Financial markets and Federal Reserve watchers are focused on when the Federal Open Market Committee will vote to raise short-term interest rates, likely by 25 basis points. Investors and pundits would do better to ask why the Fed would raise rates now, when the arguments against a hike are so strong. The shudder felt through the global financial markets over the past few weeks, culminating on Friday with the Dow plunging more than 500 points, should give anyone pause about a Fed course change in the coming weeks or months.
Let me be clear: I belong to the camp that has long argued for the Fed to raise short-term interest rates. The more the Fed held rates down, the more economic distortions its policy created. Rock-bottom interest rates stimulate investments in long-lived assets, which may be unsustainable once interest rates increase. The global bull market in commercial real estate comes to mind, as does the government bond market. Artificially low rates cause investors to chase yields and take on more risk. That was a goal of the Fed’s extraordinary monetary policy (though it was stated more euphemistically). And near-zero rates harm savers and those living on retirement income, so the policy is inherently and perversely redistributional.
All of these considerations, and others, argued for an earlier end to the near-zero policy. The question is why now, after seven years? It can’t be for any of the standard criteria traditionally employed by the FOMC in its decision-making. The Fed has a so-called dual mandate of maintaining maximal, or full, employment and low inflation.
The central bank waited too long to raise interest rates. Now, with global markets in turmoil, it should hold off.
One can say many things about employment in the recovery that began in June 2009. But it is maximal only in an ironic sense. This has been the most anemic recovery since World War II. July’s reported unemployment rate of 5.3%—within the range of the Fed’s stated target before an interest-rate increase—is misleadingly positive. With discouraged workers simply dropping out the job search, the labor-force participation rate of 62.6% is at a multidecade low. Many of the jobs people do have are only part-time—6.3 million people in July were estimated by the Labor Department to be working part time but seeking full-time employment.
In other words, the labor markets provide no basis for tightening monetary policy.
In its wisdom, the Fed has defined zero inflation as 2% inflation. Leaving aside the merits of that decision, by the Fed’s own measure inflation is feeble. Consumer-price index inflation barely exceeded 2% in 2012, and the Fed fell short of its inflation goal in 2013 and 2014. For the first half of 2015, inflation was less than zero.
Again the inflation rate doesn’t justify a monetary tightening.
So the Fed has no mandate to raise interest rates. Why, then, have Fed Chair Janet Yellen and various members of the FOMC been signaling their intention to raise rates, likely in September? Financial markets have believed them, with fed funds futures recently signaling an 80% chance that the FOMC would raise short-term interest rates at its Sept. 16-17 meeting. More recently, speculative fervor has cooled, and the futures market is signaling a 25% chance of a rate increase in September.
What is motivating some FOMC members to turn hawkish in the face of so much dovish data?
Here one must to a degree speculate. Some FOMC members, like Richmond Fed President Jeff Lacker, have for years advocated a return to normal monetary policy—higher short-term interest rates. He and other normalizers have campaigned against the distortive effects of prolonged zero-interest rates; the normalizers may have finally persuaded a majority of the FOMC.
Ms. Yellen has expressed concern about the possibility of a stock-market bubble. That can be interpreted as code for a more general concern about asset bubbles—and as a possible reason for her to ponder a rate increase. Some might suggest, however, that events in oil markets, the general bust in commodity prices, and plunging share prices in China and now in the U.S. indicate that market forces are pricking asset bubbles on their own.
Low interest rates were thought to be stimulative. But we have learned that financial intermediaries struggle with spreads in a low-interest-rate environment. Hardest hit must surely be the money-market mutual-fund industry. Absent a dangerous lunge for risky returns, how much longer can that industry cope with the current interest-rate policy?
One suspects that some combination of these motivations, reflecting a concern for financial stability, is behind the call for higher interest rates. To one degree or another, the concern is appropriate—but that has been the case for many years. Now it appears that the FOMC is at last poised to do the right thing, but with bad timing.
The global economy is weakening. Emerging-market growth has largely been driven by commodity exports, especially energy. There is weakness in almost all commodity markets, and sustained increases in interest rates would likely exacerbate that weakness. It is not just commodity exports, however, but global trade generally that is at risk. Economic sentiment in Germany, a notable European Union exporter, has turned negative, according to the ZEW Financial Market Survey.
If one truly believes the world is economically integrated, it is dangerous to dismiss the global consequences of U.S. monetary policy. The advocates of sound money, having finally won the policy argument, are in danger of being blamed for the consequences of another Fed misjudgment.