Federal Reserve: Credibility on the line
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As Janet Yellen, chair of the Federal Reserve, was preparing last month for the first increase in US interest rates for a decade, protesters in New York’s financial district were holding a candlelight vigil bemoaning the end of near-zero monetary policy.
In the crowd bearing illuminated signs saying “what recovery?” and “wage growth is good” was Mauricio Jimenez, a 44-year-old construction worker from Queens, who warned against the move as he stood outside the New York Fed.
“It was a mistake,” he said this week, arguing the central bank should have paid more attention to working families and minorities who had seen paltry wage growth, and that the Fed should reverse course. “We are the people most affected.”
Complaints about the prospect of higher rates had long been levelled by left-of-centre groups such as Fed Up, which arranged the protest, as well as Democratic politicians including Bernie Sanders, the presidential challenger, as a way to highlight the stagnating fortunes of millions of Americans.
This month, however, fears of a global slowdown and the crash in commodity prices have prompted a flurry of criticisms from a different constituency. Stung by brutal declines in the S&P 500 index, some Wall Street investors are accusing the Fed of failing to appreciate the dangers brewing overseas.
Instead of soothing the markets, US policymakers are accused of fraying nerves and exacerbating outflows from emerging markets by purportedly clinging to a strategy that envisages further increases this year.
“The market views tightening as a mistake now,” says Jordi Visser, chief investment officer at Weiss Multi-Strategy Advisers. “I don’t think 25 basis points matters much but the market clearly does. We’re now closer to a recession than we all realise.”
Having its policy decisions second-guessed is an occupational hazard for the Fed, and a failure to lift rates in December would have triggered no less irate criticisms from America’s political right, not to mention poorly positioned hedge fund managers.
The torrid opening to 2016, however, has thrown Ms Yellen and colleagues on to the defensive, coming so soon after they gambled on the rate increase. In its policy meeting on Wednesday, Fed officials said they were closely watching the gyrations in global markets.
A host of central banks, including the European Central Bank, the Bank of Japan and the Swedish Riksbank, have tightened policy only to reverse the decision. The BoJ on Friday adopted negative interest rates. It would be a painful blow to the Fed’s credibility if it turned out that it lifted rates on the cusp of a slowdown and was forced to backtrack.
Ms Yellen was initially praised for her handling of the rate rise, which came without a single voice of dissent in her policy committee. Yet the move was controversial even within the central bank.
Lael Brainard, a Fed governor, argued before the decision that the risks of tightening may be higher than sticking with near-zero rates because there would be little scope to stimulate the economy with further monetary easing if policymakers had to reverse course.
The question is whether these doubts will be confirmed by events. Perhaps sensing blood, senior investors, including bond manager Jeff Gundlach of DoubleLine Capital and Ray Dalio, the head of the world’s biggest hedge fund, Bridgewater Associates, have renewed criticism of the Fed, urging it to abandon the notion of raising rates any time soon.
Market expectations that rates could rise again as early as March have sunk, with September now seen as the earliest date.
Adam Posen, the president of the Peterson Institute for International Economics, says raising rates has been a mistake and that none of the developments in juddering global markets or China had changed the picture. Looking ahead, he says his gut instinct is that “they hold, they postpone, but they don’t reverse”.
Several factors have stoked worries about the merits of tighter policy, many driven by deteriorating global conditions at a time when other central banks continue to ease. The fall in demand for commodities that drove oil below $30 a barrel in mid-January is seen by some as an indicator of a worsening global downturn led by China, rather than simply a reflection of buoyant supply.
The US has turned out to be vulnerable to the fall in crude prices. The boost from cheap energy to consumer spending has not met expectations while the associated drop in investment in the sector hurts growth. Jim O’Sullivan of High Frequency Economics describes the oil price decline as “a wash” for the US economy instead of the lift that many had hoped to see.
Confirming concerns about the impact of the high dollar and oil price plunge on US industry, the first reading for fourth-quarter US gross domestic product yesterday showed a slowdown in growth to an annualised pace of 0.7 per cent, compared with an expansion of 2 per cent in the previous three months.
As growth in the US economy slows, inflation has stuck below the Fed target of 2 per cent. Narayana Kocherlakota, who was president of the Minneapolis Fed until December, is calling for a “hard U-turn” in monetary policy. He thinks the central bank is underestimating the risks of sinking inflation expectations and says the credibility of its target is under threat.
The dovish former policymaker says the world faces a “global demand shortfall” and tighter US monetary policy could exacerbate uncertainties outside the country.
“It is hard to know how much feedback from international weakness there will be to the US economy; as the Fed tightens, that tightens economic conditions throughout the world,” Mr Kocherlakota says.
That steep drop in inflation expectations is being watched by Fed policymakers, as is the effect of market volatility on corporate borrowing costs. Inflation has been lower than the Fed target for more than three years, and the pressures on the oil price and surge in the dollar could force the bank to again push back its forecasts for when price growth returns to its target.
Despite such challenges, some economists argue that those complaining about the Fed’s quarter-point increase have lost perspective, not least given how supportive policy remains after that increase.
Charles Plosser, who was president of the Philadelphia Fed until last year, dismisses arguments that the central bank has been partly responsible for the volatility in global markets, adding that it is much too soon to judge whether the December increase was merited.
The Fed needed to “disabuse” the markets of the notion that it would rush to investors’ aid whenever prices slid, he argues. As for the US economy, Mr Plosser says: “The data has come in mixed. There has been some volatility but if you look beyond the energy sector and beyond the financial markets, the economy is not doing too badly”.
The main reason for optimism is the labour market. In the face of chatter among analysts about the risk of a US recession, job growth has exceeded expectations, with payrolls growing by nearly 300,000 in December.
Ms Yellen placed the employment trend — which has seen 13.2m jobs added over 67 straight months — at the heart of her case for raising rates, arguing that it would be unwise to wait too long before responding to the erosion of spare capacity.
The central bank is not rushing to judgment about global developments. The Fed on Wednesday noted the jitters surrounding China, as well as the low rate of inflation and slower US growth in the fourth quarter. Its message was that even if there are risks ahead, it was too soon to decide the implications for future rate decisions. To many analysts, that circumspect approach is sensible.
An overly downbeat statement this week would have triggered a greater panic in markets. If investors calm down, the damage to the US economy could turn out to be minimal, as it was after the last China-induced bout of turbulence in August.
Tim Duy, a professor at the University of Oregon and close Fed watcher, says that December’s rise was not of the magnitude to “make or break the economy” and that talk in markets of a policy mistake was unhelpful.
He says the important aim now was for the Fed to avoid sending signals that it was hell-bent on tightening policy further. That meant downplaying last month’s forecasts from policymakers suggesting that there will be four rate increases in 2016, a bullish outlook that traders now see as divorced from reality.
The Fed has insisted it will be guided by the data and has made no commitment to tighten. Ms Yellen will give further clues in February when she addresses Congress in testimony on Capitol Hill.
A few weeks after the Fed lifted rates in a flurry of optimism, the ground has shifted beneath the feet of Ms Yellen and her policy committee. Whether or not their gamble on higher rates ends up being vindicated will depend heavily on global developments, many of them well beyond America’s control.
With reporting by Robin Wigglesworth
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