The Fed is now entering the most difficult phase of monetary policy

Key Points
  • The U.S. Federal Reserve's task is complicated by unfolding fiscal and trade policies.
  • A weak labor supply and productivity are additional problems.
  • Those critical variables have a crucial impact on growth and inflation.
A hand holding U.S. dollar banknotes in China on January 25, 2018.
Zhang Peng | LightRocket | Getty Images

The successful transition from a crisis-management monetary policy to credit conditions compatible with steady economic growth and price stability requires exceptionally good short-term forecasting — and a fair amount of luck.

That tongue-in-cheek allusion to divine intervention is meant to underscore the difficulty of "normalizing" the monetary policy that was designed to deal, for six years, with nearly catastrophic systemic problems in the financial services industry and in the real economy.

America faced all that between December 2007, when the Federal Reserve began opening wide its discount facilities to rescue the faltering banking system, and the second half of 2013 when the banks' borrowing at the Fed — an exceptional circumstance compared with central banking practices in the rest of the world — went back to pre-crisis levels.

But even then, banks remained gun-shy about taking on the risks in their core business of consumer finance. They needed to rebuild their shattered capital structures by acquiring the risk-free U.S. Treasury securities, while non-banks took up the slack with a 6 percent growth in their consumer lending portfolios.

Did the Fed do the right thing?

Lost in transition?

Technically, however, the monetary policy had a relatively simple task during the long process of ensuing economic recovery.

With subdued wages and prices in an environment of a slow-growing demand, output and employment, the money supply had to be expanded through conventional and non-conventional policy instruments in order to stimulate bank lending to households, and to prop up business investments by lowering the cost of capital.

Judging by the Fed's current management of its own balance sheet, that still seems to be the main policy concern. Last month, the monetary base — known as "M0," the only aggregate the Fed directly controls — was still 2.9 percent above its year-earlier level, and its average amount during February was $30.3 billion above the previous month.

American monetary policy operates with an estimated average lag of about six quarters. In plain English, that means that a change in interest rates takes six quarters to be reflected in aggregate demand and price stability.

What are those numbers telling us about the way the Fed sees the economic activity and price dynamics? They reflect the Fed's official statements that there are no inflation-threatening capacity pressures in labor and product markets.

The Fed also seems to be reassured by the fact that its preferred inflation gauge — the core rate of the Personal Consumption Expenditures (PCE) index — remained stable in January for four consecutive months at 1.5 percent, substantially below the 2 percent target.

Bond traders appear to agree. The Treasury's yield curve has flattened considerably since the benchmark ten-year note peaked out at 2.92 percent in the middle of last month.

All that is a good example of the problem the monetary policy faces when trying to stabilize a growing economy on a steady and noninflationary growth path.

Indeed, the Fed's current policy stance implies that demand, output, employment and the general level of price inflation will be roughly where the Fed wants them to be until the middle of next year.

Why? Because American monetary policy operates with an estimated average lag of about six quarters. In plain English, that means that a change in interest rates takes six quarters to be reflected in aggregate demand and price stability.

Do we know where the economy is?

Let me make that clear: The policy settings that we see now are reflecting the Fed's forecasts that economic growth over the next year and a half will keep price inflation contained within the 0-2 percent target range.

The question is: What happens if that forecast is wrong, and price increases begin to accelerate in the months ahead? (You may recall that many people got excited last week when they saw that the PCE index marked a monthly increase of 0.4 percent in January, after being virtually stable in the previous three months.)

The answer is that bond prices would sink, and that the Fed would step up rate hikes until it sees that the economy is slowing down. But by the time the Fed sees signs of an activity downturn and subsiding inflation, the economy could be into an irretrievable tailspin as a result of a lagged recessionary impact of interest rate increases that went beyond the necessary policy restraint.

Booms and busts are caused by maintaining easy or restrictive credit conditions beyond the point where the economy needs them.

That is not a caricature. That is what has been observed at turning points of the business cycle. And that is what has led to one of the most eloquent conclusions about monetary policy: Booms and busts are caused by maintaining easy or restrictive credit conditions beyond the point where the economy needs them.

Determining where that point lies illustrates the enormous difficulty of calibrating the monetary policy on a mix of judgmental (visual navigation) and formal, model-based economic forecasting.

What should the Fed do, then?

Monetarist true believers would say this: Stop destabilizing the economy with activist policies because you don't know where the economy is at the time you make a policy change. And you know much less where the economy will be when those changes are fully reflected in demand and inflation six quarters hence. The best you can do is set the money supply growing at a steady rate — and keep it there.

That is a simple statement of the vintage, rule-based monetary policy that got Milton Friedman his Nobel Prize in economics in 1976. A version of such an operating procedure, based on the growth of monetary aggregates, was introduced by the Fed in October 1979 and abandoned as impractical and destabilizing in 1982, ostensibly due to problems caused by financial innovation.

Since then, the Fed has been back to its policy making based on what some model builders derisively call a "kitchen sink" of judgmental and structural model forecasting.

Investment thoughts

The Fed is currently maintaining its monetary base 2.9 percent above its year-earlier level because it apparently believes that the economy will continue to grow in the months ahead at a pace consistent with the objective of price stability, defined as the core PCE inflation rate of 2 percent or less.

Some observers may take that as a rather heroic assumption. Consumer prices are already growing at an annual rate of 2.1 percent, and import prices in the year to January soared 3.6 percent. Import tariffs will make that worse.

More generally, Washington's intent to move from free to reciprocal trade regimes is bound to lead to rising price tensions in an economy driven by hugely expansionary monetary and fiscal policies well above its potential and non inflationary growth.

U.S. bond prices will keep falling. Equities will resist better, partly because corporate profits will benefit from subdued wages and from the strengthening growth in Europe and East Asia.

Commentary by Michael Ivanovitch, an independent analyst focusing on world economy, geopolitics and investment strategy. He served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York, and taught economics at Columbia Business School.

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