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The Federal Reserve’s decision last Thursday to keep interest rates unchanged caught many by surprise. That was against the backdrop of the hawkish stance of many members of the Federal Open Markets Committee (FOMC), which makes decisions on interest rates and money supply growth.
In her press conference after the latest FOMC meeting, Fed chair Janet Yellen said interest rates could increase only if inflation rises from current levels of about zero percent to the Fed’s target rate of 2% and if unemployment rates are lower. She also cited “global economic and financial developments” restraining the Fed. For the most part, she referred to the slowdown in China and commodity price declines hurting Canada, the largest trading partner of the U.S.
However, the Fed does not seem set to increase interest rates to target levels any time soon. Improvements in labor market conditions are weighed down by a fragile economic recovery that is marked by lingering high levels of consumer debt. Even as the Fed has limited control over global markets, it must clearly specify its target interest rate levels, according to Wharton experts. It must also clarify whether or not an initial increase will be followed by others, they say.
Peter Conti-Brown, Wharton professor of legal studies and business ethics, whose research specialties include central banking, said the Fed’s decision went against signals some FOMC members had sent out. He also described Yellen’s citing turmoil in the international markets and “currency elements” such as the recent devaluation of the Chinese yuan as “relatively rare” considerations. In the normal course, Yellen would have attributed a decision on interest rates purely to price stability, or stable inflation, and maximum employment, he said. “This time it was different and surprising Twitter .”
“The right interest rate for this scenario is easily higher than zero.” –Joao F. Gomes
Conti-Brown discussed the factors influencing the Fed’s moves on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)
The Crystal Ball View
An interest rate increase seems distant, going by the Fed’s press release after the FOMC meeting. “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term,” the press release pointed out. It noted that “the current 0% to 1/4% target range for the federal funds rate remains appropriate.” (The federal funds rate is the overnight interest rate banks charge each other for loans using funds maintained at the Federal Reserve.) Even if employment and inflation approach their mandated levels, economic conditions may warrant keeping the funds rate below normal levels, the press release added.
Wharton finance professor Krista Schwarz said that while global developments may have a small impact on the U.S. economy, “there is a downside risk.” She felt “it’s possible, but rather unlikely” that the Fed would opt for a rate increase at its next meeting at end-October. However, the Fed could raise rates in December. “They have virtually promised to [do so] in December unless there has been some significant adverse development,” she noted. “If, for example, the slowdown abroad actually showed up in U.S. [economic] data by December, then that would motivate the Fed to wait again.”
Conti-Brown was skeptical about the possibility of a rate increase in October or December. “Inflation is stuck stubbornly at just about zero percent … [and the] 2% inflation target will take a long time” to reach. He noted that some economists have said that even the 2% level is “artificially low” and that the Fed must target a higher rate.
Those economists have also criticized the Fed for abandoning unconventional monetary tools like “quantitative easing,” said Conti-Brown. Between November 2008 and October 2014, the Fed bought $4.5 trillion worth of mortgage-backed securities from banks to increase money supply and stimulate the economy. “Some economists think they ended that too soon,” he added.
Although quantitative easing can ultimately become inflationary, the inflation rate has not moved up, Conti-Brown noted. “[That is] because the Fed is paying banks [interest] to keep just under $2 trillion in the Federal Reserve,” he said. “You [have] a tension here pulling in different directions. How do you unwind that? That question has no answer.” He said the Fed’s critics contend that inflation is reined in because it holds all those reserves. “How do you get out from under that $2 trillion gorilla is the question.”
Wharton finance professor Joao F. Gomes points out that “inflation has actually been pretty much at the Fed’s unofficial target. True, headline inflation is near zero, but core inflation has been running pretty close to 2% all year.” (Headline inflation is not adjusted for seasonality or prices of food and energy, while core inflation excludes such items that have temporary volatility.) He noted that headline inflation fell this past year because of a large drop in energy prices, adding that it is unlikely to be repeated next year. “Both core and headline inflation expectations for 2016 are at about 2%,” he said.
“We’ve been out of a recession for a long time – this is one of the longest periods of economic growth – but the recovery is fragile.” –Peter Conti-Brown
Gomes was critical of the Fed for its reading of both unemployment and inflation trends. “The economy is near full employment, [and] inflation is close to its target,” he said. The Fed keeping the funds rate at a historical low “seems very wrong to me. The right interest rate for this scenario is easily higher than zero.”
Schwarz sees good reason for how the Fed acted. “The low level of inflation and continued overhang from the Great Recession are part of the reason why the Fed kept interest rates unchanged,” she said. “It is also why they are signaling that when tightening comes, it will be at a slow pace.” She added that the Fed is still re-investing the maturing debt in its portfolio to maintain both a large balance sheet and accommodative financial conditions. “Short of resuming quantitative easing — which would only happen if things got much worse — there is little else that the Fed can do,” she said.
According to Conti-Brown, the debt overhang with consumers is one factor causing the Fed to tread cautiously on interest rates. “We’ve been out of a recession for a long time — this is one of the longest periods of economic growth — but the recovery is fragile,” he said. “There is still an extraordinary amount of debt overhang with consumers.” He noted that was especially true for those who bought homes in the couple of years leading up to the 2008 financial crisis.
Even as many of those homebuyers have seen their wealth in their home equity wiped out, several are still paying their mortgages and haven’t defaulted, said Conti-Brown. “That means they’re not spending much, trying to making up for their past mistakes by saving more if they are completely cash strapped,” he added.
“The fact that we see so much debt in the system even now should give us some alarm about the potential for a future financial crisis, which is always debt driven — and also give central bankers a sense that this recovery therefore is far from cemented,” said Conti-Brown. The legacy debt many people carry from early 2000s and mid-2000s “is causing central bankers to pause on this unprecedented period in monetary policy,” he added. However, for consumers with borrowings, whether they are student loans or mortgages, “this is the time to refinance,” he said.
“[The Fed has] virtually promised to [raise rates] in December unless there has been some significant adverse development.” –Krista Schwarz
As for global economic trends, the red flags are the economic slowdowns in Canada, China and Brazil, and unemployment trends in Europe, noted Conti-Brown. “We just cannot stand alone in the world. We’re so deeply but unevenly integrated in the global economic and financial system that what happens in China does directly affect what happens here. Any slip in one of these major economies could have all kinds of devastating consequences for the U.S.” At the same time, the U.S. economy is a “behemoth” that consumes much of what it produces. “We’re not hanging on by our fingernails [to] what’s happening in Canada or Brazil.”
Yet, there is only so much Yellen could do, according to Conti-Brown, whom he rated as “the single most qualified central banker that we’ve ever had in the chair.” However, many factors are “completely outside of her control,” he noted. “We put too much confidence in our central bank; we assume that it is the uber regulator of the entire global economy. [But] it’s not God; it’s not the omniscient, omnipotent power that some people suppose it is.”
Yet, the Fed has to act ahead of the curve, according to Conti-Brown. He recalled the words of William McChesney Martin, Jr., who was the Fed chair from 1951 to 1970: “Our purpose is to lean against the winds of deflation or inflation, whichever way they are blowing, but we do not make those winds.” That is precisely what the Fed is now trying to do now, Conti-Brown explained. “If you wait until we see 2% inflation, then you are facing a galloping currency that may not be able to be restrained. You cannot wait to see the target before you act.”
Dot Plot Misleading
Even as the Fed treads a difficult path, Wharton experts pointed out areas where it could set its house in order. According to Gomes, the Fed is staking its credibility in the way it sends out signals. “The Fed yet again caved in to outside pressure not to raise rates,” he said. “Nearly every member was sold on a rate hike back in early August and yet again they did not follow through.” He noted that Yellen advanced several “excuses/reasons for this change of heart … but it is [the Fed’s] job to forecast these things with at least some degree of accuracy.”
“The fact that we see so much debt in the system even now should give … central bankers a sense that this recovery therefore is far from cemented.” –Peter Conti-Brown
Gomes also criticized the inconsistencies between the Fed’s so-called “dot plot” and its actual decisions. The Fed introduced the “dot plot” earlier this year, which reveals the views of each of the FOMC’s dozen members on the level they would like for the Fed funds rate in the foreseeable future. “Since the dot plot has been introduced, the Fed members have been surprised by negative events while market forecasts of their moves have repeatedly proved more accurate,” said Gomes. In the latest dot plot the Fed released, one member pegged interest rates below zero by end-2015 and 2016.
“I’m worried the Fed’s dot plot has generally been misleading as they have failed to follow through with the rate hikes they themselves anticipated,” Gomes continued. “At some point this is going to seriously erode the Fed’s credibility and become a major problem.” He presumed that such inconsistencies are a result of FOMC members being consistently far too optimistic in their forecasts about the economy. “But the implication is the same. Our confidence in the Fed’s ability to manage the economy is being eroded.”
Conti-Brown, too, noted “two inconsistent mantras” at the Fed. “One mantra is ‘We will stick to the data; we’re doing what the data will tell us to do’” he said. “The other is, ‘We need to maintain flexibility and don’t have any precise metrics to do that.’ It makes it very difficult to say when things will happen.”
Gomes called for more clarity from the Fed on interest rate trends. “The problem is, markets interpret a rate increase as signal the Fed will follow with many more future hikes and is aiming at a very high long term value,” he said. “The Fed needs to credibly inform markets of its target levels for the rates, and more significantly, that a first increase will not necessarily be followed by others.”