(This essay was published in South China Morning Post on 23 December 2015.)


The Yellen Fed has taken a huge gamble raising interest rates alone in the world, with the Nominal GDP (NGDP) growth in the US trending down from 5% in mid-2014 to barely 3% and after the trade-weighted dollar index had strengthened by 19% since July 2014.


Predictions of world economic growth have been revised downwards by almost all forecasters. The European Central Bank, the People’s Bank of China and a growing number of other central banks are still loosening and probably trying to drive down their currencies without claiming to do so.


The new Fed Chairman appears to be increasingly focused on the so-called tightening labor market to set interest rate policy. This is a worry because the labor market is notorious as a lagged indicator of market conditions. A tight labor market today reflects monetary conditions perhaps as far back as two years ago. Today the US labor market is not as tight as it seems. Inflation is nowhere near its 2% target.


Milton Friedman famously advised that we should not judge monetary conditions on real variables such as labor market conditions, but instead focus on the nominal variables. If we look at these variables – the price level, NGDP, the money supply and nominal wages – they do not make a convincing case for monetary tightening at this time.


Since the end of the 2008-09 recession, the price level as measured by core private consumption expenditure has been trending at 1.5% (below the 2% target level). This year it has fallen slightly below the 1.5% path, indicating monetary conditions are slightly too tight.


Nominal GDP has similarly grown at a path of 4% since Q3 2009. The present NGDP level is slightly below this path, again suggesting monetary policy is a bit tight.


US money supply defined as M2 has been steadily rising on an annual? 7% growth path in the post-2009 period. In the past year the M2 growth fell slightly below the trend path, also suggesting monetary policy is a bit tight.


Similarly, average hourly earnings of all employees in the private sector have been trending up over the same period at 2%. In the past year average hourly earnings were slightly above trend, suggesting either easy monetary conditions or more positive productivity growth in the US economy.


So why is dovish Yellen tightening now? Dr. Vincent Reinhart of the American Enterprise Institute has suggested that perhaps she is pursing dovish ends by hawkish means – that she is buying credibility with her colleagues and market participants to subsequently tighten slowly. After all, raising the federal funds rate by 25 basis points at this stage is relatively harmless.


If Yellen’s move is indeed a tactical ploy, then the focus now should be how markets have interpreted her move. Futures contracts priced in just two rate rises in 2016, and two more in 2017, just half as much as what the Fed is forecasting.


Still it is a big gamble. If the world economy is hit by a negative shock, Yellen’s stretching out of the cycle will not give her any room to fight another global recession, which typically requires the Fed to have 350 basis points of monetary ammunition.


Unfortunately Yellen’s emphasis on real quantities over nominal quantities in setting monetary policy could unsettle and destabilize the economy. There are two reasons for this.


First, the monetary policy rule practiced by the Fed is central to how everyone responds to economic shocks. If it is unpredictable, it will have impacts on how the economy adjusts.


And second, the global economy is still sluggish and uneven seven years after the recession first hit. Quantitative easing has averted a depression, but economies haven’t recovered fully due to the uncertainties caused by the growing polarization of views in the political arena, and to the puzzling decision by the Bernanke Fed to pay interest on banks’ excess reserves after mid-October 2008.


In practice, interest rates were low but monetary policy was not loose and did not encourage spending, rather it encouraged the bidding up of asset prices around the world because excess reserves could earn interest and assets appeared cheap.


It therefore makes it all the more amazing that Yellen announced plans to double the rate of interest on excess reserves, as a first step towards normalizing monetary policy.


The Fed would have to agree that raising the interest rate on excess reserves is a contractionary policy. If anything, monetary policy has been too tight since 2008. Therein lies the puzzle of lethargic economic growth, below target levels of price inflation, and large appreciation of asset prices.

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