As investors return from a three-day Labor Day weekend in the US, much of the talk in the financial media centers around the activity of the central banks, particularly the European Central Bank and the US Federal Reserve.
Many interpret Fed Chairman Ben Bernanke's comments at Jackson Hole last week as indicating that the Fed is preparing to "do something" at the upcoming Fed meeting on September 13, possibly including the formal declaration of the intent to keep US short-term interest rates at zero through 2015 (rather than through 2014, as the Fed has already pledged to do).
Why does the Fed feel the need to "do something," and why do many investors and pundits continue to argue that the Fed needs to "do something"? The answer is pretty obvious to anyone who has been paying attention to economic matters at all, which is that unemployment remains stubbornly high and economic growth remains stubbornly low, and many assume that central bank action is part of the solution to these woes.
In this first installment of a short series of posts about how to fix the economy, however, we will make a different argument. We would argue that when it comes to monetary policy, the best way to allow the economy to experience more robust growth with more jobs is to pursue a stable monetary policy and (equally important) a normal monetary policy.
Unstable monetary policy creates unpredictability and uncertainty that creates obstacles for businesses. If your business requires purchasing components or ingredients and you don't know whether the prices for those components or ingredients will be going up rapidly over the next few weeks or months, it makes it difficult to plan. When prices fluctuate wildly, businesses end up spending money trying to hedge against future price fluctuations, and time and talent that could be spent more productively doing something else is instead spent trying to analyze and predict price fluctuations and to plan strategies to lessen the impact of the price volatility.
Unstable monetary policy also creates obstacles to the critical function of supplying businesses with the capital that they need to grow and expand. If central banks allow massive inflation, for example, lenders may be worried about loaning capital that will be repaid to them later with less-valuable dollars. To guard against this danger, they may have to charge higher and higher interest rates, or they may become much more reluctant to lend. Either way, capital can become less available to innovative businesses -- not because those businesses are not promising but because monetary policy is unstable.
Just as important as having a stable monetary policy, however, is having a normal monetary policy. This fact is something that commentators often overlook (especially those who continue to clamor for the Fed to "do something" next week). The US Federal Reserve has kept short-term interest rates effectively at zero since December of 2008!
A zero interest rate is not a normal interest rate: it is an emergency interest rate, akin to going on a "war footing." The dramatic cuts to the fed-funds rate that were enacted in 2008 were seen as emergency measures necessitated by a potential liquidity crisis. Whether the actions taken in 2008 were appropriate or necessary can be debated, but four years later we are no longer in the middle of a financial panic and a potential liquidity crisis. Why are we still on a "war footing" with regard to interest rates?
Just as important as having a stable monetary policy, however, is having a normal monetary policy. This fact is something that commentators often overlook (especially those who continue to clamor for the Fed to "do something" next week). The US Federal Reserve has kept short-term interest rates effectively at zero since December of 2008!
A zero interest rate is not a normal interest rate: it is an emergency interest rate, akin to going on a "war footing." The dramatic cuts to the fed-funds rate that were enacted in 2008 were seen as emergency measures necessitated by a potential liquidity crisis. Whether the actions taken in 2008 were appropriate or necessary can be debated, but four years later we are no longer in the middle of a financial panic and a potential liquidity crisis. Why are we still on a "war footing" with regard to interest rates?
US GDP has been growing at an average of 2.2% annual since the recovery officially began in mid-2009, and at 2.3% in the past year (as economist Brian Wesbury explains here). While these are not stellar growth rates for GDP, they do not call for a 0% interest rate. Many economists believe that interest rates are inappropriately low and monetary policy overly loose when they lag below real GDP by even a fraction of a percent.
Keeping interest rates this low may well be contributing to the slow economic growth, and it is certainly inviting dangerous inflation. The Fed has enormously beefed up bank balance sheets by its emergency actions since 2008 (for an explanation with diagrams of what this means, see this previous post), which certainly alleviates any possibility of a liquidity crisis. But, as central planners typically do, they are "fighting the last war." It is no longer 2008! All that excess money on bank balance sheets has not found its way out into circulation for a variety of reasons, but it certainly could do so and it could do so very rapidly. If it did, that would have the potential to be enormously inflationary.
Finally, there is an aspect of "self-fulfilling prophecy" in this continued "war footing" mentality. The US economy acts like it is still in an emergency mode because the Fed continues to enact an emergency monetary policy (and has said that it will need to do so through at least 2014).
To allow the economy to return to healthy growth, it is time to stop fighting the last war and get rid of these unnecessary -- and harmful -- emergency monetary gimmicks. A crucial aspect of a healthy growing economy is a stable and a normal monetary policy.
All of this begs the question: "Why is the Fed taking this approach?" We'll tackle that in our next installment in this series.
All of this begs the question: "Why is the Fed taking this approach?" We'll tackle that in our next installment in this series.