Why the Fed Should Postpone Rate Hikes
Op-ed in Project Syndicate
© Project Syndicate
As central bankers from around the world gather this week in Jackson Hole for the Federal Reserve's annual Economic Policy Symposium, one key topic of discussion will be the current global stock market turmoil. There are many reasons for these gyrations, but the expectation that the Fed will start to raise interest rates—perhaps as early as September—is clearly one of them.
The arguments for a rate hike are valid. The United States' economy is gaining traction. The International Monetary Fund (IMF) forecasts 3 percent annual growth in 2015 and 2016, accompanied by inflation rates of 0.1 percent and 1.5 percent, respectively. When an economy is normalizing, it is reasonable to reduce expansionary measures, such as those introduced after the crisis of 2008. Because the Fed has clearly communicated that it will move gradually toward less expansionary policies, its credibility would be damaged if it did not follow through.
There is a risk of greater currency market volatility if the Fed jumps the gun in raising rates.
But there are strong reasons for the Fed to postpone interest rate hikes and to keep monetary policy expansionary over the coming quarters. For starters, the US recovery remains weak. Historically, 3 percent growth during a recovery is far from impressive. In other recent recoveries, growth often hit 4 percent or even 5 percent when increased capacity utilization pushed up productivity and investment.
Over the past three decades, the United States has been able to grow at an average annual rate of around 2.5 percent. Some attribute relatively slow growth to demographic factors, which have reduced the labor force, as well as to weak productivity levels, which have been low.
But America's potential output may be underestimated, and its inflation propensity exaggerated. The US labor market works well. Unemployment is down to 5 percent, with no signs of overheating. The employment cost index suggests that wage increases so far have been surprisingly low.
One reason for this is that labor market flexibility increased during the recovery. Self-employment, short-term contracts, or part-time arrangements account for many of the jobs that have been created over the past few years. Full-time jobs with comprehensive benefits are now much rarer. This ongoing "Uberization" of the US labor market means that the balance in the wage-setting process has shifted. As a result, it will take longer for demand to feed through to wages and inflation than in the past.
Moreover, the economy is undergoing an ongoing technological shift stemming from digitization and globalization. Estimates from Citigroup indicate that almost half of all jobs will be disrupted in the coming decades. Jobs that require lower skills and less training are particularly vulnerable, but it is also clear that many other occupational categories—including administration, accounting, logistics, banking, and various service activities—are likely to be affected. Companies will be able to reduce their headcount and production costs while improving customer service, which, like Uberization, will affect the wage-setting process.
Central bankers, I believe, are underestimating the impact of this structural shift. In the more tech-oriented economies, like the United States, the United Kingdom, and the Nordic countries, there is a risk that traditional macroeconomic models will overestimate the cost pressure from labor.
Another reason why the Fed should postpone a rate hike is that financial turmoil in emerging markets, particularly China, could have a substantial impact on the global economy, with some clear implications for the US economy. In particular, lower energy and commodity prices are likely to dampen inflationary pressure. When inflation is low for a long period, inflation expectations also tend to be low. Add falling commodity and energy prices to the mix and there is a risk that inflation expectations will remain too low to sustain a balanced recovery.
The global implications of lower emerging-market currencies are also likely to be deflationary. The direct impact is that a stronger dollar reduces the cost of imported goods. The indirect effect, which might be substantial, is that cost-competitive light manufacturing in emerging markets increases. That would reinforce the deflationary pressure from globalization for years to come.
There is also a risk of greater currency market volatility if the Fed jumps the gun in raising rates. The Fed's unconventional monetary policies have been necessary for the United States. But, because they flooded global markets with liquidity, large portfolio flows have moved into emerging-market countries, whose currencies often are not as liquid as the dollar. When investment moves back into dollars, the currency fluctuations in these less liquid markets can become excessive.
The Fed clearly has a responsibility to consider how its policy decisions affect the global financial system. Excessive currency volatility is not in America's interest, not least because large exchange rate depreciations in emerging markets would amplify the effects of globalization on US jobs, wages, and inflation, particularly as weaker foreign currencies make outsourcing a more economically viable solution.
Another reason for the Fed to reconsider hiking rates is that the legitimacy of the Bretton Woods institutions depends on a well-functioning global financial system. The global economy's center of gravity is moving to Asia, Latin America, and Africa, but the IMF and the World Bank still seem to mirror the reality of the 1950s. If the Fed is seen as unleashing a major crisis in emerging markets, this will almost certainly do long-term damage to the global financial system.
The Fed should regard lower commodity prices, reduced inflationary pressures, changes in the labor market, and further disruptive technological shifts as sufficiently convincing arguments to postpone a rate hike. Including the risk of excessive volatility in the global financial system tips the balance even further.
There is plenty of time for the Fed to signal that its policy stance has shifted, and the conclave in Jackson Hole is an excellent opportunity to start that communication. If the facts have changed, the policy implications must also change. The greatest loss of credibility always comes when policymakers try to ignore changing realities.