not sustainable. This one will be no different.
Commodity and carry-trade currencies have also surged ahead (Australian dollar, South African rand and Brazilian real, to name a few). Such gains are neither economically desirable for their countries nor are they sustainable.
Gains in precious metals and commodities are the only things that matter, as the race to make paper currencies worthless is now well under way. The number of participants is increasing by the day. We only have to wait for the Bank of Japan to join. They have resisted wisely so far. Will politicians and exporters let them stick to their sensible approach? When they too succumb, expect gold to soar. Of course, gold does not need further impetus than what the Federal Reserve and the ECB have provided already.