The shortcomings of monetary policy

November 18, 2016 01:00 PM

Never put off until tomorrow what you can put off indefinitely. That seems to be the Federal Reserve’s motto. And that’s just fine with financial markets, judging by the behavior of asset prices whenever the policymaking Federal Open Market Committee leaves the federal funds rate unchanged.

However, the Fed seems ready for firming, though at a more gradual pace than initially planned. Last December, as it raised the funds rate 25 basis points after seven years near zero, FOMC participants anticipated four rate hikes in 2016. They still foresaw two moves in June. Now, only one is contemplated, with two to follow in 2017, or so they say. But we’re left to wonder: What will induce the FOMC to get on with “normalizing” monetary policy?

As even more dovish Fed officials concede, delaying rate hikes indefinitely is not sustainable, even in a subpar recovery. Officials project real GDP growth of just 1.8-2.0%, but expect the unemployment rate to fall to 4.5% over the next few years and look for inflation to reach the Fed’s 2% target. Markets must realize the easy money stance is not sustainable, but remain skittish about a single 25 bp rate hike. Nevertheless, there is an air of inevitability after the September statement. 

Though the FOMC is divided with three September dissents, the divergences are not as stark as they might seem. Significantly, erstwhile dove Eric Rosengren, the Boston Fed President, was “arguing for modest, gradual tightening now, out of concern that not doing so today will put the recovery’s duration and sustainability at greater risk by generating significant imbalances that historically have led to a recession.”
Fed Chair Janet Yellen struck a delicate balance. She and her colleagues must be “forward-looking” in setting rates to avoid “overheating” and excessive risk-taking, but with inflation below 2% and the economy having more running room, the Fed can afford to wait for further evidence and allow more people to join the labor force.

Besides, monetary policy is only modestly accommodative because slow productivity growth has lowered the “neutral” funds rate, Yellen stressed. FOMC participants cut their estimate of the longer run funds yet again in September to 2.9%. It has been lowered 135 basis points since the FOMC first started publishing the neutral rate in 2012 — 60 basis points since last December — with parallel revisions of GDP growth potential. Also, the Fed is still looking over its shoulder at global economic developments, including what other central banks are doing. So, the fractious Fed is out of the financial crisis but not out of the box it created for itself in responding to it. Not only is it keeping real rates negative, it is nowhere near shrinking its $4.5 trillion balance sheet: “The FOMC plans to keep rolling over maturing Treasury securities and reinvesting proceeds from agency debt and mortgage-backed securities until rate hikes are “well under way.”

Complicating the Fed’s task is an unpleasant, politically sensitive reality: it’s using monetary policy to try to stimulate an economy suffering from impediments beyond its control. It used to be said in DC that monetary policy is the only game in town. Increasingly, though, it is being recognized that monetary policy alone cannot lead to balanced growth, as the Group of 20 asserts. Fed officials have been reluctant to say much publicly, but they recognize business uncertainty about taxes and regulations is curbing investment and in turn productivity and growth.

Dallas Fed President Robert Kaplan says the high cost of compliance with stricter bank regulations, especially for smaller banks, “is hurting business formation.” The Affordable Care Act is often cited as another constraint. A firm with 40 employees is unlikely to expand payrolls because it would bring it under the strictures and penalties of “Obamacare,” an official observes.

Yellen was less specific in Jackson Hole, but urged “looking for ways to reduce regulatory burdens” to boost productivity and suggested a need for fiscal stimulus. Don’t hold your breath. For the foreseeable future, the Fed will remain on the hook to sustain growth, however sluggish. In the event of a downturn, rather than fiscal or regulatory reforms, we are more likely to get an extension of crisis monetary measures. Around the world, we see increasingly radical and desperate policies. With negative interest rates having, at best, mixed results, we now hear serious proposals to largely abolish cash to trap people into digital money to make that tactic more effective.

Some at the Fed advocate restraint in the face of non-monetary growth obstacles, but that’s not the predominant view. In pursuit of their dual mandate of maximum employment and price stability, most officials subscribe to legendary football coach Robert Neyland’s dictum: “If at first the game — or the breaks — go against you, don’t let up, put on more steam.”

About the Author

Steve Beckner is senior correspondent for Market News International. He is heard regularly on National Public Radio and is the author of "Back From The Brink: The Greenspan Years" (Wiley).