The Federal Reserve Pulls a Lucy By David Malpass

Posted By on September 18th, 2015

http://www.wsj.com/articles/the-federal-reserve-pulls-a-lucy-1442531250

Mr. Malpass is president of Encima Global LLC. He served as deputy assistant Treasury secretary in the Reagan administration and deputy assistant secretary of state in the George H.W. Bush administration.

So the economy isn’t ready to withstand a quarter-point rate hike even after seven years of stimulus?

Like Lucy in the classic “Peanuts” comic strip, the Federal Reserve Thursday invited a running kick of the football—the first interest-rate hike in nine years—only to pull back at the last minute. The Fed cited recent “global economic and financial developments,” i.e., China’s stock-market woes, which “may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”

Financial circles in New York and Washington are celebrating, but the latest delay in tapering off the Fed’s near-zero interest rate policy risks plopping the economy, like the hapless Charlie Brown, flat on its derrière. While Wall Street applauds, uncertainty about future rate increases will likely keep business investment weak.

The economy is stuck in a zero-rate trap in which businesses don’t want to invest when they don’t know the impact of a rate hike, while the Fed thinks a rate hike would shake financial markets and hurt investment. Underinvestment leaves high cash balances at big corporations, but it is idle liquidity and doesn’t add to productivity.

Opinion Journal Video

The Liscio Report Chief Market Strategist Danielle DiMartino Booth on how the central bank has distorted prices and inflated asset bubbles. Photo credit: Getty Images.

By keeping rates artificially low, the Fed and other regulators are choosing winners and losers in credit markets rather than allowing credit allocation based on market prices. Near-zero rates channel cheap credit to sophisticated borrowers who often don’t need more funding. But the low rates hurt small borrowers and lenders. New business formation has been notably weak, and job gains at new businesses, one of the keys to innovation and productivity growth, have been among the weakest on record.

Borrowing conditions are easy for the top 1%, but the economy has many more lenders than borrowers—more bond buyers than bond issuers, more bank depositors than bank loans—so the net result is contractionary.

When the Fed tapered its bond purchases in 2014, its critics called it a tightening. Yet real GDP growth surged above 4% in the second and third quarters of 2014. Without that surge when the Fed was promising lenders a path to higher rates, real growth over the last three years was only 1.6%, a dispiriting performance that had previously only occurred during recessions.

The Fed’s communications spin on Thursday’s decision was glum. As already mentioned, the central bank warned of turmoil abroad and thinks the economy, while improving, still isn’t ready to withstand a quarter-point rate increase even after seven years of supposed stimulus.

The Fed’s new economic forecasts highlight its insecurity over markets, policy tools and its own effectiveness. It lowered its GDP forecasts for 2016-17 and provided a dismal 2% forecast for real growth in 2018 and beyond. It also lowered its interest-rate expectations for 2016-18, basically admitting that the tools aren’t working as expected. Still, there is no intention of changing course.

Persistent near-zero interest rates punish savers and hurt income growth for average U.S. households. Meanwhile, income inequality worsens as credit flows up the pyramid from middle-class savers earning paltry returns to the upper crust leveraging itself with cheap credit and stock gains.

New census data this week showed that real median household incomes are still falling, down 1.5% in 2014 from 2013. It’s a terrible setback for the middle class this far into a recovery, and the Fed should be urgently rethinking its policy.

The theory of zero rates and giant Fed bondholdings works for the government, big bond issuers and the upper crust, but it hurts lenders, savers and the broader economy. Japan has followed the same program since its bubble economy burst in the early 1990s, and it has experienced the same poor results. The Bank of Japan has maintained near-zero rates since the ’90s and bought bonds equal to 70% of its GDP—more than double the Fed’s appetite—yet growth and inflation haven’t budged and Standard & Poor’s just downgraded the ratings on its massive national debt.

A year ago the International Monetary Fund projected world GDP at $82 trillion in 2015, but it will likely end up at only $72 trillion, a $10 trillion shrinkage. There’s lots of blame to go around, but the Fed’s seven-year zero-rate trap is a big part of the problem.

The Fed’s decision to do nothing new was in part a response to the warnings of calamity from Wall Street and in part a desire to not be blamed should the economy worsen. But it’s hard to see how a continuation of past policies will generate more loans or faster economic growth. Let’s hope the next time Fed officials tee up a rate increase, they don’t pull it away again and do further damage.

 

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