(This essay was published in Hong Kong Economic Journal 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.


In November 2015, government bond yields of various maturities turned negative in Switzerland, Germany, Finland, Netherlands, Austria, Belgium, Denmark, France, Ireland, Sweden, Italy and Spain. The zero lower bound has been breached.


The new Fed Chairman appears to be increasingly focused on the so-called tightening labor market to set interest rate policy. This is a worrying development 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. But easy monetary conditions have started tapering off with the ending of quantitative easing in October 2014. Today the US labor market is not as tight as it seems. Inflation is nowhere near its 2% target.


Yellen’s emphasis on labor market conditions could be a serious concern if she believes that changes in inflation are determined by the amount of slack in the US labor market. This is the long discredited Phillips curve relationship, where causality runs from labor market conditions to wage growth and subsequently to price inflation.


But this relationship is unstable. Milton Friedman demonstrated in his famous 1967 presidential address at the American Economic Association that the alleged relationship between labor market tightness and inflation should not be viewed as a trade-off between inflation and unemployment nor as a basis for conducting monetary policy.


At best it is a temporary trade-off – there is no permanent trade-off. The temporary trade-off comes not from inflation, but from unanticipated inflation. The public may be fooled in the short-run because they have not yet realized that inflation will soon be rising. The mistaken belief that there is a permanent trade-off comes from confusion between “high” and “rising” rates of inflation. A rising rate of inflation (that is still unanticipated) may reduce unemployment, but a high rate of inflation (that materializes after the rising rate has subsequently been realized) will not.


If the Fed sets its monetary policy (or more narrowly, its interest rate policy) by looking to labor market tightness, then it is akin to steering your car by looking at the rearview mirror. If the public begins to form expectations of future Fed policy on this basis, then future Fed policy could be destabilizing. The Fed should be paying a lot more attention to the development of nominal variables and to the expectations about these variables.


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


Nominal GDP has similarly grown at a path of 4% since Q3 2009. The present NGDP level is also slightly below this trend path, again suggesting that 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 has fallen 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.


If we look at these nominal variables – the price level, NGDP, the money supply and nominal wages – they do not make a convincing case for why monetary tightening at this time is either necessary or compelling. Friedman’s message to the profession in 1967 was that we should not judge monetary conditions on real variables such as labor market conditions. Instead we should focus on nominal variables.


One can think of the Bernanke Fed as having followed any one of the following policy targets: 1.5% price level targeting on core private consumption expenditure, 4% NGDP targeting, 7% M2 level targeting, or 2% wage level targeting since Q3 2009. This was not stated policy, but it appeared to the public as if it had been.


So when Yellen began to communicate a different message on July 15, 2015 at the House Financial Service Committee that: “If the economy evolves as we expect, economic conditions likely would make it appropriate at some point this year to raise the federal funds rate target”, the market reaction interpreted those remarks as hawkishness. Gold prices immediately came down, the US Dollar immediately went up, and inflation expectations immediately came down.


That Yellen may go down in central banking history as “The Great Tightener” appears somewhat surprising given that so many Senate Democrats signed a letter to President Obama endorsing her Fed-chair candidacy in 2013 expecting that she would be a dove. Dr. Vincent Reinhart of the American Enterprise Institute has suggested that perhaps the shift in monetary and interest rate policy does not reflect a transformation of her dovish beliefs, but rather their pursuit by different means.


Tightening now follows from Yellen’s understanding of the current economic outlook and the dynamics of the Fed’s policymaking group. Hiking the funds rate, even as economic growth disappoints and inflation remains subdued, buys Yellen credibility with her colleagues and market participants to subsequently tighten slowly.


So the lady positions herself as a conservative central banker to ensure that she can be a compassionate one later by allowing Fed policy to remain considerably accommodative for a considerable time. She’s storing up reputational ammunition, which can be used in the future.


This seems to be the most plausible explanation for Yellen’s oddly hawkish views. Raising the federal funds rate by 25 basis points is relatively harmless. The real tightening kicked off two years ago when the Bernanke Fed began to slow its $85 billion bond purchases each month. China imported US tightening through its dollar-peg, compounding the slowdown already under way in the country. US tightening may have been the primary reason for the bloodbath in the commodity markets and the emerging economies.


The Fed has given clear assurances that it will roll over its $4.5 trillion balance sheet for a long time to come rather than winding back quantitative easing and risking monetary contraction. The pledge more than offsets the negative aspects of the rate increase. The markets have expected the rate rise and are taking it in their stride.


If Yellen’s move is indeed a tactical ploy to buy credibility now so that she can drag out the tightening cycle later, then this time the focus should be how the markets seem to 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.


But 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 that would begin with rates already near zero. The Fed typically needs 350 basis points of monetary ammunition to fight a downturn.


Unfortunately Yellen’s emphasis on examining real quantities rather than nominal quantities in setting monetary policy can become a self-inflicted wound and unsettle and destabilize the economy. Let me explain why this is the case.


First, the monetary policy rule practiced by the Fed is central to how everyone (households and firms) responds to economic shocks and government economic policies. Whether the Fed sets interest rates based on inflation targets, exchange rate targets, unemployment targets, some formulaic combination of these targets, or in an ad hoc manner that is unpredictable, is crucial to how the economy adjusts.


For example, if the Fed uses monetary policy to ensure a stable exchange rate, then it will not seek to offset any shocks to aggregate demand. As a result, a tightening of fiscal policy will cause aggregate demand to drop, precipitating deflationary pressures. However, if the Fed targets inflation, then a tightening of fiscal policy will initially cause a drop in aggregate demand, which will cause a drop in inflation expectations, but as the Fed’s focus is a fixed rate of inflation, it will ease monetary policy to offset the fiscal tightening. In the first situation we will have successful fiscal stimulation as described by the Keynesian model, but in the second situation fiscal stimulation becomes ineffective according to the Classical model.


So what monetary policy rule the Fed adopts has consequences for how the economy responds to fiscal policy. Moreover, a monetary policy rule is not necessarily credible and market expectations about the monetary policy rule can change over time as a result of the actions and communications of the Fed. When this occurs, then the way in which the economy adjusts may also change.


If Yellen deviates from the established Bernanke pattern, then so will the manner of the economy’s functioning. This by itself will create uncertainty. Suppose the economic situation in China deteriorates significantly. This would have an immediate negative effect on market inflation expectations, but Yellen would likely downplay its significance. Instead she might still focus on the US labor market, and since the labor market is a lagging indicator it will tell her everything is fine even after the shock has hit. As a result she would not be inclined to shift monetary policy until the shock shows up in the unemployment data.


Second, the world is already 7 years after the recession first hit, but global economic recovery is still sluggish and uneven. Quantitative easing has averted a depression, but why haven’t the economies recovered fully? One critical factor has been the growing polarization of views in the political arena that has increased the uncertainty and has compromised the effectiveness of fiscal policy.


Another significant factor is the puzzling decision taken by the Bernanke-Fed to pay interest on banks’ excess reserves after mid-October 2008. By so doing it effectively introduced a policy measure that was equivalent to sterilizing lending. It made sure that the Fed’s gross asset purchases did not give rise to any corresponding increase in bank lending.


Once banks began earning interest on the excess reserves they held, they became more willing to hold on to excess reserves instead of attempting to purge them from their balance sheets via loans. For some banks that were not capital constrained, paying interest on excess reserves discouraged them from lending out their excess reserves. It therefore allowed the Fed to add trillions to its balance sheet without adding to any significant amount of bank lending.


So in practice the loosening of monetary policy did not encourage spending, rather it encouraged the bidding up of asset prices around the world. Clearly if excess reserves could earn interest, then asset prices everywhere would begin to look cheap.


It is all the more amazing that as part of the Fed’s first steps toward the normalization of monetary policy, Janet Yellen announced plans to double the rate of interest on excess reserves. On 4 December 2015, Ted Cruz asked Yellen reported in the Washington Examiner how much interest had been paid since 2008 on excess reserves. Yellen was not sure, but added: “It is a critically important tool.” Cruz then asked: “So what has the impact been paying billions of dollars to those banks in the last seven years?” Yellen responded: “It’s helped us to set interest rates at levels that we thought were appropriate for economic growth and price stability.


This is obviously misleading. 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. Monetary policy loosening simply did not happen throughout this period. Therein lies the puzzle of lethargic economic growth, below target levels of price inflation, and large appreciation of asset prices.

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