Western central banks face extraordinary challenges in unwinding their 10-year experiment with unconventional monetary policy that has left them with trillions of dollars of financial assets on their balance sheets and real policy rates still near zero. The Fed, as the first mover, will bear the brunt of these challenges for many reasons. First, Americans are led to believe that low interest rates are good for whatever ails the economy. This myth persists despite ample historical evidence that low interest rates in fact are destabilising once they no longer serve to stimulate domestic demand. That perverseness clearly has been the case over the past few years; according to several studies, the effectiveness of QE has waned, while debt levels at home and abroad have continued to soar. Recall that the Federal Reserve’s foremost mandate is to mitigate systemic risk – a point that Chairman Powell has reiterated of late. Ultra-low real interest rates undermine this goal.
Second, the Fed’s policy of negative short-term interest rates clearly favoured banks and debtors at the expense of savers. The unfashionable phrase for these circumstances is ‘financial repression’. At full employment, financial repression of saving, which is the only sustainable source of funding for investment, is detrimental to long term growth. Indeed, the most common cause of recessions and financial crises is excessive consumption (either public or private) at full employment; the inevitable overheating and debt accumulation prove to be the Achilles Heel of expansions. In that context, the huge tax cuts enacted in early 2018 were a giant step in the wrong direction.
Most members of the FOMC seem to recognise this dilemma with two subtle changes in their latest outlook at the December FOMC meeting. First, the median forecast for inflation was lowered to match the Fed’s target rate of 2%, implying they did not anticipate the need for overshooting on the policy rate. Second the median long-term growth rate, which is tantamount to their estimate of potential growth, was raised to 1.9%, or closer in line with projected real GDP growth. And third, the central tendency for the fed funds rate in the long term declined to 2.75%, or little different from the current level of 2.5%.