Indeed, the FED implemented sizeable programs of Quantitative Easing early on in the aftermath of the financial crisis. These large-scale asset purchases were designed in order to stimulate spending in the economy, thus addressing the enormous shortfall of aggregate demand. Increasing the monetary base by purchasing financial assets (i.e. printing money) is, however, less effective in "liquidity trap" situations where interest rates are stuck at zero. Nevertheless, there is ample evidence that QE has affected the real economy via various channels (lowering interest rates, affecting inflation expectations, increasing various asset prices, lowering the exchange rate, and so forth). There is no doubt that the recovery of the U.S. economy and the accompanied decrease in unemployment from 10% shortly after the crisis to roughly 5% nowadays can be mostly attributed to the FED’s accommodative polices.
A comparative analysis with the Eurozone and Sweden is particularly illuminating. The ECB raised interest rates twice in 2011, plunging the Eurozone into a recession. The Swedish Riksbank also raised rates several times during the same year. It is noteworthy that both Central Banks were at that point in time heavily critized for tightening by the most renowned experts on monetary policy, the likes of Krugman and Svensson, for example (http://www.voxeu.org/article/debt-deflation-and-riksbank-s-policy). The outcome was, of course, as one should have anticipated. Economic conditions deteriorated very quickly and both the ECB and the Riksbank had to reverse course. Long after the U.S. has ended its final asset purchase program and is now thinking about ’normalizing' interest rates, both the Eurozone and the Swedish economy are now stuck in a low-growth and low-interest rate environment because of premature tightening of monetary policy by their respective Central Banks. More specifically, the ECB as well as the Riskbank were recently forced to implement negative interest rates on bank deposits as well as implementing large-scale asset purchases to boost the economy, just like the FED did in previous years. The key take-away from this really should be that expert opinion from prominent macroeconomists should not simply be dismissed.
However, in recent months the FED has shifted its position and looks increasingly eager to tighten monetary conditions even though such a move is totally unwarranted, given the current economic state of the U.S. economy. The hypermind prediction market currently assesses the probability that the FED will rise rates this year at more than 60% (https://hypermind.com/hypermind/app.html#welcome).
Yellen & Co. thus seem to be willing to join the group of sadomonetarists, a term coined by Paul Krugman for the exclusive club of Central Bankers who want to raise interest rates, well, just because interest rates HAVE to go up again at some point in time even though economic conditions clearly do not warrant such a move
The monetary tightening subsequently depresses economic activity by that much that interest rates end up being stuck at zero again. This has happened a number of times, most recently in Sweden and in the Eurozone, but also in Japan in the early 2000s. They just do not seem to learn.
In what follows I will argue in the spirit of Larry Summers and others why it would be a great mistake for the FED to hike rates right now (http://larrysummers.com/2015/09/09/why-the-fed-must-stand-still-on-rates/).
By the end of 2012 the FED implemented the so-called Evan’s rule, which stated that it would keep interest rates close to zero at least until the unemployment rate falls below 6.5% or until inflation rises above 2.5%. The rule clearly indicates that FED officials thought at that time that the natural rate of unemployment could very well be around that level, but not much lower. Well, it turns out that they were wrong. The unemployment rate decreased from about 9% in the beginning of 2012 to now 5.1% in August 2015. More importantly, there are no clear signs as of now that the labor market is in the process of overheating, which could eventually create inflationary pressures.
To the contrary, the labor force participation of prime age workers, for example, is still about 2 percentage points lower than before the crisis. There are some reasons to believe that some of these workers might come back and join the labor force as economic conditions improve across the board. Furthermore, there is some evidence that many workers are still stuck in part-time jobs even though they really want to work full-time. Rising rates right now could seriously threaten the recovery and deny jobs to hundreds of thousands of workers, potentially up to 2 million or even more, as argued by Andre Levin (http://www.voxeu.org/article/conceptual-pitfalls-and-monetary-policy-errors). There is just no way of knowing where exactly the natural rate of unemployment is. It could be close to the 5% where we are right now, even though that’s highly doubtful. Or it could even be at about 4% like in the beginning of the noughties. The FED should just sit back and wait until the labor market starts to tighten. Any sensible read of various labor market indicators suggests that we have not reached that moment yet by a wide margin.
As a result of the recent China turmoil, stock markets have tumbled in the U.S. (and elsewhere). Credit spreads as well as market volatility have increased, indicating a tightening of financial conditions. The fall of asset prices across the board (other than Treasuries because of their safe haven status), the soaring dollar vis-à-vis a broad range of emerging market currencies and, most importantly, the fall in inflation expectations over the last few months all indicate that monetary policy is getting more contractionary again by the week. The Wicksellian interest rate seems to be falling. Meanwhile, FED official are debating an interest rate hike, thus imitating the mistakes made by the ECB, the Swedish Riksbank and the BoJ. Next week will be crucial. Hypermind evaluates the chance that the FED will fully convert to sadomonetarism and raise interest rates at about 20%. These are not small odds, they are actually excessively high for my flavour.
One final thought about the “financial instability” argument. Some have argued that asset prices are in bubbly territory and that the FED has to "lean against the wind”, i.e. hike rates to curb the boom. This is just silly. First of all, it is not at all clear that we are facing bubbles at the moment. With very low interest rates globally, asset prices are supposed to be high because of economic fundamentals: Future expected cash flows are discounted with low rates. Second, even if there are bubbles, a measly increase of 25 basis points will only have a marginal effect. The Swedes have tried recently. They hiked rates and put the economy back into deflation while housing prices remain extremely elevated. Of course, it is always possible to pop a “bubble” by engineering a 1930-style Great Depression or 2008-style Great Recession. Mass unemployment and misery across the board will even pop the most persistent asset price “bubble”. I feel that this is really not something one wants to go for,but maybe that’s just me.
To sum up, the economy is still not reached full employment. Moreover, monetary conditions have tightened over the last few months. It thus seems bizarre that the FED would even consider an interest rate rise at the moment. Now is really not the time to tighten the screws even more. Interest rates will probably have to remain low for secular stagnation reasons for a number of years.
Wanna raise rates nonetheless? How about changing to a 4% inflation target or a nominal GDP level target, getting the economy back to full employment, and then we can talk!