If there is a single question that will drive global markets – and potentially global politics – over the next year, it is how the US Federal Reserve will extricate itself from its extreme monetary policy. That’s what had market mavens trembling in anticipation on Friday morning, then dissecting the latest unemployment release. “What does it mean!? 173,000 jobs created!? 5.1 unemployment rate!? The Fed will move in September! No – it can’t move now, look at the plunging markets!”
The confusion and contention stem from the fact that we’ve become heavily dependent on monetary policies to manage the major economies of the world, and we’ve traveled far away from any comfortable textbook scenario.
In a textbook setting, the Fed pulls its levers and knobs to make it easier or harder to borrow money. It does this with the dual goals of achieving full employment and maintaining stable prices. If it starts to see inflation bubbling up, it “tightens” – makes it more expensive to borrow. If the economy looks slow and too many people are out of work, it “loosens” – makes borrowing cheaper.
Traditionally, the main tool that it uses to do this is the Fed Funds Rate. For the two decades prior to 2008, that rate slid up and down between a peak of near 10 percent and a trough of around 1 percent. Then, when the global financial crisis hit, the Fed dropped the rate to near zero and it flat-lined. That was seven years ago. Is it time to get monetary policy back toward normal?
If world markets were calm, the US economy were showing strong growth, and wages and prices were all starting to pick up, the answer would be obvious: Yes. Raise rates. There are a couple of reasons not to wait too long. First, it is harder and more painful to beat back inflation once it has gotten rolling than it is to prevent that inflation in the first place. Second, when money is very cheap (low rates), we can see speculative bubbles. People put that cheap money into assets like houses or stock markets, driving up prices. Then they start buying those same assets just because their prices are rising (rather than out of a desire to live in the house or hold the stock). The popping of a housing bubble was a significant cause of the recent global financial crisis.
So why doesn’t the Fed charge ahead? Because the signals the US and the world economy are sending right now are decidedly mixed. The 5.1 percent unemployment rate announced Friday is historically low – near the point where inflation traditionally starts to pick up. And average hourly earnings in August were up about 2.2 percent from a year earlier. Yet there is an unusually large group of people who have stopped looking for work and the latest inflation numbers showed only a 0.2 percent increase over the last year (2 percent might be considered normal). The economy has fluctuated between recovery-speed growth (3.7 percent in the 2nd quarter of this year; over 4 percent in the middle of 2014) and worrisome torpor (0.6 percent growth in the first quarter, and a 0.9 percent contraction in early 2014). World markets, meanwhile, have been swooning from Asia to Europe to here in the United States. To continue the pattern of ambiguity, however, those market drops come in the wake of very strong gains – China’s main index has plunged 39 percent from its June high, but is still up about 36 percent from a year ago.
Even with these conflicting signals, the Fed’s problem wouldn’t be so difficult if it knew just how and when a rate hike would affect the economy. Unfortunately, it doesn’t. In normal times, a small rate increase would have a modest effect on the economy, but these are not normal times. When, in 2013, then-Fed Chair Ben Bernanke publicly stated the obvious – that Fed policy would someday tighten – global markets reacted with what is now known as the “taper tantrum.” To the extent a rate hike now shifts the market mindset, a small change could bring a large reaction. Even in normal times, it was hard to say exactly how fast the effects of a rate hike would kick in. It’s never immediate; maybe a year and a half? In these abnormal times, monetary experts just say that lags are “long and variable.”
The August employment release that just came out was full of data, but not clarifying. The Fed’s conundrum persists, amid raucous cries of “Tighten!” and “Are you crazy? Not now!” The fall season of economy-watching will kick off on September 17, when the Fed makes its next call.
Phil Levy is senior fellow on the global economy at The Chicago Council on Global Affairs. Previously he was associate professor of business administration at the University of Virginia’s Darden School of Business. He was formerly a resident scholar at the American Enterprise Institute and taught at Columbia University’s School of International and Public Affairs. From 2003 to 2006, he served first as senior economist for trade for President Bush’s Council of Economic Advisers and then as a member of Secretary of State Rice’s Policy Planning Staff, covering international economic matters. Before working in government, he was a faculty member of Yale University’s Department of Economics for nine years and spent one of those as academic director of Yale’s Center for the Study of Globalization.
His academic writings have appeared in such outlets as The American Economic Review, Economic Journal, and theJournal of International Economics. He is a regular contributor to Foreign Policy magazine’s online Shadow Government section and writes on topics including trade policy, economic relations with China, and the European economic crisis. Dr. Levy has testified before the House Committee on Foreign Affairs, the Joint Economic Committee, the House Committee on Ways and Mean, and the US-China Economic and Security Review Commission. He received his PhD in Economics from Stanford University in 1994 and his AB in Economics from the University of Michigan in Ann Arbor in 1988.
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