The next few years will test the ability of the Federal Reserve to jump a number of hurdles. With more and more political pressure of all kinds, it is difficult to see an outcome where the Fed comes through unscathed. And the way in which the Fed navigates these obstacles will determine its future.
Following the Great Recession, the Fed took controversial and unconventional steps to avoid the worst outcomes. But QE left many people—both on Main Street and in Washington, DC—wondering about the efficacy and fairness of the policy.
Interest rates are now stuck at near-zero levels. And the benefits of this are largely flowing to those with assets. As a result, the Fed has made itself a target. This has far-reaching consequences for the Fed… even beyond maintaining its independence.
The Fed has now become a source for future funding
The funding for the “FAST Act” of 2015 came, in part, from a Federal Reserve rainy-day account. This could impact how future tax cuts or spending are funded. One infrastructure bill has already been funded using a part of the Fed’s QE windfall. That money was supposed to be set aside to cushion against losses. This could become a problem for the Fed’s independence.
But perhaps more important, the funding of the Fast Act eroded the barrier between the power to print money and the power to spend money. That is a barrier that is critical to the proper execution of monetary policy… past, present, and future.
Granted, the raid on the Fed’s assets has been mild thus far. However, these two—the monetary and fiscal policies—were separated from one another for a reason. This precedent of crossing the line is disconcerting.
This is commonly referred to as “helicopter money.” This small step of using monetary policy to directly finance fiscal expenditures could evolve into a catalyst for larger spending packages.
The Fed is now faced with the potential of being used to directly finance government spending. Otherwise, it may find itself in the position of attempting to conduct monetary policy without the proper tools or capital cushion.
What is the most likely outcome for a government in need of easy money? Congress gets its helicopter money, and the Fed will be forced to balance between independence and partisanship. Even the current political reality makes it difficult for the Fed to maintain its bipartisan mandate.
So it will not be easy. Sustained growth will be elusive even with large fiscal packages.
What the Fed does affects the entire world
Demographics, high global debt loads, slowing innovation, China’s secular slowing, and other central banks’ actions are all headwinds. Slow growth makes monetary policy more difficult to execute. This leaves monetary policymakers with few tools to spur sustainable, long-term growth.
Also, the Fed will be fighting itself as it attempts to raise interest rates. Spurring growth will be a tricky task, especially as the Fed tightens policy.
If the United States were a “closed” economy (one with no outside economic influences), there is a good chance interest rates would be higher. This is fine as a thought experiment. But given the hyper-globalized reality, it is useless for policy design.
In reality, the United States is an ultra-open economy. And the dollar is the dominant currency in trade and finance. This means that even small differentials in monetary policy between the Fed and other central banks will have a large spillover effect.
Policymakers at the Fed must deal with the economic realities facing the United States. They must also handle the impact of their policies on other central banks.
This is part of the Fed’s dilemma. The US economy has proven to be far more resilient than other developed countries. The United States avoided a multi-dip recession after the Great Recession. That is something Europe cannot claim to have done. The Fed should receive some credit for it.
In a vacuum, the strides the US economy has made would cause the Fed to raise rates modestly. This resilience should be a blessing. In many ways, though, a stronger dollar and the resulting lack of monetary policy leeway diminish many of the advantages.
The Fed has little choice but to raise interest rates
The Fed will struggle. Given the possibility of fiscal spending and stimulus, the Fed’s problem now becomes more complex. In the near term, there is a significant tightening of financial conditions with US yields and the strong US dollar. This could slow US growth before it gets a chance to accelerate… justifying the elevated yields and value of the dollar.
The Fed has said it plans to raise rates. So the Fed has little choice but to move ahead with future hikes. But then, the Fed may have to accept a rise in inflation.
This is due to the fact that the natural rate of interest has fallen to a very low level. That rate is the theoretical federal funds rate that neither heats nor cools the economy. In theory, a higher inflation target implies a higher long-run federal funds rate. This is a way to avoid being trapped at a near-zero fed funds rate.
It is logical to allow a little extra inflation. But it may be a difficult pill for many to swallow. It just does not jive with the thinking of the past several decades. Allowing inflation to rise beyond the 2% target—and to do so intentionally—is anathema to the post-Volcker world.
But it should not be scorned. Why? A low inflation target is not useful in a low interest rate/low growth environment. The primary benefit of raising the inflation target is that eventually it should allow the Fed a higher fed funds rate.
Of course, this lets the Fed move farther away from zero than it otherwise could. And that gives it a first line of defense to combat future recessions and shocks… and ultimately, the potential for less reliance on unconventional tactics.
Changes to policy targets and style do not happen quickly. But the Fed should be willing to absorb much higher inflation. And they should not have to worry so much about the consequences.
Simply, if the Fed adopts a much higher inflation target, it is implicitly—or explicitly—announcing that interest rates will be raised down the road, but will be held lower to allow inflation pressure to building the near term.
This is critical to the entire global economy
This is a different monetary world. Many of the old rules still apply… prudence and patience chief among them. But it is very different from the past couple of decades.
And the Fed will not be the same. Political pressure will become more onerous, the economy more volatile, and inflation more unpredictable and of questionable sustainability. These will make for a more opaque operating climate.
How the Fed unfolds will be critical to how the US and the global economy navigate the emerging hurdles.