Tag: interest rates

The Federal Reserve Must Rethink How It Tightens Monetary Policy

By Thomas Palley

Cross-posted at the author’s website, thomaspalley.com.

After more than 7 years of economic recovery, the Federal Reserve is positioning itself to tighten monetary policy by raising interest rates. In light of the wobbly reaction in financial markets, an important question that must be asked is whether raising interest rates is the right tool.

It could well be that the world’s leading central bank is going about the process of tightening in the wrong way. Owing to the dollar’s preeminent standing, that could have severe global repercussions.

Just as the Fed has had to rethink how it combats recessions, so too it must rethink how it transitions from an easy monetary policy stance to a tighter stance.

A quick review

In December 2015, the U.S. Federal Reserve increased interest rates for the first time in almost a decade. This move came with the expectation of gradually raising its interest rate to a new normal of 3%. Initially, normalization aimed to lighten pressure on the monetary policy pedal, and only later would it turn to hitting the monetary policy brake.

The normalization process was contingent on the data showing continued improvement, but the U.S. economy slowed in the first half of 2016, putting it on hold. However, since May, the data have again been robust regarding job creation and wage growth. Furthermore, there are signs of asset and house price exuberance in the U.S. economy that can be destabilizing and also inflict large future losses on working families.

These recent developments have prompted the Federal Reserve to consider restarting the process.

Raising interest rates is the wrong way to begin normalization

The problem is not that the Federal Reserve wants to restart the normalization process, but rather that it wants to do so by raising its policy interest rate. That risks spilling the infamous monetary policy “punch bowl”.

Raising interest rates is a dangerous step in today’s integrated global economy. The Fed must calculate especially carefully given that other economies (the UK, Japan, and the European Union) are on the ropes and lowering rates.

Raising U.S. rates in such an environment threatens to cause an inflow of hot money into the United States that will appreciate the dollar’s exchange rate and further fuel US financial markets.

That, in turn, will negatively impact manufacturing via lower exports and increased imports. It will also lower investment spending by injuring manufacturing. And it would further distort financial asset prices, setting them up for a possible disorderly correction.

There is an alternative normalization path

There is an alternative normalization policy path that avoids these problems.

1. The Federal Reserve should shelve plans to raise its policy interest rate. Later, if the normalization process goes well, it can put rate hikes back on the policy table.

2. The Federal Reserve should immediately stop reinvesting the income from its private sector bond holdings and should start running-off those holdings.

Having the private sector repay debt held by the Federal Reserve would drain liquidity from financial markets, thereby tamping down financial speculation and also putting incipient upward pressure on long-term interest rates, which is what policymakers desire.

3. If the Federal Reserve is concerned about house price inflation, it should impose a temporary reserve requirement on new mortgages.

That would make new mortgages more expensive, given that banks would pass on the cost of the reserve requirement to borrowers, thereby cooling house price inflation.

Most importantly, this well-targeted measure would not affect interest rates in the rest of the U.S. economy, thereby avoiding causing hot money inflows and collateral damage on manufacturing and investment.

4. If the Federal Reserve is concerned about a stock market bubble and related impacts on consumption spending, it should raise margin requirements.

Margin borrowing for stock purchases is at near-record levels. Even a symbolic increase would put speculators on notice and discourage borrowing. Such a move would also rehabilitate an important anti-speculation policy tool that has been allowed to fall into disuse.

Rethinking monetary policy in normal times

Chairwoman Yellen’s recent Jackson Hole conference speech was titled “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future”. She argued that the policy tools developed in the economic crisis to promote recovery need to be retained for possible future deployment. Those tools include interest on excess reserves (IOER), large scale asset purchases, and explicit forward guidance.

Whereas the Federal Reserve has radically rethought how to combat recessions, its policy framework for normal times is less changed and remains focused on interest rates. For instance, both IOER and forward guidance concern interest rate policy.

This lack of change means the Federal Reserve risks spilling the punch bowl. The above alternative program shows how that can be avoided.

Instead of immediately raising interest rates, the Federal Reserve should use the current transition as an opportunity to introduce quantitative policy tools such as margin requirements and adjustable discretionary reserve requirements on problematic asset classes. Doing so can allow it to drain the punch bowl without spilling the punch.

Unfortunately, the Fed is far behind the curve. It has directed all of its efforts to preparing the market for higher interest rates, when it should have first been preparing the market for these type of targeted measures. However, better late than never.

New Issue! Plus–Fed Rate Hike Explained

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Our new issue is at the printers!  Print subscribers should get their copies in the first week of January (the holidays will delay things a bit), and I expect to email the issue to e-subscribers early next week.

We have posted one feature from the issue, Marty Wolfson’s The Fed Raises Rates–by Paying the Banks.  (For more on the Fed’s rate hike, see Gerald Epstein’s The Fed’s New “Operation Twist”:  Twisted Logic over at our sister blog, Triple Crisis.)  You can see the table of contents of the Jan/Feb issue here.  And here is our p. 2 editors’ note, which gives an overview of the issue:

Greed?

In this issue, we paired the article “How Private Equity Works—And Why It Matters,” by Eileen Appelbaum and Rosemary Batt, with Dutch Renaissance painter Pieter Bruegel’s Avaritia, from his Seven Deadly Sins. Breugel depicts not only Greed (as a mythological figure), but a host of surrounding figures whose machinations illustrate the sin. And Bruegel lived in the 16th century, so he didn’t know the half of it.
Greed would appear to come up in this issue over and over again:
Appelbaum and Batt describe how private equity firms buy out target companies with borrowed money, load them up with debt, strip them of valuable assets, and pay themselves extraordinary dividends and fees. And it’s (mostly) legal.
In his article on the Federal Reserve’s recently announced interest-rate hike, Marty Wolfson explains that the Fed is planning on paying banks billions of dollars in interest (even though it need not). It’s a windfall for the banks, and just another example of how the public authority acts in the service of private “greed.” The Fed’s conduct of monetary policy is channeled through private banks and beholden to their interests. More, its decision-makers see it as their sacred mission to act as protectors and benefactors to high finance.
Matías Vernengo gives us yet another example, this one from Argentina. The country’s newly elected right-wing president has promised currency and spending policies that would be misguided—though could be rationalized—as responses to a serious international payments crisis. Yet there is no such crisis in Argentina! The only way to make sense of these policies is as a deliberate offensive, on behalf of the wealthy elite, against the laboring masses.
The neoliberalism that Vernengo recognizes as “resurgent” in Argentina, after an interlude of relatively pro-worker and pro-poor policies, meanwhile, has been the dominant tendency of capitalism worldwide for decades. As David Kotz argues in his cover story on “Neoliberalism, Its Crisis, and What Comes Next,” this epoch has seen the most predatory and destructive forces of capitalism unleashed from the restraints of labor organization and state regulation.
A critique of greed, a condemnation of it as a sin (as Breughel’s engraving frames it), however, simply does not suffice. In the medieval morality play, the social order torn asunder by sin is restored by purgation and repentance. In the police procedural of modern capitalist society, the social order upset by crime is restored by the administration of justice.
If sin is an offense against the social order, though, greed is no sin today. As Noam Chomsky put it back in the mid-1990s, amidst a surge in media criticism of “corporate greed”: “Talk about corporate greed is nonsense. Corporations are greedy by their nature. They’re nothing else. … You can’t make them more or less greedy.”
Far from being an offense against the order of contemporary capitalist society, greed is at its foundation. Greed is neither a sin whose perpetrators must fear for their souls, nor a crime whose perpetrators must fear earthly justice. And the battle against institutionalized greed seeks not to restore the social order, but to overturn it.