Should the Fed raise interest rates?

This week, the Federal Open Market Committee, the policy-making body of the US Federal Reserve (Fed), is scheduled to hold a much anticipated two-day meeting. Just weeks ago, there was a common expectation that the Fed would raise interest rates for the first time since June 2006, and initiate a policy tightening cycle for the first time since 2004. A lot of people now working will have no experience of what this looks like, and many more will not remember. But then August happened.

The mishandled Chinese mini-devaluation, and the failed attempt to prop up the Chinese equity market forced people to focus on faltering Chinese economic growth, and its alleged consequences. The UK, US and other major stock markets dropped by 12-13 per cent, though they are now about 3-4 per cent off their low points. Brent oil dropped $10 a barrel to $43, though it too has rallied back to $48. The IMF and World Bank warned about new downside risks to global growth, and advised the Fed publicly not to raise interest rates at the September meeting. Some high profile economists, such as Paul Krugman, Joseph Stiglitz, and Martin Wolf warned the Fed off too. Amid the cacophony of fear, some forecasters crunched their models and predicted another global recession. According to financial betting markets, there is now only a 30 per cent probability the Fed will announce a policy rate increase this week, not least because the Fed rarely likes to surprise financial markets.

Whether or not the Fed—and the Bank of England for that matter—should change the monetary regime that has been in place since the financial crisis has become a highly charged debate.

Antagonists insist that inflation is so low that nothing but harm could be done to the economy by what they call a premature increase in the policy rate. The Fed’s 2 per cent inflation target still lies well above its preferred measure of inflation, which is 0.3 per cent, or 1.4 per cent excluding food and energy prices. American wages are showing some signs of picking up, but increases are still low at 2.2 per cent, in spite of very low unemployment of 5.1 per cent, and the creation of 12m jobs in the US since the last recession.

The participation rate of people in the American labour force is in a funk and the lowest since the 1970s, partly because of the effects of ageing as more and more people retire, but also because a lot of younger workers have dropped out of the labour force for various reasons. The share of labour in national income has dropped from a post-war average of 70 per cent to 63 per cent, reflecting labour market changes, globalisation, and the withering of unions in wage determination. The economy grew by 3.7 per cent at an annualised rate in the second quarter, but expectations are that growth in the quarter ending this month may be less than 2 per cent. Nothing has changed the underlying picture of 2.2 per cent growth over the last 6 years, more or less full employment, but persistent lowflation. Throw in a strong US dollar—up over 16 per cent over the last year—and angst about the world economy, and the Fed’s decision looks crystal clear.

This, though, is too simple. And if the Fed does desist from raising rates this week—and many economists think it should not—then a lot of attention will be paid to what the Committee says about the economy, and to clues as to when and under what circumstances it might change its mind back again. Some analysts think December is one possibility, or perhaps February next year. A rate rise might, therefore, be given a short stay of execution.

Protagonists don’t deny any of the above, but also insist on other important things. The time for emergency and unusual monetary policies, they argue, has gone. The economy may not be roaring along, but the reasons have nothing to do with monetary policy, which is incapable of addressing them anyway. In the meantime, zero interest rates are having an array of "unintended consequences" including new bubbles in richly valued equity, bond and commercial real estate markets. Zero rates, it is argued, are not cost-free if they precipitate asset price inflation that ends badly. One of the leading proponents of this view, the Bank for International Settlements, which is a sort of central banks’ central bank, has just published a report purporting to show how US easy money over the last few years also had deleterious effects on emerging and developing countries leading to excess credit creation and the type of financial instability from which many emerging countries are now suffering.

I would add that the China factor in global pontificating is important to China and to commodity producers, but the global effect of slower Chinese growth is most likely overstated. True, if growth collapsed to 2 per cent, and whole swathes of Chinese provinces sunk into a recession, there could be much more negative consequences, including a large devaluation of the yuan. But as things stand, and on the basis of what seems probable, this is extreme. There should be few reasons for the Fed to cite China as a major hurdle to raising rates.

The don’t-wait-any-longer crowd also say inflation is a backward looking indicator, and that unless there is another plunge in oil prices this winter, the reported annual rate of inflation will rise to 2 per cent or more over the next few months. This, along with steady if sometimes halting improvement in the economy, is likely to see inflation picking up a bit, and so it follows, it would be better to act in a measured way now, than in a more destabilising way later.

Looking beyond immediate economic arguments, my suspicion is that the Federal Open Market Committee is leaning towards a change in the monetary regime largely because it feels time has moved on since the financial crisis, and that it is appropriate to start manoeuvring the economy’s monetary settings slowly away from "emergency." But this week’s decision is a close call. Some people argue that the longer ZIRP stays in situ, the greater the distortion to the economy, and the more likely it becomes self-perpetuating as central banks become ever more reluctant to upset the financial apple-cart by pulling the proverbial trigger. Living in this sort of Alice-in-Wonderland, though, is probably something with which central banks are not comfortable. And executing a regime change for the first time since the financial crisis may be uncomfortable, but not the disaster some fear.

This discussion, of course, won’t be lost on Governor Carney and the Monetary Policy Committee in the UK, especially after the smart Kristin Forbes recently raised the likelihood of a rate increase by arguing that the temporary factors depressing UK inflation could "burn off quite quickly." Watch this space.