The Great monetary Debate

Media seems ever infatuated with the Federal Reserve (Fed), or rather its policy-making arm, the Federal Reserve Open Market Committee (FOMC). This intense attention stands to reason. Monetary policy at all times holds great power in financial markets and in the economy generally. Today matters call for special interest, since so many now hold such disparate opinions on policy directions. Here is guide to this debate and where probabilities lie.

The Fed’s Stated Objective

According to Fed Chair Janet Yellen, policy aims to raise interest rates gradually in coming months and quarters to what she and others have termed more “normal” levels. The Fed, she insists, has no desire to restrain the economy. Rather, it wants to unwind the emergency measures it took during the financial crisis and great recession.

Then, first to ease the threat of severe financial dislocation and afterwards to help revive the economy, the Fed brought short-term interest rates down to near zero and, in three programs it referred to as “quantitative easing,” it injected trillions into markets. The Fed held to this policy for years into the cyclical recovery that began in 2009. It only began to change in 2014 by neutralizing its quantitative easing program. Only late last year it started the process of lifting short-term interest rates up from near zero.

Ambiguities still surround how far the Fed intends to push up rates, what it means by “normal.” A reasonable assumption would look to a level where neither borrowers nor lenders will gain from the effects of inflation. That would take the Fed’s benchmark federal funds rate up gradually over time from about 0.50 percent (50 basis points) presently to somewhere near 1.5-2.0 percent. The Fed believes that if done cautiously, it can return to normal without either shocking financial markets or derailing the economic recovery.

Wall Street’s Concern

Many in the financial community worry that the Fed’s objectives, even if only modest, are dangerous. They contend that the strength in equities and the relative stability of bond markets have come to depend on very low interest rates and an otherwise active flow of liquidity into financial markets. They fret that even the gradual steps contemplated by the Fed will cause a major market correction. Worse, they argue that economic growth, already disappointing by historic standards, will suffer as a result of the financial retreat and that the economic weakness will then exacerbate the market correction into a great bear movement.

Though it would be foolish to dismiss such concerns out of hand, the evidence to date suggests that Wall Street may well have exaggerated market and economic vulnerabilities. After all, the Fed made its first rate move late last year, pushing up the target on federal funds from 25 to 50 basis points, and stocks, after a brief correction (more from concerns over Chinese growth prospects than interest rates) have since reached new highs. At the same time, bond markets have remained stable, and some classes of bonds have actually rallied. Perhaps a still more compelling argument against Wall Street’s fears emerges from the experience in mid 2013 when then Fed Chair Ben Bernenke first announced his intention to taper quantitative easy policies to neutral. In what became known as the “taper tantrum,” markets, fearing the loss of liquidity, plunged for weeks. Yet, they then recovered and continued to rise through 2014 even as the new Fed Chair Janet Yellen fully executed the her predecessor’s policy.

Concerns on the Opposite Side of the Ledger

As a counterpoint to Wall Street’s fears, many in policy and especially academic circles worry that the Fed has waited too long to normalize policy. With varying degrees of intensity they argue that the FOMC should have raised rates gradually over the period since Ben Bernanke announced the gradual neutralization of quantitative easing. The intervening period of near zero interest rates and excessive flows of liquidity, they claim, have distorted economic decisions, channeling monies into financial markets, for instance, instead of investments in real capital equipment or new businesses. They conclude from this that perhaps the recovery would have proceeded more robustly if policy makers had acted sooner and more decisively. Further, they fret that having squandered this opportunity the Fed now has no policy options available should this already weak recovery weaken further. To such concerns, the Fed has mentioned negative interest rates, but the response is no more convincing than when its Euro-zone equivalent, the European Central Bank (ECB), uses it.

Pulling the Threads Together

For all this debate and commentary, the Fed’s planned course seems the only practical one. Even if Wall Street’s concerns are valid, Fed action could hardly go on indefinitely supporting what is after all an artificial situation. Longer-term needs demand that policy extract itself from such circumstances even if it causes some market disruption. Meanwhile, those who say that the Fed has squandered its opportunity and contend that it is now too late, offer little direction for the future. Even if the Fed made the error they claim, its only remedy now is the plan it has.

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