The Federal Open Market Committee, the official policy making body of the Board of Governors of the Federal Reserve System, is expected to announce an increase, or lift-off, in the Federal Funds rate of .25 percent at its Dec. 15-16 meeting. This action comes as no surprise, as it has been widely expected by financial market practitioners and represents the beginning of a return to normalcy, since 2008, when the Federal Reserve has been operating at the zero lower bound.
Because interest rates cannot go below zero, the Fed has been using unconventional monetary policy measures, known as Quantitative Easing (Q.E.) or Large Scale Asset Purchases (L.S.A.P.), to stimulate the economy in the face of the great recession.
By “large scale” asset purchases, we really mean large scale. The monetary base in the United States has risen from about $400 billion prior to 2008 to about $4 trillion in recent years. The world financial system is massively flooded with U.S. dollars. Most of the liquidity injections remain as excess bank reserves, but some of these funds have found their way to Asia, particularly Hong Kong, which is experiencing a massive property price inflation.
Traditional monetary analysis holds that monetary expansion leads sooner or later to inflation. In today’s globalized financial system, the massive monetary expansion has not led to inflation at home. Rather it has nurtured inflation—specifically property price inflation—in many regions of the Pacific.
The Fed kept the interest rate—specifically the U.S. Federal Funds rate, the interbank lending rate—at zero in order to keep borrowing costs low and encourage investment. When the interest rate remained at the zero lower bound, and the economy was not recovering, the Fed turned to these unconventional measures. Similar policies were undertaken by the European Central Bank and the Bank of Japan.
We should not be shy about acknowledging how much of a break these Q.E. policies represent for Fed policymaking during the past seven years. We have seen massive interventions not just in banks but in non-bank financial institutions. Normally major asset purchases of non-bank institutions are done by the U.S. Treasury with the approval of Congress (such as the bailout of General Motors). Christopher Sims at Princeton has labeled these Fed actions as “quasi-fiscal” monetary policies. To be blunt we have been in the world of Twilight Zone macroeconomics, where nothing is as it seems. The Fed has been doing quasi-fiscal actions, conducting massive purchases of long-term securities from private financial firms. The firewall representing the independence between the monetary authority (the Fed) and the fiscal authority (the U.S. Treasury) is not as hard and fast as we presume.
With the U.S. economy now in apparent recovery mode, the Fed, quite understandably, is attempting a gradual, careful attempt to return to normalcy—to exit from this Twilight Zone world. By normalcy, we mean a return to the use of the Fed funds rate as the normal instrument for executing monetary policy.
Most realize that the Q.E. policies have not been particularly successful policy instruments for getting the economy back into recovery mode. Granted, maybe things would have been a lot worse without the massive Q.E. policies. But no one is saying that these policies worked wonders. But there are other reasons that the Fed would also like to unwind its massive holdings of private-sector securities in its portfolio. This is not the traditional business of the monetary authority. Central bankers, by and large, like to follow tradition.
Furthermore, holding large amounts of private-sector securities in its portfolio exposes the Fed to the small risk of running a deficit, should the returns on these securities take a nosedive. Never in its 101-year-old history has the Fed run a deficit. This is a nightmare scenario that the Fed would not want to face. Such a nightmare would force the Fed to ask for a bailout from the U.S. Treasury, which would entail Congressional approval. The last thing the Fed wants at this time is for the U.S. Congress to start meddling in the way it does its business. There is enough uncertainty in the world of finance without bringing into the Fed machinery members of Congress with an ax to grind about monetary policy.
The normal way of doing things is for the Fed to adjust this rate by given basis points in response to indicators of inflation relative to a target, or a target for the output gap (a measure of GDP relative to potential GDP). If inflation or output gap are below target, lower interest rates are called for, and if inflation or output gap are above targets, higher interest rates are called for. Getting the interest rate back to a long-run level of 2 percent, over time, gives the Fed maneuvering room to lower interest rates when there is slack in demand, as well as to raise interest rates when there are inflationary pressures or signs of the economy overheating. It does not have this option when the interest rate is at zero.
Of course, the Fed cannot affect current inflation or output gap targets. The Fed relies on forecasts of future inflation and output gap, and sets its interest rates for targets several quarters ahead.
So the expectation is that we will see gradual increases in the Fed Funds rate over the next several quarters, barring any faltering in the recovery, until the interest rate is back to a steady rate of about 2 percent.
The question left unasked is what these actions will do to emerging market economies. The U.S. interest rate is the global risk-free rate, against which all sorts of investment and portfolio decisions are made, throughout the world. While the industrialized countries have been in crisis mode, emerging market economies have gone on for more than a decade without a major financial crisis. This is not just due to good luck. Having the world dollar interest rates at or near zero has been a helpful shield. But there are dark clouds on the horizon across the world of emerging markets, ranging from Asia, to Latin America to the Middle East. A return to financial normalcy in the United States could well bring with it a return to more frequent financial crises in the emerging developing nations of the world.
Paul D. McNelis, S.J., America’s contributing editor for economics, holds the Robert Bendheim Chair in Economic and Financial Policy at the Graduate School of Business Administration at Fordham University, New York.