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Fed has done all it can to fix US economy's non-structural issues, now it must hike rates

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If you accept the propositions (a) that the Fed's policy should be data-driven in accordance with its mandate and (b) that the monetary policy operates with long and variable lags, you should have no problem accepting the conclusion that a major adjustment of the Fed's credit stance is long overdue.

The most recent data on America's economic growth, labor market conditions and inflation developments make it very difficult to understand why the Fed keeps postponing the process of a gradual and orderly normalization of its bloated monetary base (M0) and its implausibly low federal funds rate - the only interest rate it directly controls.

To explain that, here is a quick review of the variables that should drive the Fed's policy.

The latest number for first-quarter GDP growth is more than double its initial estimate. It is showing an annualized quarter-on-quarter pace of 1.1 percent and a 2.1 percent increase from the year earlier.

Most people, me included, consider that this growth rate is too low. But the problem is that even that low growth rate of 2.1 percent exceeds America's potential and noninflationary growth rate (i.e., a growth rate given by productivity and the available labor and (physical) capital resources) of 1.6 percent for the fifth consecutive year.

Not by Fed alone

Should we blame the Fed for that? I can visualize a sea of hands stuck out in emphatic approval. But that would not only be grossly unfair to our money managers – it would also be dead wrong.

Why? Because the volume and the efficiency of labor and capital stocks are essentially structural problems that must be addressed by structural policies.

Sure, the Fed can help by supporting domestic demand with appropriate credit policies, but the labor force productivity (i.e., the quality of human capital) and investments in best-practice technologies depend on education, labor force retraining, investment incentives and trade policies in an economy widely open to unbridled international competition and predatory pricing.

The Fed, in my view, has done its part – and more – but the two other big players in economic policy (you know who they are, don't you?) have fallen far short of what's needed to go back to an average potential growth rate of 2.7 percent we had in the last two decades.

So, we can perhaps temporarily settle for this: That 2.1 percent actual growth rate is fine, given the structural problems we continue to face.

We should also acknowledge that - in the absence of fiscal and structural policies we need - the Fed takes most of the credit for solid income and job numbers that will strongly underpin our domestic demand in the months ahead.

The real disposable personal income over the last four quarters has been growing at an average annual rate of 3.4 percent, a modest acceleration from a 3 percent growth rate in the previous four-quarter period. These steady income gains have also raised the personal saving rate to 5.8 percent in the first quarter of this year. That is one of the highest readings in almost twenty years.

Last Friday's strong employment numbers are reflecting a sharp increase in the output of service sector industries. They account for nearly 90 percent of the economy and for most of the new job creation. The latest survey evidence shows that healthcare and social services, finance and insurance, retail and wholesale trade and professional and scientific services strongly raised activity levels in this critically important segment of domestic demand. Indices measuring general business conditions, new orders and employment growth stood at very high levels, signaling a steady expansion of demand and output.

The Fed should stop circling

In spite of that, the unemployment rate of 4.9 percent in June was exactly what it was at the beginning of the year, and only marginally below its level of a year ago. The various categories of labor market data also show that we may have reached structural barriers to further reductions of our unemployment rates.

For example, the average level of involuntary part-time workers in May and June had roughly stabilized, and the number of people marginally attached to the labor force (basically people no longer looking for a job) was unchanged from the year ago. The two million long-term unemployed (people without a job for 27 weeks or more), which represent 26 percent of the jobless total, were virtually stable over the second quarter.

Yes, it is unfortunate that 10 percent of our active civilian labor force is out of full-time employment (as opposed to the officially reported 4.9 percent), but there is not much that the Fed alone can do about that.

I, therefore, wonder whether the statements of Fed's officials that they wanted to see lower jobless numbers before their next rate hike were just a convenient pretext to justify their policy holding pattern. And if that was not the case, I wonder whether these officials are aware of the limits their policies are reaching in an economy systematically operating above its noninflationary potential for an unusually long period of time.

Either way, it seems like it is of no consequence to note that, in spite of double-digit declines of energy prices, the core rate of consumer price inflation now stands at 2.2 percent, and that the core PCE (personal consumption expenditures) price index has reached 1.6 percent. Taken together, these indices are telling us that the Fed's inflation target of 0-2 percent is being overshot.

We also have two-fold increases of unit labor costs over the last two years, and a further acceleration to 3 percent in the first quarter of this year. These rising labor costs will be easily passed on to consumers in a steadily growing economy as businesses move to protect their profit margins.

Investment thoughts

The current evidence on U.S. economic growth, labor market conditions and consumer price inflation strongly suggests that the next move toward interest rate adjustment is long overdue.

Building up on the present growth dynamics, an exceptionally easy credit stance will continue to prop up demand, output and price increases this year and next as a result of long lags in the impact of monetary policy. That is likely to create the typical problem in business cycle management when the stimulus continues to operate well past the point where the economy needs it. In a more familiar language, that is also called adding oil to fire.

In view of all this, it is puzzling to see the Fed's slowdown of liquidity withdrawals in the course of the second quarter. That slowdown brought the Fed's balance sheet last month within $10 billion of what it was at the end of last year. A curious case of "fine tuning" indeed.

I don't know whether that makes more plausible the latest timing call I heard last week that the next rate hike will be closer to Christmas than to September.

But whatever it is, you may wish to keep this in mind: The longer the Fed waits to normalize the term structure of interest rates in a gradual and orderly manner, the greater the danger of serious economic and financial instabilities once such policies become unavoidable.

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