Home > Fiscal Policy, Global Crisis, Monetary Policy > Raise Fed Rates Now?

Raise Fed Rates Now?

A quick note on the US and the Fed. Pressure for rate rises never really stopped, but lately it has intensified. Today I read on the FT that James Bullard, Saint Louis Fed head, urges Janet Yellen to raise rates as soon as possible, to avoid “devastating asset bubbles”. Just a few months ago we learned that QE was dangerous because, once again through asset price inflation, it led to increasing inequality. Not to mention the inflationistas (thanks PK for the great name!) who since 2009 have been predicting Weimar-type inflation because of irresponsible Fed behaviour (a very similar pattern can be found in the EMU). Let’s play the game, for the sake of argument. After all, asset price inflation, and distortions in general are not unlikely in the current environment. So let’s assume that the Fed suddenly were convinced by its critics, and turned its policy stance to restrictive (hopefully this is just a thought experiment). I have two related questions to rate-raisers (the same two questions apply to QE opponents in the EMU):

  1. Do they think that private expenditure is healthy enough to grow and to sustain economic activity without the oxygen tent of monetary policy?
  2. If not, would they be willing to accept that monetary restriction is accompanied by a fiscal expansion?

I am afraid we all know the answer, at least to the second of these questions. Just yesterday, on Italian daily Il Corriere della Sera, Alberto Alesina and Francesco Giavazzi called for public expenditure cuts, invoking the confidence fairy and expansionary austerity (yes, you have read well. Check for yourself if you understand Italian. And check the date, it is 2015, not 2007) What Fed (and ECB) bashers tend to forget, in conclusion, is that central bankers are at the center of the stage, reluctantly, because they have to fill the void left, for different reasons, by fiscal policy.  Look at the fiscal stance for the US: 2015_03_Fiscal_Impulse_1 Fiscal impulse, the discretionary stance of the US government, was positive only in 2008-2009, and has been restrictive since then. In other words, while the US were experiencing the worse crisis since the 1930s, while recovery was sluggish and jobless, the US government was pushing the brake. We all know why: political blockage and systematic boycott, by one side of Congress, of each and every one of the measures proposed by the administration (that was a bit too timid, if I may say so). Whatever the reasons, the fact remains that fiscal policy was of very limited help during the crisis. What do Fed bashers have to say about this? What would have happened if, faced with procyclical fiscal policy, the Fed had not stepped in with QE? I am afraid their answer would once again turn around confidence fairies… The EMU is pretty much in the same situation. The following figure shows the cumulative fiscal impulse since 2008 for a number of countries: 2015_03_Fiscal_Impulse_2   The figure speaks for itself. With the exception of Japan (thanks Abenomics!) governments overall acted as brakes for the economy (Alesina and Giavazzi should look at the data for Italy, by the way). Central banks had to act in the thunderous silence of fiscal policy. So I repeat my question once again: who would be willing to exchange a normalization of monetary policy with a radical change in the fiscal stance? To conclude, yes, monetary policy has been very proactive (even Mario Draghi’s ECB); yes, this led us in unchartered lands, and we do not fully grasp what will be the long term effects of QEs and unconventional monetary policies; yes, some distortions are potentially dangerous.  But central bankers had no choice. We are in a liquidity trap, and the main tool to be used should be fiscal policy. Monetary policy could and should be normalized, if only fiscal policy would finally take the witness, and the burden to lift the economy out of its woes; if fiscal policy finally tackled the increasing inequality that is choking the economy. If fiscal policy did its job, in other words.

I don’t know why, but I have the feeling that Janet Yellen and Mario Draghi would not completely disagree.

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  1. Francois
    March 24, 2015 at 11:24 am

    ‘To conclude, yes, monetary policy has been very proactive (even Mario Draghi’s ECB)’

    Suuuure … that is why we have deflation in the Euro area today.

    In the Euro Area, we had a monetary tightening in 2011 (two rate increases) and in 2012 (collateral rules). Result: explosion of interest rates in 2011-12 followed by collapse since then, recession in 2012-13, deflation now. This is the standard pattern of a massive and unwarranted monetary contraction. If the ECB was very proactive, then it was in the wrong direction most of the time.

  2. Patrick VB
    March 24, 2015 at 11:58 am

    Francesco,
    I understand your reasoning and share your concerns. However, if you look at the Commission’s latest (Winter 2015) forecast, it indicates that the Euro Area output gap is closing rapidly, from -3.1% in 2013 to -1.2% in 2016, under a relatively constant structural fiscal stance. So, officially, the EU must be thinking that all is well, GDP growth is picking up and is strong enough to close the output gap even as potential output growth rises from 0.4% in 2013 to 0.9% in 2016; so, in this framework, monetary policy should be normalizing even without any positive fiscal impulse…
    Now, the question is, of course, is the Commission’s latest GDP forecast credible, and are their output gap estimates (and particularly their NAWRU estimates) credible… But that’s quite another question.
    As for the ECB’s monetary policy, I think (and hope) that M. Draghi understands well enough that policy should very much be data dependent, and that rates must not rise before (core) inflation picks up sustainably throughout the Euro Area.

  3. Joe
    March 24, 2015 at 3:14 pm

    What matters for bubbles is where, how much and at what price is investment taking place, NOT things like demand growth in the economy or fiscal impulse etc. And the Fed and other CBs have no clue how to measure or control reckless behavior in markets or economy in general. Anyone who thinks that macro prudential measures will be successful are fooling themselves.

  4. merijnknibbe
    March 25, 2015 at 11:16 am

    The confidence fairy turns out to be a witch, according to recent ECB study. Government cuts lead to lower confidence https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1770.en.pdf

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