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The Path to Normalization – As it Stands Today

Nitin Bajaj

“Inflation is always and everywhere a monetary phenomenon”   — Milton Friedman

The Federal Open Markets Committee (FOMC), the chief decision making arm of the Federal Reserve System of the United Sates, is scheduled to meet on 16th September for deciding on its overly speculated benchmark lending rate hike (referred to as “lift-off” in the monetary world parlance). It is special for two main reasons: one, it’d be the first of its kind since before the Great Recession (2006 to be precise); second, it’s in the aftermath of the recent economic turbulence in China, which took the stock markets across the emerging and developed worlds alike for a bumpy ride last month. Even the Chinese state media – often taciturn about the not-so-good aspects of the Chinese society – called 24th August,  a “Black Monday”.  Everybody wants to know when the Fed would raise the benchmark interest rates, not necessarily because it’ll help the economy, but because it’d help a lot of investors in knowing when to get out of some of the major emerging markets they are currently invested in.

The aim of this article is to look at the upcoming Fed decision in the current US economic environment, but doing so in the context of a few important economic themes. One is that of the more globally integrated world that we find ourselves in than any other point in the history of the world; the testimony to that global integration is the international pandemonium that resulted from an American asset-bubble and banking turmoil following 2007-08. Hence, the challenge of conducting monetary policy in a more coordinated fashion in this new global economic order.  The second theme assumes that the long-rallies of fast-moving year-on-year growth for the rich world are over, and more recently, that the emerging markets – where the largest money market funds invested a significant portion of their portfolios – are clearly more vulnerable than an informed analyst would have presumed even an year back.

In the years since the Great Recession of 2007-08, the Federal Reserve has exercised an extreme form of monetary expansion – the short-term risk-free interest rate stands at zero as this article goes to press – in order to boost growth through increased money supply.  Compare the zero percent short-term interest rate of today to the twenty percent interest rate of 1982. Stanley Fischer, the Fed Vice Chair, calls it an “ultra-expansionary” monetary policy.  It’d be safe to say that now gone are the days of the three decades following the great depression of 1929 when the general belief remained that “monetary policy doesn’t work in deep recessions.”  The US government, similarly, has exercised a widely expansionary fiscal policy through government spending.  As a result, the economy seems to be returning back on track with robust labor market statistics every month. The American budget deficit is very normal—around 2.5%. The IMF is forecasting a 3% GDP growth for the next fiscal year. So, what does it meant for the United States—is an interest rate hike necessary, or for that matter a safe choice?

A historical perspective, here, is important to understanding the role of Fed in the present American economic framework.

If we run a brief historical analysis, the Fed was set up in the year 1913, as a vanguard of financial stability, chiefly to provide financial liquidity in tumultuous times. Over time, its main role, much in line with the mandate of the other central banks around the world, was defined as ‘maintaining price-stability’ in the economy. In 1946, only two years after the Bretton Woods Agreement, the US Congress passed the employment act to add ‘stabilizing employment’ as the second duty to Fed’s mandate. Many economists still find the idea of giving the mandate of controlling employment to Fed as distasteful since, according to them, it requires manipulation of asset prices on Fed’s behalf to control employment. With this unusual dual mandate, the two implicit numbers became Fed’s inscribed goals over the business cycle, i.e., achieving an inflation rate of 2%, and a natural unemployment rate of 5-5.5%. Over its long history of over a century, the Fed has been through various phases of being blamed for inaction, or on many other instances, for acting very late. In 1971, as Nixon virtually ended the gold standard of the US Dollar – when the dollar couldn’t anymore be converted in to gold – the dollar became a much more venerable currency and the Fed entered in to a new era. It is important to note here that gold had ceased being a backing standard for world’s currencies in 1944 as most of the world embraced dollar as its reserve currency, the dollar still was backed by gold until 1971. As U.S. inflation skyrocketed in late 60s and early 70s as a result of the insurmountable U.S. treasury bills from Vietnam War, Nixon found it unsavory to have gold reserves for all the new dollar bills that needed printing. Henceforth, the US bills were backed only by the faith in the Federal Reserve System and its policies. The successive leaderships of Paul Volcker and Alan Greenspan manifested the Fed’s good, and sometimes God-like, abilities. The era from early 1980 through 2000, referred to as ‘Great Moderation’, exhibited mild recessions, rising stock markets, growing economy, low unemployment and extremely low inflation. At the beginning of the 21st century, the then widely admired Fed Chairman, Alan Greenspan decided to decrease the interest rates to record low levels and what ensued in the form of a housing-price bubble and a banking crisis is now history.


Coming back to the question of interest rate hike, even as the central bankers around the world move with a tunnel-vision focus on stabilizing prices, the Fed remains obligated to monitor and control price-rise as well as unemployment. Some of the policies used to tackle both inflation and unemployment at once, turn out to be double-edged swords. Even though the unemployment rate is close to Fed’s target of 5%, inflation hasn’t risen much in the last few years; overall inflation remains around 0.3%, while the core inflation (excludes the energy and food-prices) is at 1.2%—still far from the 2% Fed target. One of the premises and an important condition for monetary tightening is rising inflation. What if, despite the lift-off, the unemployment continues to fall, but inflation doesn’t increase; worse still, it declines. It’ll be a visceral environment again, followed by visceral market voices. Secondly, an increased interest rate in the U.S. will expedite the already in-process capital flight from the emerging markets. We have clearly seen in the last one-decade how the spillovers of policy decisions cross borders through exchange rates and capital flows. And cross-border flows driven by low-yields in the domestic economy – or in this case, higher yields in the American economy – are some of the ugliest consequences of infighting between countries, fought with an arsenal of unconventional monetary policy instruments.

The global economic environment seems particularly uncertain. When the Chinese government, in order to boost its exports, devaluedsuperpower-showdown-share Yuan on August 11th, the stock markets around the world went in to a free fall. The government’s subsequent decision of pumping money in to the markets by buying $156 billion worth of stocks exacerbated the situation. Since the Yuan’s devaluation, around $5 trillion have been expunged off the global equities markets and a vast range of commodity prices have ebbed to their lowest in more than a decade. It’s apparent that China is entering in to the phase which its South-East Asian counterparts, namely Korea, Japan, Malaysia, and Thailand have experienced in the past after their successive decades-long high growth periods.

The bright side from the U.S. perspective is that the U.S. government is not dependent upon the Chinese economy as much as some of the other countries like Germany (DAX fell by 20% on Aug. 24), Brazil, Indonesia and Zambia are, even though China owns about $1.3 trillion of U.S. debt. The American exports to China account for less than 1% of American GDP.

Yet the question is, can the U.S. monetary policy makers ignore such dramatic economic events in world’s second largest economy and focus their attention on a lift-off without addressing the fundamental element of output growth in the economy. The underlying factor, which has kept US economic growth very slow for the last several years is the extremely low – and perhaps often stagnated – productivity growth. Its aging infrastructure needs significant spending, yet the policy makers failed to put money in to its roads and highways despite historic low interest rates. Instead of building factories that produce income, Americans have spent the last few decades building houses that don’t produce any. Despite all of this and the resounding echoes of a developing plutocracy – as we know the richest 1% now own 42% of the financial wealth – the American economy has time and again tested the turbulent waters of boom and bust, and emerged resilient. The plentiful discussions that abound the boardrooms of its private and public corporations, think-tanks and government agency headquarters have proved remarkably efficient in finding solutions, even when the problems weren’t always precisely defined.

Certainly the stock market, for the long run, provides no indication of economic fundamentals, yet it’d be prudent on the part of the FOMC to keep studying the economic numbers for a few more months to come and then make a decision.

“Whether China’s economy can continue to grow rapidly will depend far more on its ability to reform than on how its stock markets perform.”

The bottom line, according to me, is that coordination amongst the central bankers – which doesn’t always mean cooperating on domestic monetary policies – matters in the new integrated world where cross-border spillovers are all but inevitable. A U.S. interest rate hike without discerning attention to the developments, and hence the repercussions in the rest of the world, is a foolish step at best. Thinking about the direct effects the world would have, instead of only the effects supplied to the US economy through various feedback loops, would be extremely useful in setting a first step towards a cooperative monetary policy environment. The intention to change course of policies in anticipation of market turmoil in emerging markets would be a good gesture of America’s leadership in the world. Nevertheless, it’s usually the mandate of the domestic policy that takes effect, but starting with a mere recognition of the international cross-border affects before every policy decision will go a long way in fostering economic cooperation in monetary policy.

imagesAs for China, the Asian Development Bank’s chief economist, Shang-Jin Wei, put it perfectly last week when he said, “Whether China’s economy can continue to grow rapidly will depend far more on its ability to reform than on how its stock markets perform.” It’s high time that China understands what most other countries have already grappled with at some point or the other, i.e., “sustained exchange rate intervention to manipulate exchange rates is a bad policy.” As China transitions from an exports-driven economy to a domestic consumption economy, it wouldn’t hurt to remember the lessons learnt by the emerging economies in the last few decades, mainly, don’t expand domestic demand while running large current-account deficits, maintain a competitive exchange rate, and build large dollar reserves.

My suggestion for the Fed—don’t raise benchmark-lending rates now. There are no visible signs of inflation, and in any case, an early interest rate hike would hurt much more than a late one. An unhurried glance at the global economic environment is crucial, as it’d be wise.

It’ important that we learn from history and think critically if we want to keep living in a prosperous world.

Nitin Bajaj works as an economist for EY. The views expressed are his own and do not represent the views of any organization.

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