Six and a half years since the end of the Great Recession, the Federal Reserve appears likely to raise interest rates for the first time at this month’s Federal Open Market Committee Meeting on December 15th and 16th. We recently spoke with Kevin Warsh, former Fed governor, to get his thoughts on the timing of the impending rate rise, the Fed’s policy approach to normalizing markets, and why weakness in the global economy threatens the Fed’s tools, objectives and credibility in coming years.
Q: Federal Reserve Chair Janet Yellen made a strong case for a Fed rate increase in her speech to the Economic Club of Washington on December 2nd. What was your reaction to her comments?
A: Chair Yellen has certainly boxed herself in and now has little choice but to raise rates at the December meeting. She had a long window of opportunity to tighten monetary policy, but it may well be closing. I find it an odd moment to raise rates when there are a number of indicators that show that the economy is weakening. While the Fed’s preferred dashboard shows only improving data (e.g., payrolls, unemployment insurance claims, wages and prices), these are, to my mind, backward-looking indicators. They tell me more about what happened in the summer than what we can expect going forward.
There are important signs of weakness that the Fed is choosing to ignore: business investment, global trade, commodity prices and emerging market weakness. Still there is an almost universal belief that the Fed will raise rates at its meeting December 15-16 absent a major event, like a significant pullback in the S&P 500 or a terrorist attack. Since the October Federal Open Market Committee (FOMC) statement, the Fed has chosen to outsource its decision-making power to the fixed income markets.
Q: Quantitative easing was supposed to be an extraordinary measure. Why has it lasted so long? Is there something called quantitative tightening? Why wouldn’t the reasonable course to normalize markets be to sell assets back to the market and then raise interest rates?
A: There would have been great symmetry to have begun the normalization process by first shrinking the balance sheet in a regular, predetermined way. In the crisis, we first cut rates to zero, then grew the balance sheet when we hit what we thought was the zero lower bound for interest rates. My view is that in order to normalize markets, it would have made good sense to shrink the balance sheet first, then raise rates ― but that is not the path the Fed is choosing.
I can’t say for sure why the Fed is raising rates first, but this is my theory: quantitative easing (QE) had a much greater effect on financial markets than on the real economy. As a result, the Fed might well be nervous that if it were to begin to sell assets, then private market participants would also choose to sell assets. If that happens, the so-called successes of QE in supporting financial market asset prices would be undone.
The Fed is likely to continue to leave its balance sheet at current levels by buying assets to replace those that mature. Sometime in the next six to 12 months, after beginning to raise rates, they say they will start to shrink the balance sheet by allowing assets to mature without replacing them. I would be surprised if they actually sold any assets into the market outright.
Q: Where are these policies likely to leave us?
A: We have never in U.S. economic history run this experiment. No one should have any definitive convictions about where the central bank is taking us. There is no historical model to reference. That said, I am quite concerned about the direction we are heading. Commodity prices are telling us that global demand is weak. Productivity is low and I expect corporate profits and margins to be down next year ― with real implications for financial markets and real economic prospects around the world.
This process of normalizing interest rates to levels approaching their long-run average and shrinking the balance sheet to its sub-$1 trillion pre-crisis levels might be a three- to four-year process. For this outcome to occur, you would have to believe that we will be experiencing the longest economic recovery in post-war history. It is worth noting that the Fed has never predicted a recession a year in advance of its occurrence in the post-war era.
If indeed a recession were to occur before the normalization process is complete (which I would consider as likely), the Fed’s credibility would be damaged. After the persistent use of extraordinary policies, the Fed’s most important asset – its institutional credibility – is at stake.
My greatest concern is that when we enter the next recession or period of financial distress, the Fed may not have the tools, credibility and courage to offset what comes. The implications for the least well-off among us is particularly troubling.
Q: Given these concerns, what would be your preferred policy path at this point?
A: The Fed should have a medium-time horizon. And it should be in the risk-management business to help the economy achieve its goals. So I would hope that the Fed would not find itself with such a paucity of good options as it does today. In my view, the Fed missed a wide open window of opportunity to tighten monetary policy and exit its crisis-era policy innovations. If the Fed’s balance sheet had been made smaller and interest rates were 75 to 100 basis points higher, the Fed could quite prudently adopt a neutral bias for policy at its forthcoming meeting.
Q: Why have interest rates been so low for so long? Has Fed policy changed or has the economy changed?
A: Actually, both. The underlying trends in the economy haven’t changed much in the six and a half years since the end of the Great Recession, while GDP has been growing around 2 percent annually. This recovery is the weakest in post-World War II history and there is some evidence in the last quarter or so that the real economy might be weakening relative to its recent trend, both in the United States and around the world. Indeed, real economic growth has run far short of the Fed’s vaunted forecasts since 2009.
On the policy side, policy-makers outside of the central banks have largely forgone the adoption of sound economic policies. And my former colleagues at the Fed have proven themselves all too willing in the post-crisis years to step into this vacuum. Congress and the President are increasingly reliant on Fed monetary policy to compensate for their inability to construct growth-oriented economic policies. Sadly, the Fed cannot satisfactorily substitute its policies for those of Congress and the President.
The Fed’s seeming acceptance of a newfangled, broad-based economic management role throughout business cycles may have affected how the central bank defines its objectives. The core inflation rate today is only about half a point under 2 percent. This is a rate that in the past was squarely in the comfort zone of what was considered price stability. Now it is considered to be too low, even dangerously low by some. This is a big change from the past.
Q: Internationally, it appears that the Fed’s emphasis on raising interest rates is at odds with the European Central Bank (ECB) and the Bank of Japan (BOJ), which are moving in the opposite direction. What do you make of this divergence and what is the ECB’s goal?
A: We are entering a period of the greatest divergence in monetary policy in at least a generation. I think the ECB plan is pretty straightforward. Mario Draghi, the president of the ECB, believes that inflation in the euro area is too low and weakening the euro is his preferred means to stabilize prices and move inflation higher toward his 2 percent inflation objective. It also serves to bolster European exports at a time of weaker global trade.
Central bankers outside the United States are beginning to say that the zero bound on nominal interest rates is not actually zero ― that negative deposit rates might be more efficacious than quantitative easing. The ECB’s recent deposit rate cut will become a much more common practice, and likely sanction the new vanguard of monetary policy. Time will tell whether this new policy innovation is more effective to the real economy than QE. The academic community seems enamored with negative nominal rates.
Q: You were on the front lines during the financial crisis as a governor of the Fed. What lessons did you take away from that experience?
A: First, the Federal Reserve is a truly nonpartisan institution and is embedded with hundreds of economists as well as 26,000 staff members who are overwhelmingly motivated by public interest. Any criticisms I have (or anyone else should have) are about hard judgments, models and markets, not about intents.
The most lasting takeaway for me was how smart, motivated, well-intentioned and, frankly, patriotic the staff was at the Fed. In the depths of the crisis, Ben Bernanke led the Fed with courage and the wherewithal to make hard, radical decisions amid huge amounts of uncertainty. The Fed didn’t dither, it acted.
As an example, over the course of about eight to nine months, we rolled out nearly a dozen new financial products in order to provide necessary liquidity to markets with the predominant purpose of ensuring that markets would open and asset prices would find a clearing price. I agreed with some conclusions and disagreed with others ― but either way, it took a huge amount of courage and conviction for Bernanke to lead in some of the darkest hours.
Nevertheless, we have not been in a financial crisis regime for many years. Policies and judgments that were appropriate during the depths of the financial crisis are inconsistent with the financial and economic conditions that have marked the last several years. The Fed missed the opportunity to raise rates in the past and that inertia may well prove costly as the economic cycle ages and broad economic conditions remain unsatisfactory.
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