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Fed talk of neutral monetary policy is a smokescreen, the US is ready to hike

Eleonora Martini | Getty Images

The headline rate of price inflation in the United States has been suppressed by double-digit declines of energy costs. As a result of that, a steady upward push of the core rate of inflation to 2.2 percent in May from 1.7 percent a year earlier is erroneously taken as a non-event.

People seem unaware of the fact that the Fed's medium-term price stability target is a core rate inflation of 2 percent. Based on the consumer price index (CPI), that target has been hit since November of last year. And we are almost there - i.e., at 1.6 percent - if you prefer, as the Fed apparently does, to look at the core personal expenditure price index (PEPI).

Either way, from the policy viewpoint, the signal should be clear: It is time to defend the credibility of the Fed's monetary management.

But that's not what we are hearing. To confuse the gallery, the Fed is now throwing in the concept of policy neutrality that, according to media reports of official statements, revolves around the zero real short-term interest rate.

A nice smokescreen

Here is how that particular idea of neutral monetary policy (i.e., a policy stance that is neither tight nor loose) looks like based on current numbers of inflation and the effective federal funds rate – the only interest rate the Fed directly controls.

Take the core CPI of 2.2 percent, or the core PEPI of 1.6 percent. And then take the last Friday's effective federal funds rate of 0.39 percent. That gives you real short-term interest rates of -1.81 percent or -1.21 percent, based on core CPI or core PEPI respectively.

These negative real short-term interest rates are falling in the range that signifies a hugely expansionary monetary policy.

Now, one can quibble about the proper definition of the neutral monetary policy. That concept is still debated in the academia. But the point here is that the U.S. monetary policy is far from being neutral.

It is, in fact, extraordinarily easy in view of inflation numbers and the evidence that the actual economic growth has been nearly an entire percentage point above the physical limits to growth (set by labor and physical capital resources) over the past two years.

And if that is not enough to fix the ideas of the Fed's actual policy stance, here is what the labor costs and labor productivity are telling us about the underlying inflation pressures in the U.S. economy.

The growth of unit labor costs has more than doubled over the last two years to an annual rate of 2.5 percent in 2015. Their growth accelerated to 3 percent in the first quarter of this year, as labor compensation shot up to 3.7 percent while productivity growth remained at 0.7 percent.

This is simple and clear: America's economic growth and inflation are results of Fed's efforts to strengthen the recovery against the headwinds of a restrictive fiscal policy and growing trade deficits.

But then the policy issues are needlessly confused by all sorts of conveniently pessimistic economic forecasts to "justify" the policy neutrality and guesses about the number of rate hikes in the months and even years to come.

Investors should pay no attention to that. These forecasts are dime a dozen.

Solid growth and inflation drivers

To evaluate the policy stance one should assess the actual state of variables that will be driving the economic growth and price stability over the short and medium term. These variables are jobs, incomes, credit costs and the strength of external demand.

Here are my thoughts on that.

I believe that we have reached a point where a significant further employment growth will be very difficult. Monthly variations of labor supply numbers are stuck in a very narrow range, and so are the numbers of involuntary part-time workers and people marginally attached to the labor force. It, therefore, seems that there is not much more that monetary policy can achieve through cyclical changes of the demand for labor. We have apparently reached structural obstacles that need to be addressed by structural labor market policies. And that may well mean that the current 4.7 percent jobless rate could be a structurally given "full employment unemployment rate."

Household finances don't look bad either. The rising employment and the increasing labor compensation have kept the inflation-adjusted disposable household income on a steady annual growth path of 3.4 percent in the year to the first quarter. People are also stashing away more money to finance their customary consumption patterns. The personal savings rate (personal saving as a percentage of personal disposable income) is currently reported at 5.7 percent - one of the highest levels in the last twenty years.

This shows that employment, household incomes and personal savings are as good as we can expect them to be. Together with low credit costs, these variables are directly driving three-quarters of the U.S. economy.

External demand is a problem; it will remain a significant drag on the GDP growth because the U.S. is a growing, open economy and a favorite export (dumping?) market for the rest of the world. But most of the problems here are caused by trade policies and growth differentials rather than a strong dollar, which is invoked as one of the reasons not to raise interest rates. At the moment, the dollar's trade-weighted exchange rate is 2.2 percent below its year-earlier level.

Speculations that political and security problems in Europe and in the Middle East would drive the dollar up – which would make rate hikes problematic - are based on tenuous assumptions. These problems have been there for some time, and they have not affected significantly the dollar's relative price over the last twelve months.

Investment thoughts

To keep the financial markets as stable as possible, I believe the Fed will refrain from interest rate increases during the election year. That is what usually happens, and it is perfectly understandable that the Fed would not want to get itself in the middle of what might be one of the nastiest election fights in recent memory.

The policy neutrality issue is a smokescreen to put off any interest rate increases until after the elections (in early November) and year-end holidays.

The fact that core inflation rates are already at or above the Fed's target will be ignored. Only an inflation flare-up could upset this scenario.

Given the huge inflation-dampening impact of America's sinking energy costs, a sudden surge of oil prices could easily reverse the quiescent inflation expectations we have at the moment.

Whether that will happen or not depends on what the Saudi deputy crown prince got from the White House last week on his wish list about Syria, Iran, Iraq and Yemen.

Keep an eye on the fallout of this visit because the Saudis are driving the OPEC output.

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