The Federal Reserve Board is re-thinking its whole approach to setting interest rates and controlling credit and money. Its bruising encounters with a falling stock market and an angry President in the final quarter of 2018 left it at a loss to explain why it needed to take action to ease monetary conditions. It had to admit that the markets held fears of slowdown or recession that the Fed itself did not share, and these worries in themselves might slow the economy and do wider damage. The Fed, which in late 2018 was telling us the economy was strong and could be subject to upward inflationary pressures, came round to the view that it had raised interest rates enough. It was also persuaded to shrink its balance sheet less and for a shorter time period than it had been planning.
The Fed has recently joined a conference on monetary policy at the Hoover Institution in Stanford to help define its evolving approach. The papers discussed included consideration of what options a future Fed would have if it needed to stimulate the economy whilst interest rates remained low. Last year, the Fed was preoccupied by the wish to get back to a new normal, planning rates well above the ultra-low levels needed at the height of the banking crisis. Part of the rationale for this approach was the idea that cutting rates and, if necessary, buying bonds is the right way to reflate – and can only be done effectively if you start from a position of higher rates and a strengthened Fed balance sheet. The Fed did not want to have to take more reflationary action in due course without having restored some “normality” to rates and bond holding.
World trade has changed
Central to the problems the Fed faced last year in understanding the economic position and the likely reaction of markets is its approach to setting rates. It holds a view that there is something called “national economic capacity”. As an economy grows, so more and more capacity is used up. Unemployment falls to levels where recruiting new labour is difficult. Factories work at full capacity and cannot suddenly produce more if demand expands further. These pressures mean, as demand rises, so wages are bid up as companies try to recruit, and prices of goods rise as companies take advantage of strong demand and limited capacity by selling at more expensive rates. The so called Phillips curve gives technical backing to the simple idea that as employment rises so wages rise by plotting unemployment against inflation, to the point where extra demand for labour is too inflationary. As the Fed sees this happening, so it gradually throttles back on credit by raising interest rates and regulating banks to avoid excess demand based on too many loans.
Even the US continental-sized economy relies on overseas suppliers
This theory does not seem to be working as it used to. Even the US continental-sized economy relies on overseas suppliers for many of its needs and can always import goods or services if they are scarce at home. As job vacancies increase we also see more people tempted back into the workforce in an economy with a low overall participation rate of adults in the workforce. More women decide on a career outside their homes, and more elderly people decide from necessity or choice to work on beyond the previous age of retirement. More migrants arrive in the US to take up some of the new jobs. The Phillips curve turns out to be a lot flatter than they thought, with expansion not automatically leading to higher wages or prices.
The internet ups capacity
It is also more difficult to pin down capacity in an internet age. If you want a new car there has to be car factory to make it. Today there is plenty of spare factory capacity around the world to make cars, but there is finite global capacity and its takes months if not years to put in new lines or new factories. If you want to expand your digital footprint, develop more on line business, offer interactive services and entertainments, there is plenty of extra capacity for any individual or company, and a fast pace of introduction of extra global capacity to avoid price rises.
The Fed will need to come up with new guides for setting rates based on money growth, inflationary pressures and credit growth without relying so heavily on a concept of domestic capacity. It is elusive given modern service sector and digital growth, and needs to be placed into the context of a fluid global market. The Governor of the Bank of England gave a lecture explaining the problems with setting rates based on a concept of national capacity, but the Bank of England too still relies heavily on this approach. In current conditions the danger is a central bank judges the economy to be too close to capacity and tightens money policy too much as a result. That is why markets went up when the Fed backed off in January. It is also part of the reason why markets are now less impressed, as we await new directions on how rates can be set sensibly. The trade war is knocking markets, and provides more reason to be careful about too tight a money stance.
The above article was previously published by Charles Stanley on 14th May 2019