D
oes the Federal Reserve even have history as a guide? The world’s most powerful central bank has said it wants to raise interest rates this year, after six years in which they stuck at zero.
We know why it wants to do this. Many fear that monetary policy since the 2008 Lehman crisis has distorted markets and the economy. These were measures for exceptional circumstances, and it naturally wants to return to normal.
But investors are desperate for rates to stay on the floor, and take any evidence that rate rises will be postponed as an excuse to buy stocks.
Three times in three months world stocks have sold off but rebounded on a cue from the Fed.
In October, a near-10 per cent correction ended when James Bullard of the St Louis Fed said the Fed’s “QE” bond purchases, designed to keep rates low, might be continued. In December, after a 5 per cent correction, the announcement by the Fed at its regular meeting that it would be “patient” in waiting for rates to rise triggered another rebound. And this week, after the new year had started with another sell-off, the publication of the minutes from that meeting, which appeared to rule out a rate rise as soon as April, again prompted a rebound.
The picture of a market still desperate for easy money, and jumpy about the prospect of any increase in rates, is deeply disquieting.
But the stock market should not be a prime concern for the Fed, which is mandated to control inflation and promote full employment. On that basis, inflation is very low, and falling, and the Fed has made clear that it wants to avert outright deflation – which theoretically deters consumers from buying, as goods can later be bought for less money.
Low inflation is in large part due to falling oil prices, which the Fed calls “transitory”. But there is more to this deflation scare than that. The bond market’s forecast for inflation in five years is also tumbling, while the eurozone – which lapsed into deflation according to official data this week – had seen gathering fears of deflation for many months.
Then there is unemployment. The latest data, for December, show the jobless rate down to 5.6 per cent, its lowest since before Lehman. After each of the three previous US recessions, the Fed raised rates by the time unemployment hit this level. But it is not as clear as that. Annual earnings growth – much watched – slumped to 1.7 per cent, showing an absence of inflationary pressure, (and a lack of any reason for Main Street to cheer). The proportion of Americans looking for work returned to an all-time low.
Problematic history
So data can be found to back almost any move on rates. That suggests looking to history. But even that is problematic. History can be used and abused; different precedents have different implications.
Take two excellent books recently published – Hall of Mirrors by Barry Eichengreen (reviewed in the Life & Arts section), and The Forgotten Depression by James Grant. The former covers the Great Depression that started in 1929; the latter covers the previous depression of 1921. One suggests rates should stay put, the other that they should rise.
Mr Eichengreen looks at the Great Depression and says that the main lessons were learnt.
Interest rates were cut, stimulus spending filled the gap, banks were recapitalised, and as a result the Lehman crisis led only to a Great Recession, rather than another depression.
He suggests that the Fed should avoid the mistake it made in 1937, when it raised rates prematurely and sparked a fresh slump. Until it is clear that labour force participation and earnings are rising, he says, rate rises would not be worth the risk.
The implications of the 1921 episode covered by Mr Grant are the exact opposite. This depression, he argues, “corrected itself”.
Following a brief postwar inflationary boom, prices were allowed to fall – almost exactly as far as they did at the outset of the Great Depression – as were wages. After a brutal dose of unemployment, growth resumed within 18 months. The Roaring Twenties ensued.
Deflation was the market mechanism that allowed the economy to find an ignition point. Meanwhile, when the next depression hit officials tried to ensure that wages did not fall – an intervention that forced up unemployment. On that reading, higher rates would bring good discipline and deflation is nothing to fear.
What is clear? Perhaps two things. First, central banking is difficult. And second, this is too uncertain for investors to take on new risks.
