By Anthony Tokarz
Money and Investing Writer
Investors the world over rejoiced on Wednesday, September 21, when the Federal Reserve voted 7 to 3 at its monthly FOMC meeting to hold interest rates steady. Markets rallied in response to the news, by an average of 1 percent in the US, and firms found their access to cheap credit unobstructed. Developing economies also benefitted from the decision.
In October 2015, at the annual World Bank and International Monetary Fund’s joint Board of Governors meeting held in Lima, Peru, many government officials from developing nations begged the Federal Reserve not to raise rates in order to prevent capital flight out of their countries.
When the Fed raised its target by 25 basis points to a 0.25 percent lower bound in December 2015, investors sought the highest rate of return on their capital and drained approximately $500 billion out of foreign markets before investing that sum in US securities.
This situation did not recur this year, but many analysts, even members of the Fed’s Board of Governors, lament the dovishness which reigns in the Fed Boardroom.
Over the past year, a plethora of developments have arisen that strengthen the case for a rate hike, as the Fed itself notes. Most obviously, the Chinese economy has rallied from its startling slump last year, which sparked global anxieties that caused markets to tumble and central banks to hesitate on their planned course of slowly but steadily raising rates.
Furthermore, creeping gains in American GDP growth have nonetheless picked up slack in the labor market and pushed the economy closer toward full employment, and toward fulfilling the labor aspect of the Fed’s Dual Mandate.
There has also arisen a heretofore unprecedented variable which may soon affect global markets in unpredictable ways: Brexit.
If the Federal Reserve does not act to raise rates in the short term, any possible consequences of Britain’s severance of its business ties to the continent might well make a rate hike risky, if not outright dangerous, in the coming months.
Since the latest recession, financial media have obsessed over the idea that the Fed will have no policy tools to deploy in the event of another recession, whether caused by a Brexit scenario or some other black swan event.
Prior to the violent sub-prime mortgage crisis of 2008-9, the effective Federal Funds Rate stood at 5.25 percent, leaving Bernanke’s Fed with a lot of wriggle room for slashing rates to cheapen money and incentivize investment.
Now, the paucity of strategies attendant upon a meager effective federal funds rate (EFFR) of 0.4 percent could force the Fed to pursue controversial policy, such as third round of Quantitative Easing, or to experiment with new or long-neglected policy instruments, such as helicopter drops or margin requirements.
This idea holds merit, as the Fed’s counterparts in Europe (the European Central Bank) and Japan (the Bank of Japan), have begun experimenting with the current dark horse of monetary policy: negative interest rates.
Post 2008 monetary policy has its own macabre sense of irony. If the Fed drags its feet in raising rates in the near future for fear of tightening the availability of credit (a contraction of credit is widely believed to have turned a normal business cycle “bust” phase into the Great Depression), it will do worse if it limits itself to exploring negative rates in the future.
For wherever a central bank has instituted a negative interest rate (Japan, Switzerland, Sweden, etc.), consumers have found every excuse to avoid spending, and, in Japan’s case, responded by pulling their deposits out of their bank accounts.
As consumer led bank-runs deplete the supply of loanable funds, businesses will have every incentive to borrow at advantageous rates.
Should such a strategy become widespread, it would likely create asset bubbles, an artificial inflation of the value of some class of goods, such as real estate, in which the Fed was created to prevent.
These reasons, perhaps, explain why the Boston Fed’s Eric Rosengren is leading the crusade against the dominant dovishness regarding FFR moves.
He stands not alone: Esther George, of the Kansas City Fed, and Loretta Mester, of Cleveland, joined their Boston colleague in voting for another 25 basis-point rate hike.
The market seems to agree; signs of accelerating inflation have emboldened Fed rhetoric and all but confirmed the suspicion that rates will again rise by the end of the year.
Once the Presidential Election ends, expect to see the world watching the FOMC’s December meeting like a (Rosengren) hawk.
A version of this article appeared in the Tuesday, September 27th print edition.
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