December 16 2015 may go down as the date of one of the most monumental policy errors in history. The financial markets were nervously anticipating that the US Federal Reserve would raise the interest rate for the first time in nearly a decade — but few grasped the inadequacy of the data driving the decision.
The Fed had never before initiated a tightening cycle when the manufacturing sector was shrinking. Moreover, US corporate borrowers had begun reducing their debts, according to Morgan Stanley; in previous cycles, the Fed had tightened to cool credit cycles.
Of course, the Fed is not obliged to pursue any economic objectives beyond its two formal mandates of stable prices and maximum employment. In late 2012, when a third round of quantitative easing was launched, the unemployment rate was 7.8 per cent. It must have seemed a safe bet to undertake a commitment to stop easing when it fell to 6.5 per cent. Safe, that is, until the target was achieved sooner than the markets were willing to give up their stimulus.
It was no coincidence that in the first half of 2014 the Fed unveiled a tracking index to better capture the health of the jobs market. The labour market conditions index is derived from indicators including obscure metrics such as the micro-gauge favoured by Janet Yellen, Fed chair: the percentage of workers who voluntarily quit in a given month.
That August, with unemployment at just over 6 per cent, Ms Yellen addressed the central bankers’ symposium at Jackson Hole, Wyoming. She explained that, though the labour market had improved in the past year, the index suggested “the decline in the unemployment rate over this period somewhat overstates the improvement in overall labour market conditions”. In other words, give the stimulus more time.
With hindsight, few dispute that the Fed missed an opportunity to raise rates in 2014. No doubt, tightening policy at that stage would have created its own messy side-effects. That said, the benefits would have been significant.
First, for example, commodity prices might not have risen so high or so fast without the cheap money flowing from the US to emerging markets. Property prices worldwide might not be as frothy had investors not sought refuge in the sector from what they rightly recognised as risky valuations in equity and bond markets. And “fragile” would not now be the word for financial markets and economies worldwide. This fragility was laid bare in August after a minuscule currency devaluation by Beijing exposed systemic risk simmering just beneath the surface of intricately interconnected global markets.
History has shown time and again that labour market data are the most lagging and least predictive indicators. In the current instance, the data from the December jobs report are also misleading, given the lack of income being generated to propel consumption. A scant 3 per cent of jobs created in December went to those ages 25 to 55, with the balance going to cohorts that tend to work part-time for less pay.
For a more forward-looking indicator, Jonathan Basile of AIG tracks the University of Michigan’s survey of households’ unemployment expectations. The latest data show 29 per cent expect a higher rate in a year’s time — the worst outlook since September 2014.
The bond market, meanwhile, sees no shades of grey in the data; it is shifting rapidly from pricing in one rate hike this year towards pricing in the possibility of the next move being a rate cut, all but ridiculing the Fed’s insistence that four rate hikes would come to pass in 2016.
Tellingly, Fed officials are softening their tone on the number of times the rate might rise this year. “Don’t fight the Fed” — the idea that markets ultimately benefit from the Fed’s decisions — has become a cliché. The truth is the Fed has never dared fight the markets.
Danielle DiMartino Booth is president of Money Strong, an economic consultancy, and a former adviser to the Dallas Fed