Pressure mounts on Fed to hike rates after ECB stimulus move

25 Jan 2015 | Author: | No comments yet »

Eyes on Fed after ECB, other bank stimulus moves.

NEW YORK: The Federal Reserve could be key for Wall Street next week as investors get to hear from the US central bank for the first time since a series of moves by its global peers, including the European Central Bank’s massive stimulus plan. Washington: The US Federal Reserve will now have to contend with a potential flood of money from investors looking to the US as the global economy’s sole bright spot.Washington: Federal Reserve policymakers, already struggling to assure investors that they remain on track for a midyear interest rate rise, will find the task has just become harder with their peers in Europe and elsewhere headed in the opposite direction.Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities and the author of the forthcoming book “The Reconnection Agenda: Reuniting Growth and Prosperity.” There are two competing narratives about economic policy. Thursday’s larger-than-expected stimulus package from the ECB lifted US stocks, helping indexes post gains for the week after three straight weeks of losses.

The swelling ranks of central banks cutting rates and ramping up stimulus make it more difficult and riskier for the Fed to proceed with plans to end crisis-era policies, according to Fed analysts and former staffers. In one, economists have no clue how to manage advanced economies, or else we wouldn’t have faced the Great Recession, Europe wouldn’t be the basket case it is, the U.S. recovery wouldn’t have taken so long to gain traction, and middle- and low-income households would be sharing in more of the growth.

It is not unusual for central banks to be out of synch at times, but the deepening divide between the Fed and much of the rest of the world is unprecedented, heightening the risks and uncertainty surrounding the Fed’s plans. If Europe, Japan, China and other economies fail to respond to more stimulus, it would reinforce the notion that the world has moved into a permanently lower gear, so called “secular stagnation” — a bad omen for US wages and growth. More important to the Fed, the argument goes, the U.S. economy can’t abide higher rates either, because it would lead to an even stronger dollar that would kill U.S. exports (and jobs) while threatening outright deflation. Should the United States raise rates when other major developed economies are being more expansive, that could boost the dollar, putting further pressure on commodity prices — which because they are denominated in dollars become more expensive for non-U.S. investors — and adding to the threat of deflation. The World Bank also warned last week that developing countries “may be tested” in coming months if investors decide to shift from emerging market stocks, bonds and businesses into US assets.

The stimulus rivals the size of the quantitative easing programme the Fed ended only three months ago in a sign of confidence about US economic recovery. In the tidal struggle that is developing over the direction of global interest rates, investors last year already pulled a quarter of a trillion dollars out of emerging markets, according to a recent report by the Institute of International Finance (IIF). The euro fell below $1.14 (Dh4.19) after the ECB announcement, its lowest level since July 2003, while interest rates on long-term US bonds continued their recent nosedive. “The foreign outlook has darkened. Cross-border investment is expected to fall again in 2015 as a Fed policy shift approaches, according to the IIF. “We have not lived through a period of such wide monetary policy divergence …

US central bankers have been adamant on that point over the past several months despite tumbling oil prices, ebbing global growth, and market expectations that the Fed will eventually capitulate and delay its first rate increase since 2006. It’s true that we often fail to apply what we know — in part because of political interference, in part because we’ve unlearned key lessons from the past, leading to mistakes such as premature deficit reduction or inadequate financial-market oversight.

If oil prices were to go lower, that could create more of a problem.” Sharp declines in the euro, which hit an 11-year low against the dollar on Friday, make European stocks cheaper, especially compared with U.S. equities. But the lesson of the recovery is this: In crucial areas of the economy, we have the historical knowledge to diagnose what went wrong, and when we undertake the prescribed policy responses, they work like they’re supposed to. But this week will test whether, in fact, they are willing to swim against the current in conditions that get tougher by the week, and also if they can make their case convincingly.

With the leftist Syriza party — which has pledged to scrap austerity measures and secure a debt write-off — leading in polls, the euro may see further pressure. “European equities will likely improve in the short term, but in the medium term equity performance is likely to be tied to the performance of the real economy,” Rob Waldner, chief strategist at Invesco, wrote in a note last week. The Recovery Act, the financial and auto bailouts, Federal Reserve policy, and Obamacare are examples of applying the known hydraulics to achieve the intended effects. The Bank of Japan is buying Japanese bonds, while the Bank of Canada just cut interest rates as insurance against low oil prices. (Remember, unlike the U.S., Canada is a net exporter of oil.) The Bank of England seems to be backtracking on rate hikes too.

As my colleague Steve Goldstein put it: “If the Fed starts hiking in this turbulent global environment, it will only accelerate overseas investment here — further damp already muted inflationary pressure and making life difficult for exporters, and possibly furthering risky behavior that some on the Fed want to clamp.” In a recent analysis of what they called the “sizable growth drag” (at least 0.5 points a year) from a stronger dollar, economists at Goldman Sachs argued that the reasons for dollar strength matter. Fed officials have downplayed the dollar’s strength, noting that the US is less reliant on trade than other developed nations, and able to count more on domestic demand. Shortly after the February 2009 implementation of the stimulus, real GDP swung from the 5 percent nosedive of late 2008 to a 2.6 percent growth rate in late 2009.

Bank of Canada’s surprise rate cut on Wednesday knocked down the Canadian dollar against the US currency below 81 cents, adding to a drop of 15 per cent since mid-2014. The nonpartisan Congressional Budget Office found that the stimulus increased jobs and growth (though its estimates cover a range of outcomes, from economically small to significantly positive). Equally important, when economic policy pivoted too quickly to deficit reduction in 2010, before demand had returned, growth and jobs suffered, an observation wholly consistent with our understanding of these macrodynamics. Obama officials, myself included (I was chief economist to the vice president at the time), contributed to this blunder by not recognizing the depth of the downturn; economic forecasting still belongs to narrative No. 1 — things economists do badly.

Just this week, the International Monetary Fund raised its forecast for U.S. growth to 3.6% this year and 3.3% next year, despite the appreciating dollar. Even in 2013, austere fiscal policy was holding GDP growth down by 1.6 percentage points; in 2014, fiscal policy was neutral, and the economy did much better.

Banks slowly began lending again, and a financial sector that was in crisis soon began to generate record profits (yes, there’s something seriously unjust about that picture). U.S. auto companies sold more than 16.5 million cars last year, the most since 2005, and after shedding jobs for a decade, the auto industry has added back more than 500,000 positions since mid-2009. Insolvency, conservatorship and consumer-debt forgiveness would probably have resolved the crisis more quickly and a lot more fairly, though possibly at greater government cost. The prices of services excluding energy — which account for about 58% of the consumer price index — have been rising in a narrow range of 2.2% to 2.7% for the past three years, just as the Fed desires. All of this — including the housing bubble inflated by reckless finance — occurred in the first place because prominent economists such as Alan Greenspan replaced the lessons of scholars such as the late Hyman Minsky, who warned of financial volatility as recoveries progressed, with those of theoreticians whose models predicted that markets would self-regulate.

Now, some House Republicans are trying again to dial back the Dodd-Frank financial reforms even as financial markets are beginning to bubble, a clear example of the way politics creates a destructive wedge between our knowledge and our actions. The Federal Reserve: Its answer to weak demand and illiquid credit markets was to lower the key short-term interest rate it controls from north of 5 percent all the way to zero, cheapening the cost of borrowing. It also signaled to investors that rates would stay at zero for a while, and when even that proved insufficient, the Fed launched other tactics, spending money on longer-term bonds (“quantitative easing”) to lower longer-term rates.

Here’s something else we know: When the Fed rate is zero and it’s still not low enough to generate the needed economic activity in the private sector, temporary fiscal stimulus — government spending — goes much further. But deficit hawks chanting the mantra of the “failed stimulus plan” prevailed, and predictably negative results (an initially jobless, and for many still wageless, recovery) followed. That takes health care out of the market in ways that every other advanced economy acted upon well before we did, and thus their ability to provide quality care while controlling costs has far surpassed ours. To provide near-universal coverage, the risk of illness must be pooled across the population; that means mandatory insurance, which requires subsidies for those who can’t afford it. That meant changing the way we deliver medical care in America by rewarding efficiencies (e.g., fewer readmissions, a fixed payment for a set of services).

Budget deficits necessarily rise as a result of these interventions — a trend we should not block in the name of austerity, because the increase is temporary. The economy is a system, and technocrats roughly know how it works, at least the part about restoring and sustaining growth, which is why our economy has recovered while others have not.

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