Financial and Monetary Systems

Why the Fed should postpone rate hikes

Anders Borg
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Financial and Monetary Systems

As key central bank policy-makers meet this week in Jackson Hole, one of the most important topics of discussion will almost certainly be the recent global market turmoil. There are many reasons behind the sudden and abrupt moves in the market, but one contributing factor is the expectation that the US Federal Reserve will start to raise interest rates – some even think a hike could come as early as September.

The arguments for a rate hike are valid. The US economy is gaining some traction. The IMF is forecasting growth of about 3% in 2015 and 2016, and an inflation rate of 0,1% this year and 1,5% 2016. When an economy is normalizing, it is reasonable to gradually reduce expansionary measures, such as those that were put in place during the Great Recession. And as many have pointed out, the Fed has clearly communicated that it will move towards less expansionary policies, and its credibility would be damaged if it didn’t follow through with a rate increase.

But I think there are strong reasons for the Fed to postpone rate hikes and to keep monetary policy expansionary over the coming quarters.

A less-than-impressive recovery?

The US recovery is still weak. From a historical perspective, a growth rate of 3% during a recovery phase is far from impressive. If you look at other recoveries from the past few decades, growth rates often hit 4% or even 5% when increased capacity utilization pushed productivity and investments upwards. Over the past three decades, the US has been able to grow by around 2,5% without pushing cost pressure in the labour market. Some put these slow growth rates down to demographic factors, which have reduced the labour force, as well as productivity levels, which have been low.

However, I would actually argue that potential output is perhaps underestimated, and that the economy’s inflation propensity is exaggerated. I say this for a number of reasons.

The US labour market is well functioning. Unemployment is down to 5% without evident signs of overheating. The employment cost index suggests that wage increases so far have been surprisingly low. One reason for this is that labour market flexibility has increased during the recovery. Of the jobs that have been created over the past few years, many of them are self-employment, short-term contracts or part-time. Full-time jobs with comprehensive social security contracts are now a much rarer thing. There is an ongoing Uberization of the US labour market. This means that the balance in the wage setting process has shifted. It will take longer for demand to feed through to wages and inflation than in the past.

There is also an ongoing technological shift in the economy stemming from digitization and globalization. Estimates from Citi Group indicate that almost half of jobs are going to be disrupted in the coming decades by digitization. Jobs that require lower skills and less training are particularly vulnerable, but it’s also clear that administrative tasks, accounting, logistics, banking, service jobs and many other sectors are likely to be affected. This means that companies will be able to reduce their headcount and production costs while improving customer service. Once again, this will create a shift of balance when it comes to wages.

To my mind, central bankers are underestimating the structural shift that is now taking place. In the more tech-oriented economies, like the USA, the UK and the Nordic countries, there is a risk that traditional macro-economic models will overestimate the cost pressure.

Emerging markets: feeling the pinch

The financial turmoil has hit emerging market countries particularly hard, and even in China, growth has slowed. This could have a substantial impact on the global economy, with lower commodity prices an obvious implication. The Chinese government needs to take charge of the situation. A more expansionary monetary policy, and a weaker exchange rate as a consequence, is a natural step. The debt levels of state-owned companies and local government should be dealt with resolutely. Given the strength of the central government’s balance sheets, it would make sense for them to issue more bonds and take over and restructure bad assets. This must be underpinned by structural reforms. It’s important to support demand and deal with bad debt, but it is absolutely crucial to front-load structural reforms and further open the economy.

Other emerging markets have also been feeling the pressure. The triple whammy of lower commodity prices, the Petrobras corruption investigation and a growing current account imbalance has pushed Brazil into recession. Growth rates in the rest of South America are now closer to 2% – well below the 4% we’ve seen over the past decade. The escalating conflict between Russia and Ukraine adds to the worries: if Russia continues to push the conflict further, the risk of tighter sanctions will increase. At the same time, political problems in Turkey are increasing.

The myth of splendid isolation

Emerging markets need to tackle these problems themselves, but there are some clear implications for the Fed. Lower energy and commodity prices are likely to dampen inflationary pressure in the US. When inflation is low for a long period of time, inflation expectations tend to also be low. When prolonged low inflation rates are combined with falling commodity and energy prices, there is a risk that inflation expectations will stay low.

The global implications of lower emerging market currencies are also likely to be deflationary. The direct impact is that a stronger dollar reduces the cost of imported goods. The indirect effect, which might be substantial, is that the push to produce cost-competitive light manufacturing goods in emerging markets increases. That would reinforce the deflationary pressure from globalization for years to come.

If the Fed jumps the gun in raising rates, there is also a risk that we will see excessive volatility in the currency market. The unconventional monetary measures implemented by the Fed have been necessary. But as a result of them, liquidity has flooded the global markets and large portfolio flows have moved into emerging market countries. Many of their currencies are not as liquid as the dollar. When investment moves back into dollars, the currency fluctuations in these less liquid markets can become excessive. The Fed clearly has a responsibility to seriously consider how its policy decisions affect the global financial system. Excessive currency volatility is not in the US interest, not the least because a large emerging market depreciation would amplify the effects of globalization on US jobs, wages and inflation, particularly as weaker foreign currencies make outsourcing a more economically viable solution.

Changing realities

Another reason for the Fed to reconsider an interest rate hike? The legitimacy of the Bretton Woods institutions depends on a well-functioning global financial system. IMF and World Bank reform processes have been criticised as too slow – the world economy’s centre of gravity is moving to Asia, Latin America and Africa, but international financial institutions still seem to mirror the reality of the 1950s. If the Fed is seen as unleashing a major crisis in emerging market countries, this will almost certainly do long-term damage to the global financial system.

To me, the situation is clear: the Fed should postpone rate hikes. Lower commodity prices, reduced inflationary pressures, changes to the labour market and further disruptive technological shifts are convincing enough arguments. When you add to that the risk of excessive volatility in the global financial system, it tips the balance even further.

There is plenty of time for the Fed to signal that its policy stance has shifted, and the Economic Policy Symposium in Jackson Hole is an excellent opportunity to start that communication. If facts have changed, policy implications must also change. The greatest loss of face always comes when policy-makers try to ignore changing realities.

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Author: Anders Borg is a Swedish economist and politician who served as Minister for Finance in the Swedish Government. He is the Chair of the World Economic Forum’s Global Financial System Initiative

Image: A U.S. flag hangs above an entrance to the New York Stock Exchange August 26, 2015. REUTERS/Lucas Jackson

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