A new wave of economic optimism in both the US and UK, alongside the Federal Reserve’s recent decision to taper its programme of Quantitative Easing—scale back its asset purchases—opens a new chapter for monetary policy in both countries. After five years of unconventional monetary policies, investors have every right to think we have arrived at the beginning of the end. But they should also see this moment as the beginning of a trend towards higher interest rates. The two new central bank heads, Janet Yellen in the US and Mark Carney in Britain are facing a new quandary, and will have to manage carefully the markets’ propensity to discount higher interest rates, especially in view of extremely low levels of inflation. If they don’t do this well, the credibility of forward guidance could be seriously damaged, leading to renewed market and economic volatility.
The terms of forward guidance will have to be reformulated so that central banks won’t be ambushed by markets into premature increases in policy rates. Normally, low inflation is the result of earlier economic weakness and rises as the economy strengthens. But in today’s post-crisis world, excessively low inflation could be a leading rather than a lagging indicator, and be a cause of future economic weakness because low inflation raises the real value of debt and debt servicing. Against this background, premature monetary tightening would be an embarrassing own-goal.
Getting interest rates back to normal is, of course, a desirable goal in spite of negative effects on those with mortgages. It would help to correct many ‘distributional’ issues that have accumulated under QE. Savers, and retirement plans would benefit. Lower corporate pension plan sponsorship costs would help cashflows. The aggravation of income inequality, spurred by the effect of QE on asset prices, would be relieved. The restoration of a proper cost of capital would improve lending decisions, and induce companies to borrow for investment rather than buying their own stock back.
But despite the better economic news in the US and UK, things are not yet so robust that we can be glib about the return of higher interest rates. Yet this is precisely the risk that is looming for two reasons.
First, the single focus on unemployment thresholds is flawed. With US unemployment at 7 per cent, the Fed has already ‘coloured’ its 6.5 per cent threshold by saying that unemployment would have to fall ‘well past’ this level before policy rates would be raised. In the UK, with a 7.4 per cent unemployment rate, the Bank of England’s caveats under which policy rates might not be raised at its 7 per cent threshold, will need stronger elaboration.
Good as the headline news on jobs and unemployment may be, consider the following labour market frailties that will curtail a self-sustaining recovery. The growth of wages and salaries is weak in money terms, and stagnant or negative, adjusted for inflation. The decline in labour force participation, especially in the US, because of the swelling of the retirement age cohort, has obscured the real meaning of lower unemployment rates. New automated technologies are a leading cause of the huge substitution of low-wage for middle-wage paying occupations.
Second, the trend in inflation is still down. There are few if any pressures coming from wages. Energy prices have been softening, and could fall further as China’s economic transition continues. And fundamentally, the relative pressure of demand remains subdued. Whether or not you subscribe to Larry Summers’ idea of secular stagnation, our economies are being constrained by structural drags in labour markets, income inequality, weak capital spending, and long-term deficit reduction programmes.
In fact, with the Fed’s preferred inflation measure at just over 1 per cent, and UK inflation at around 2 per cent, we cannot be complacent about avoiding the deflation risks that loom larger in the Eurozone, where a handful of countries are already experiencing deflation, and that have barely been lifted in Japan. A premature tightening of monetary conditions, or policy, triggered perhaps by an excessive focus on unemployment thresholds could be the proverbial straw. As Japan discovered in the mid-1990s, economic recovery is no guarantee that the deflationary dragon has been slain.
Now that a cyclical economic pick-up is underway, it is time for the Fed and the Bank of England to reboot their ideas about forward guidance if a messy outlook is to be averted. They could choose from a range of indicators, including unemployment and inflation. Steady growth of 4-5 per cent in the money value of GDP, for example, could send an additional strong signal of interest rate intent. What they call ‘macro-prudential judgement’ to constrain the effects of zero policy rates on buoyant asset markets, including housing, is also important. In the end, though, central banks have a limited brief. The task of realising normal interest rates, sustainable growth and just enough inflation also requires active government policies to promote public investment in physical and human capital. And sooner rather than later.