The Fed's Limited Ability to Stimulate
Barring an unforeseen calamity, the Federal Reserve will raise short-term interest rates this week. Among Fed watchers, this is known as "liftoff." The analogy is misleading. Short-term rates have been stuck near zero since late 2008, but they aren't about to rocket upward. The anticipated increase is a tiny 0.25 percentage points. That's still historically low, and Federal Reserve Chair Janet Yellen has said she expects further increases would be gradual.
What's more, the fed funds rate - by itself - isn't especially significant. It applies mainly to overnight loans between banks. The long-term interest rates that most influence the economy won't move much. Last week, rates on 30-year fixed-rate home mortgages fluctuated around 3.9 percent, according to Freddie Mac, and rates on 10-year Treasury bonds hovered near 2.2 percent, reports Bloomberg.
All in all, "it's going to be a very gentle liftoff," says economist Ted Gayer of the Brookings Institution.
The argument for liftoff is that ultra-low interest rates, if maintained too long, could fuel unwanted inflation or dangerous financial speculation. After 6½ years of recovery, the economy is said to be near "full employment." In a recent speech, Yellen noted that employment has increased by 13 million from its low point and that, at 5 percent, the unemployment rate is half its 10 percent peak in 2009. The economy can tolerate slightly higher rates, she implied.
Not everyone shares the Fed's benign outlook. Capital Economics, a consulting firm, predicts that next year's "big surprise will be how quickly inflation rebounds," forcing the Fed to raise interest rates sooner and higher than it now expects. Meanwhile, Martin Wolf, the Financial Times's chief economics commentator, thinks the opposite. The Fed's credit "tightening might be small and brief," because weak foreign economies will depress U.S. exports and slow the economy. A strong dollar will magnify the effect by making U.S. exports costlier.
Our perceptions of the Fed's powers have shifted dramatically since the heady days of Alan Greenspan's chairmanship (1987-2006). It seemed then that the Fed could, with periodic flicks of interest rates, virtually ensure prolonged prosperity. Now the problem seems just the opposite. Despite historically low interest rates (so low that, if past patterns had prevailed, the economy would have boomed), the recovery has been lackluster. From 2010 to 2014, economic growth averaged 2 percent annually, well below post-World War II averages.
The answer is not that the Fed failed to provide ample stimulus. Just the opposite: There was plenty. The Fed poured hundreds of billions of dollars into financial markets in 2008-09 to rescue some institutions and to stem a terrifying panic; it has maintained the zero-interest-rate policy on fed funds for about seven years; and it bought roughly $3.5 trillion of U.S. Treasury securities and mortgage bonds to reduce long-term interest rates and raise stock prices (so-called quantitative easing).
The problem was not a shortage of stimulus; it was that the stimulus, being artificial, was inferior. In the 1980s and '90s, consumers and businesses were eager to spend. The Fed accommodated that demand but did not create it. By contrast, consumers and businesses now are conditioned to be wary. Having lived through events - the financial panic and crushing recession - that supposedly could not happen, they are reluctant spenders. The Fed can try to ease their caution but cannot systematically eliminate it.
One lesson of the financial crisis and Great Recession is that the Fed faces very real limits in its ability to stimulate and steer the economy. Monetary policy can't do everything. It can enable people who wish to take economic and financial risks to borrow at reasonable rates. But it cannot unilaterally create a climate of risk-taking - which results from a mix of private behavior and government policies - where none exists.
The fundamental question about liftoff is whether it symbolizes a slow return to a more normal economy, in which buying and selling, saving and investing are self-sustaining without the Fed providing torrents of artificial stimulus. If so, that would be very good news.