19 September 2015

Financial Times: The US Federal Reserve has got it wrong

The US Federal Reserve decided not to raise the key policy rate in the US, which would be an understandable decision if rates were at or close to a normal level. Seven years into a recovery, central bankers need to explain why the interest rate playing field is still so heavily tilted to borrowers.

[...] Continuing with such low interest rates in the UK and the US, when unemployment rates are back to 5-5.5 per cent and our economies are growing well, raises some more profound questions about monetary policy in the west.

First, how independent are central banks? Since the 1990s, the Fed and the Bank of England have pursued policies similar to the ones any well-meaning government official would have chosen. They have cut interest rates very readily, but when they have raised them (in 1994-5 and 2005-7) they have been behind the curve. Independent central banks were established precisely to avoid this “behind the curve” interest rate policy. But it has not worked. Once again, they are at serious risk of lagging behind in their interest rate decisions as the major western economies climb out of the post-crisis recession.

Second, if interest rates cannot rise now, when will they increase? In the case of the US, growth has averaged over 2 per cent for more than six years since the recovery started in mid-2009. Unemployment has halved from around 10 per cent to 5 per cent over roughly the same period. Yet interest rates remain stuck — close to zero. A similar position prevails in the UK. [...]

The third problem is that central bankers appear to lack a clear strategy for monetary policy. Their implicit strategy is that interest rates will remain at current excessively low levels — until sufficient evidence accumulates to raise them. But a more realistic approach to keeping monetary policy on a steady and neutral course would involve a gradual rise in interest rates over the next few years. The key debate then should be around the pace and extent of this rise, not whether it should take place at all.

The discussion of UK and US monetary policy is taking place on the basis of a false premise — that we can maintain near-zero official rates indefinitely — and that this would somehow be a satisfactory basis for economic growth over the medium term. I do not believe that, and I do not meet many people in the business and financial world who do either. If they do have a view about long-term near-zero interest rates, it is that this is likely to drag the UK and/or the US into a low growth equilibrium like Japan. That would be a major policy failure for the leading western economies.

The failure of the US Federal Reserve to raise interest rates is a major setback to the normalisation of western monetary policy. But we should not despair. There is another opportunity to start the process of raising rates in October. However — in cricketing parlance — the Fed is now on the back foot. Their decisions are getting behind the curve. A sharp interest rate correction between 2016 and 2018 is becoming increasingly likely. Central bank independence is not delivering the benefits we have been promised.

© Financial Times