Financial and Monetary Systems

The Fed, interest rates, and the US economy

The United States Federal Reserve Board building is shown behind security barriers in Washington October 28, 2014. The U.S. Federal Reserve this week will likely reinforce its stated willingness to wait a long while before hiking interest rates after a volatile month in financial markets that saw some measure of inflation expectations drop worryingly low.     REUTERS/Gary Cameron    (UNITED STATES - Tags: BUSINESS POLITICS) - RTR4BX4X

It seems like every time the Fed places a rate hike “on the table,” the economic data quickly weaken. Image: REUTERS/Gary Cameron

Pedro Nicolaci da Costa
Editorial Fellow, Peterson Institute for International Economics
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This article was first published by the Peterson Institute for International Economics.

The Federal Reserve once again finds itself in the awkward position of backing away from an interest rate increase this month after several weeks of hints to the contrary from a string of central bank officials.

It seems like every time the Fed places a rate hike “on the table,” the economic data quickly weaken, making the chances of an actual rise ever rockier. So it appears set to go with September.

It didn't have to be this way. While the US unemployment rate has dipped below 5 percent to a level central bank policymakers view as broadly consistent with full employment, there is still plenty of evidence the economy is operating well short of its potential—and therefore not ready for tighter monetary policy.

"Almost since the turn of the year core inflation has been stuck at 1½ percent with really no clear signs that it's moving up yet," said David J. Stockton, senior fellow at PIIE and former Fed chief economist. Core inflation excludes energy and food costs viewed as more volatile and less predictive of the future. "I do think the case for patience and waiting just a bit longer is to make sure that in fact the Fed's expected return to 2 percent looks like it's actually under way."

Indeed, the Fed has undershot its 2 percent inflation target for much of the economic recovery. This reflects anemic wage gains and a lack of business pricing power, both signs of subpar economic activity. The growth figures themselves have been disappointing. Gross domestic product expanded just 1 percent in the first half of the year, and hopes for a big rebound were moderated by weak retail sales figures for August(link is external).

Given this shaky outlook, PIIE President Adam Posen was surprised to see Fed officials largely dismiss new potential avenues for future monetary easing when he attended the central bank's Jackson Hole conference in late August.

These included many of the policy options laid out in the new Geneva Report(link is external) entitled What Else Can Central Banks Do? authored by Laurence Ball, professor at Johns Hopkins University, Joseph Gagnon and Patrick Honohan, both PIIE senior fellows, and Signe Krogstrup, adviser at the International Monetary Fund. The key tools in focus are negative interest rates, increased asset purchases, and a higher inflation target.

Given the fairly tepid US economic backdrop, and a number of risks still looming overseas, there is really no need for the Fed to be playing a destructive game of will-they-or-won't-they with financial markets and the public. And really no necessity for it to preemptively jettison potentially useful tools in its policy arsenal.

Still, Jason Cummins, chief US economist and head of research at Brevan Howard, argued against central bankers getting too fancy or complex in their approaches to monetary policy during remarks at PIIE’s Geneva Report launch. Instead, the Fed should focus on truly making sure the economy is on a solid path before it ponders further rate increases, instead of constantly fidgeting with its toolkit and communications signals.

"I like simple," Cummins said. "What you need to do is stop explaining to the public that when the economy succeeds you're going to punish it."

Copyright for this work is held by the Peterson Institute for International Economics.

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Related topics:
Financial and Monetary SystemsEconomic Growth
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