Decisions, decisions...

“We all make choices, but in the end our choices make us.” Ken Levine.

The Federal Reserve will, by the end of this week, have made one of the most important decisions in its 102-year history in deciding whether or not to raise the fed funds rate (the overnight inter-bank lending rate, used as a monetary policy tool) from its 0% floor. The consequences of its decisions will reverberate all across the world and may well affect future generations. The aim of this post is to discuss whether or not the correct timing of the rate-rise is now.

Economists are divided as to whether the Federal Open Market Committee (FOMC) meeting on Thursday and Friday will conclude with a decision to hike rates. Financial markets have priced in a probability of 20% for a September rate hike, but 60% for December. 

I am in support of a delay to the first rate hike for four reasons: 

1) The labour market is not as strong as people think
2) A broad range of inflation indicators continue to show weakness
3) We have already had some financial tightening via the market
4) The risks towards halting the recovery with a rate-hike are still too high.

The economy

The US economy in one word? Mediocre - that is, when compared to pre-crisis levels of growth. Compared to post-2007 though, a quick glance at the recent economic numbers in the US suggest an economy that is chugging along quite nicely. GDP growth was at 3.7% last quarter, far above the 5-year average. Importantly here, nearly every component of GDP contributed to growth, showing how broad-based the recovery really is. The US ISM (a survey asking corporate executives about their current business situation) remains above the 50% expansion-contraction line.

So far, the case for a rate-hike is somewhat powerful. But these are all indicators of what has already happened in the economy. Leading indicators, such as the Federal Reserve of Atlanta Now Indicator are showing signs of weakness, and the uncertainty of the global outlook (especially China) demands more caution from policy makers. 

From the domestic side however, the majority of the debate is in the labour market and inflation indicators. Though headline unemployment has halved since 2009 to 5.1% now, this masks a large divergence in both demographics and type of unemployment in the US. For example, underemployment (i.e. those who are working part-time or with zero-contract hours but want to work more) is still high, at 10%. This number was 9.5% at the beginning of the last Fed tightening cycle. 

The more underemployment falls, the more likely we will get the wage growth that Janet Yellen is so keen to see. And once wage growth picks up (so the theory goes) inflation is just around the corner. But so far, wage growth has been subdued. True, real wage growth (wage growth adjusted for changes in prices) has increased, meaning higher purchasing power for workers, but that is predominantly because of the transitory effects of low inflation - a cursory glance at the nominal wage growth indicators confirms this. 

Inflation

A large range of inflation indicators (including those that strip out effects from food and energy prices, which is believed to look past ‘noisy’ inflation) currently sit below 2%. Indeed CPI (the measure that is explicitly part of the Fed’s legal mandate) currently sits at 0.2%. With half of the Fed’s legal mandate so far away from its 2% target, what rationale is there to suggest that it is time for a tightening? 

The argument sympathises with the lagging effect of monetary policy. Much has been made of trying to estimate the lag with which monetary policy affects the economy, and results vary. What is clear though is that there is a substantial lag and in general, as Bernanke mentioned in 2003, accounting for this by being proactive and raising rates earlier than later is preferable. 

But this time isn’t ‘in general’. The US economy is on a straight but fragile path, where any sudden adverse movements will surely tip the US economy back in the recession. Even if inflation did rise rapidly, I would rather have a few quarters of above average inflation and be sure that the recovery was strong and healthy than try to curb mild inflation and risk another spiralling downturn.

Financial conditions

Central bank tightening policy is aimed at ensuring the economy doesn’t overheat. Tightening financial conditions via raising the rate for borrowers should dampen demand for debt, as well as raising the required rate of return for investment projects causing consumption and investment to moderate. Haven’t we just had a natural tightening of financial conditions courtesy of the markets? Summer 2015 was one of the most painful summers for financial markets since 2012, with the S&P 500 and Chinese stock markets down 7% and 40% from their peaks respectively. 

In 2013, around 50% of all US adults owned stocks, and if today’s number is anywhere near that, then the negative wealth effect stemming from the fall of stock prices may well be large enough to pare business and consumer confidence and keep a lid on the economy.

Raising rates risks damaging a fragile recovery

Finally, with interest rates at their effective lower bound - 0%, hawks argue that were the US to fall into recession, there would be no room for policy accommodation. To prevent this, the Fed should raise rates to allow room for cutting rates if need-be later. I’m sorry, what?! True, there is no conventional policy left, but all that will be achieved by raising rates is increasing the chance that the US will fall into recession again. Surely the more important thing is to ensure that the US economy DOESN’T plunge back into recession?!

The bottom line

So, this week is a very important week in the Fed’s existence - more important than almost any other rate rise in the past. A good decision, I believe, will be to delay the rate rise until at least the December FOMC meeting.

The above Ken Levine quotation is very befitting of Yellen's job at hand as she arrives at the Federal Reserve's two-story chandeliered Board Room on Wednesday. She and her colleagues are at a crossroads, and their choices will not only make them, but the rest of the world as well.