Most advanced economies in the Western world have been exposed to zero interest rates and suffered from subpar economic performance since the global financial crisis of 2008. The U.S. economy is now finally picking up steam and the Fed was able to raise interest rates last December for the 2nd time after the global financial crisis. The labor market has been performing well in recent years and the unemployment rate is with 4.7 now even slightly below the Fed’s estimate of the natural rate (graph 1). As inflation is now approaching the 2% target, we can see that officials at the Fed are starting to get itchy, especially in the light of Trump’s announcements of a massive investment program in public infrastructure. Such a stimulus might lead to additional pressure on a labor market that is already running hot, at least this seems to be the perception at the Fed, never mind that labor force participation is still several percentage points below the pre-crisis normal (graph 2). Of course, we do not know to what extent this decrease is supply-side driven rather than cyclical. However, over the last year we have seen a slight uptick in the labor force participation rate again while the unemployment rate remained flat. Furthermore, for the first time in many years, nominal wage growth has reached a pre-crisis level (graph 3). Given the good performance of the U.S. economy in the second half of 2016, there is a chance that full employment has already been reached. In that case, any further accommodation will only result in higher nominal growth, but not real growth (that is to say it will lead to higher inflation). Fed officials are apparently very worried that they will get behind the curve as running the economy hot might lead to the danger that they will have to choke off inflation with a series of rate increases, thus potentially creating a recession. I find this line of reasoning a little hard to understand. Financial markets are, as of now, not anticipating any rapid inflation increases beyond the 2% target. The unwillingness to run the economy hot for a little while is frankly quite disturbing. After almost a decade of dismal economic performance, Fed officials should embrace this opportunity and find out to what extent discouraged workers might be willing to join the labor force again as well as to ensure adequate wage growth for a majority of workers who have seen their living standards stagnate since the global financial crisis. Inflation expectations have been well-anchored for almost three decades right now. Many Fed officials seem to operate under the belief that monetary policy works with long lags and that the Fed will find itself behind the curve once inflation is starting to pick up. This belief is, in my opinion, quite unreasonable and maybe outright dangerous. While the case for monetary tightening is much stronger than just a year ago when the Fed decided to hike interest rates for the first time after the crisis, a premature move has the potential to keep hundreds of thousands of people out of the labor market who would otherwise be able to find a job. Financial markets react instantaneously to changes in the Federal funds rate. With a careful monitoring of asset markets and financial conditions in the economy, Fed officials definitely have the means to run the economy hot for a little while and hike interest rates without causing a recession only when inflation starts to move away from the 2% target but not before. So my plea to the Fed is to give those discouraged workers a chance before writing them off permanently as structurally unemployed. Furthermore, the Fed will also have to think about the global implications of additional rate hikes insofar as the dollar is the dominant global currency and movements in the exchange rate will have global effects that might then feed back into U.S. domestic conditions. The U.S. economy now increasingly looks out of sync with the Eurozone and Japan where negative interest rates still prevail. The dollar has already appreciated substantially, which leads to a tightening of financial conditions in many emerging market economies and thus can depress global aggregate demand in the rest of the world. Any further appreciation of the dollar, if large enough, might actually turn out to be quite harmful for economies that have pegged their exchange rate to the dollar and for those who have large dollar denominated liabilities or both.
I’ve written previously about the current conundrum that stock and bond markets have enthusiastically embraced the election of Donald Trump despite the fact that many of his policy proposals, if implemented, are somewhat negative if not outright harmful for the U.S. economy. Seemingly, economic fundamentals have not changed that much since last November. However, the entire U.S. stock market is up by several percent, thus creating hundreds of billions of dollars of new wealth. Furthermore, the entire U.S. yield curve has also shifted up significantly, which indicates that investors expect a mixture of higher growth and higher inflation in the foreseeable future, both of which is obviously extremely desirable under current economic circumstances. However, there is a quite significant chance that current investor sentiment is purely driven by animal spirits. Of course, expectations also affect fundamentals. In that sense, the current upswing could become self-fulfilling.
Most advanced economies in the Western world have been exposed to zero interest rates and suffered from subpar economic performance since the global financial crisis of 2008. The U.S. economy is now finally picking up steam and the Fed was able to raise interest rates last December for the 2nd time after the global financial crisis. The labor market has been performing well in recent years and the unemployment rate is with 4.7 now even slightly below the Fed’s estimate of the natural rate (graph 1). As inflation is now approaching the 2% target, we can see that officials at the Fed are starting to get itchy, especially in the light of Trump’s announcements of a massive investment program in public infrastructure. Such a stimulus might lead to additional pressure on a labor market that is already running hot, at least this seems to be the perception at the Fed, never mind that labor force participation is still several percentage points below the pre-crisis normal (graph 2). Of course, we do not know to what extent this decrease is supply-side driven rather than cyclical. However, over the last year we have seen a slight uptick in the labor force participation rate again while the unemployment rate remained flat. Furthermore, for the first time in many years, nominal wage growth has reached a pre-crisis level (graph 3). Given the good performance of the U.S. economy in the second half of 2016, there is a chance that full employment has already been reached. In that case, any further accommodation will only result in higher nominal growth, but not real growth (that is to say it will lead to higher inflation). Fed officials are apparently very worried that they will get behind the curve as running the economy hot might lead to the danger that they will have to choke off inflation with a series of rate increases, thus potentially creating a recession. I find this line of reasoning a little hard to understand. Financial markets are, as of now, not anticipating any rapid inflation increases beyond the 2% target. The unwillingness to run the economy hot for a little while is frankly quite disturbing. After almost a decade of dismal economic performance, Fed officials should embrace this opportunity and find out to what extent discouraged workers might be willing to join the labor force again as well as to ensure adequate wage growth for a majority of workers who have seen their living standards stagnate since the global financial crisis. Inflation expectations have been well-anchored for almost three decades right now. Many Fed officials seem to operate under the belief that monetary policy works with long lags and that the Fed will find itself behind the curve once inflation is starting to pick up. This belief is, in my opinion, quite unreasonable and maybe outright dangerous. While the case for monetary tightening is much stronger than just a year ago when the Fed decided to hike interest rates for the first time after the crisis, a premature move has the potential to keep hundreds of thousands of people out of the labor market who would otherwise be able to find a job. Financial markets react instantaneously to changes in the Federal funds rate. With a careful monitoring of asset markets and financial conditions in the economy, Fed officials definitely have the means to run the economy hot for a little while and hike interest rates without causing a recession only when inflation starts to move away from the 2% target but not before. So my plea to the Fed is to give those discouraged workers a chance before writing them off permanently as structurally unemployed. Furthermore, the Fed will also have to think about the global implications of additional rate hikes insofar as the dollar is the dominant global currency and movements in the exchange rate will have global effects that might then feed back into U.S. domestic conditions. The U.S. economy now increasingly looks out of sync with the Eurozone and Japan where negative interest rates still prevail. The dollar has already appreciated substantially, which leads to a tightening of financial conditions in many emerging market economies and thus can depress global aggregate demand in the rest of the world. Any further appreciation of the dollar, if large enough, might actually turn out to be quite harmful for economies that have pegged their exchange rate to the dollar and for those who have large dollar denominated liabilities or both.
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