Brocker.Org: There’s a major miscalculation behind the Fed’s interest rate hikes



Federal Reserve officials are committed to being “data-dependent”
in assessing what to do with US interest rates, but it’s not
always clear what data they’re watching.

The central bank’s mandate is low, stable inflation and maximum
employment, and Fed officials monitor a range of indicators to
assess progress on those two goals.

But the Fed may be keen to hike rates for another reason:
reigning in what it sees as excessively high prices in stocks and
other financial markets.

If that’s its intention, it goes against what Fed Chair Janet
Yellen and other key members of the rate-setting Federal Open
Market Committee have said they would do.

In their recent push to gradually raise interest rates from
rock-bottom lows seen during and after the Great Recession,
policymakers have pointed to a historically low 4.4% unemployment
rate and soft but steady economic growth of about 2%.

But inflation, arguably the indicator Fed officials control most
directly, has
consistently failed to reach to the central bank’s 2% target
reflecting stagnant wages and suggesting the labor market is not
as hot as the headline figures suggest.

So what could justify the Fed’s apparent gusto to keep tightening
monetary policy even in the face of deep economic policy
uncertainty in Washington? Until the recent global sell-off, the
main, unspoken reason for pushing interest rates higher was to
tame runaway stock and credit markets, which have broken all
sorts of records under the Fed’s zero-rate policy, frightening
some on the policy committee.

Neel Kashkari, the Minneapolis Fed president who is seemingly the
last true remaining dove at the central bank, however, makes a
solid case in an essay this week as to
why this is a terrible idea
. Here are his bullet points on
the Fed’s limitations from the essay:

1. It is really hard to spot bubbles with any confidence before
they burst.

2. The Fed has limited policy tools to stop a bubble from
growing, even if we thought we spotted one.

3. The costs of making policy mistakes can be very high, so we
must proceed with caution.

4. What we can and must do is ensure that the financial system is
strong enough to withstand the inevitable bursting of a bubble.

5. Monetary policy should be used only as a last resort to
address asset prices, because the costs to the economy of such a
policy response are potentially so large.

The funny thing is, caution about using monetary policy to fight
bubbles was supposed to be the dominant view at the Fed. It has
also been Yellen’s perspective.

Here’s Yellen during a keynote 2014 speech on the subject:

“Monetary policy faces significant limitations as a tool to
promote financial stability. Its effects on financial
vulnerabilities, such as excessive leverage and maturity
transformation, are not well understood and are less direct than
a regulatory or supervisory approach; in addition, efforts to
promote financial stability through adjustments in interest rates
would increase the volatility of inflation and employment. As a
result, I believe a macroprudential approach to supervision and
regulation needs to play the primary role.”

That last part means using regulatory tools outside monetary
policy to make sure banks are not overly indebted, and raise
enough equity capital to maintain an ample cushion against
potential downturns in the markets. It also means keeping an eye
on specific markets and using more targeted tools to tamp down
excess borrowing or risk.

Like Kashkari, Yellen sees rates as a last resort to fight
bubbles: “I am also mindful of the potential for low interest
rates to heighten the incentives of financial market participants
to reach for yield and take on risk, and of the limits of
macroprudential measures to address these and other financial
stability concerns. Accordingly, there may be times when an
adjustment in monetary policy may be appropriate to ameliorate
emerging risks to financial stability.”

But here’s the catch. If the Fed wants to be truly transparent in
its communications, and if it is raising interest rates because
it’s worried about rising asset prices, whether in stocks or
other sectors like commercial real estate, it should come out and
say so instead of dropping thinly veiled hints.

Otherwise the credibility of its commitment to be data-dependent
is brought into question and officials open themselves to the
accusation of paying too much attention to short-run moves in
stock prices.

Yellen seems to know this, acknowledging in the same 2014 speech:
“Because transparency enhances the effectiveness of monetary
policy, it is crucial that policymakers communicate their views
clearly on the risks to financial stability and how such risks
influence the appropriate monetary policy stance.”