New Year's 'Ratesolution'

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Hei Ming Ernest Chu's picture

After more than a year of announcing plans to increase interest rates (and doing nothing), the Fed has finally taken action! Now that the new paradigm approaches, let’s analyse and evaluate the Fed’s monetary policy over the past 7 years.

Why the Fed did it

Firstly, US’s GDP and unemployment rate – the two indicators which the Fed cite most – are now better than they were at pre-crisis level.[1] Secondly, persistently low interest rates damage the long-term economy (discussed below). Yellen herself sounded only too anxious to increase interest rates earlier this month.[2]

An increase in rates of 0.25% has no significant tangible effect per se, especially since there is so much surplus liquidity in the economy; it is likely that adjusting the Fed funds rate alone would not have much of an impact on other interest rates in the market. Furthermore, the Fed had been signalling and preparing financial markets for the rate hike that, realistically, markets should have already priced some of the expectation into bond and equity prices. In fact, the Fed was counting on it.

The primary reason why the Fed had been hesitating was the fear of instigating a downward economic spiral. In principle, the Fed should be basing its judgement on long-term fundamentals, specifically those during the past three-quarters of the decade. Yet it appears that recent employment and economic data played just as large a role. Hence, it seems that (short-term) market sentiments, as much as anything else, determined the Fed’s decision. Fortunately, all the ingredients were available. Despite the appreciation of the USD and continued expansionary monetary policy in other regions such as the EU, China and Japan, US economic data had shown no clear sign of deterioration.

Did QE work?

It depends on how one defines “worked”. Injecting $2tn into the economic system is bound to have some positive effect. In theory, expansionary monetary policy should stimulate the consumption and investment components of GDP and indeed, as aforementioned, GDP levels have been sustained. But in doing so, QE may have set the economy up for another disaster.

Breaking down US’s GDP by its components paints a mixed picture. Whilst many choose to gauge the health of the US economy through looking at consumption, gauging long-term economic prospects entails analysing the investment component of GDP, rather than consumption. The reason is simple: investment adds value and generates production, whereas consumption does not.

Figure 1: Growth rate of US GDP components [3]

According to figure 1, while consumption growth has remained relatively stable, investment growth has been more volatile. Investment decreased between 2007 and 2009, but have been increasing faster than consumption since 2010. Keep in mind that the US government utilised expansionary fiscal policies as well, which would have had an impact on these GDP components; hence the positive signs cannot be attributed to QE alone.

Bubble trouble

However, when compared to the growth experienced in the financial market, gains in GDP are almost negligible in comparison, as figure 2 below shows.

Figure 2: Growth rate of major US stock indices and US GDP [4]

This brings out a key detriment of the QE mechanism. Although QE is akin to “printing money”, unfortunately the printed money was not distributed evenly – mainly participants in financial markets directly received the liquidity injected by the Fed, as the money was distributed through purchases of securities. There has been talk of a trickle-down effect, but in reality, no-one is sure how large these effects are. Judging by the discrepancy between financial market and GDP growth, possibly not very large.

It is probable that liquidity from QE mostly went back to fuelling equity and derivative markets. Simultaneously, there are incidences of investors seeking higher yield from riskier assets. The low interest rates have skewed financial investors’ risk perception: they are effectively seeking the same yield but at a higher risk. Combined with comparatively weaker economic fundamentals, it is reminiscent of yet another asset bubble.

High liquidity would not cause bubbles if liquidity is distributed evenly, as the situation is reduced to a “when everyone is richer nobody is” scenario. However, when distributed unevenly, the value of money becomes distorted – those who benefit from liquidity put their money into asset markets, pushing prices up, but the fundamental economic situation does not support the asset price increases (which is the definition of a bubble).

Moreover, banks’ reserves are flooded, with surplus liquidity and are doing nothing to stimulate the economy.[5] This is not surprising given the prevalence of macro-prudential policies in light of the recent financial crises. But in light of all the potential problems, idle money is perhaps the least of anyone’s worries.

Combining all the previous analysis, what is likely is that since the liquidity (I surmise) did not enter the real economy, there has been little inflation as the impact of liquidity on production and consumption in the real economy has been limited.

There is no looking back

If anything, the biggest impact of QE and low rates should be the wealth effect – increasing consumption through an increase in perceived wealth. This is inherently uncertain in nature, as it involves so-called “animal spirits”. It exclusively targets consumption, supposedly a spark which reignites the engine; and if the engine is broken, no spark can make it move. The QE is thus effectively a short-term quick fix for deep-rooted structural problems.

Hence, whatever benefits of the expansionary monetary policies should have been transpired after 7 years, and the damage is being done. Consider the immediate costs of not increasing rates: the signal which that would have sent would be negative, as it would suggest that the US economy remained in poor health. Furthermore, financial markets would continue to be submerged in bouts of uncertainty, continuing to guess the Fed’s next move.

 

[1] Economic Research, Federal Reserve of St. Louis (FRED)

[3] U.S. Bureau of Economic Analysis (BEA); author’s calculations

[4] FRED; BEA; author’s calculations