Fed needs to normalize Monetary Policy

The US Federal Reserve Board meets this week just after the seventh anniversary of the collapse of Lehman brothers on September 15, 2008. The collapse of Lehman Brothers was a surprise to many, but a greater surprise were the subsequent events it triggered and the impact on the global economy. In the end it wasn’t this single event that caused the global financial. It was the context in which this trigger event occurred that mattered.

The global financial crisis followed a period of ultra low interest rates in the US from 2001 to 2004 in response to the bursting on the Dotcom bubble and the crash in US high tech stocks. By the time the Fed started raising interest rates from June 2004 until June 2006, there were many problems generated by the long period of loose monetary policy. These included significant over-building and over-pricing of US housing and other financial assets. There was also the creation of various financial derivatives aimed at generating high return in a low return economy, as well as important regulatory changes. The mis-pricing of risk and misallocation of capital over this earlier period carries many lessons as the Fed deliberates on current policy for the US economy.

A strong case can be made that the US economy is close – if not at – full employment. Inflation is well within the Fed ‘s comfort zone. The US economy is looking in good shape and well able to handle a return to higher interest rates. How high a “normal” interest rate might be in today’s US economy is an open question. With low productivity growth, the new normal might be a real interest rate closer to 2%. With inflation running at 1-2% this suggests an interest rate around 3 to 4%. This is lower than historical experience but well above the current zero federal Funds Rate.

The real issue facing the Fed is whether to wait until there is sign of rising inflation and then repeat the 2004 to 2007 experience of chasing a rising inflation rate. The alternative is to act in anticipation of inflation rising over the coming year. The correct strategy is not unambiguous but my view is that the Fed should err on the side of a 25 basis point rise at the current meeting.

A very important consideration is the uncertainty that current Fed policy is generating in global asset markets. No-one is sure what will happen when the Fed raises rates from zero and there is no previous experience of this. The uncertainty is weighing heavily on investment and confidence globally. This could be resolved with a clear announcement of a path for interest rates over the coming year including a rise this week. Waiting longer risks the possibility that there could be a high wage cost outcome in coming months that is not anticipated by the Fed. This would dangerously undermine confidence.

The Fed had no choice but to cut rates to zero to save the US financial system from collapse. It has carefully managed expectations of policy over the past 5 years and has already telegraphed its policy goal. It is time to act and reduce uncertainty generated by speculation of when rates may rise. If a 25 basis point rise in the federal funds rate causes the chaos that many Keynesian commentators argue, then the US economy is in a much more perilous position than even the pessimists believe.

The big problem is not what the Fed policy will do to the US economy. The biggest concerns are the implications for emerging market economies, particularly those with high public and private debt. For more than half a decade, they have been awash with liquidity and the drying up of this liquidity clearly poses challenges for these economies.

The World Bank and IMF have highlighted the global risks associated with rising US interest rates. However the Fed should be focused on what is best for the US economy. Fortunately in this case, a change in US policy would, over time, be of benefit to all countries. Reduced global uncertainty will benefit many countries currently experiencing significant asset price volatility. If some emerging countries experience a crisis as a result of 25 basis points this week, they would have do so whether the Fed raises interest either this month or in December.

Editor’s Note: This post originally appeared on The Australian Financial Review