Any US Fed move to raise rates will only set back America's weak recovery
Guru Ramakrishnan says desultory inflation and high debt in the US make raising interest rates - as the Fed seems prepared to do - a rash move that would torpedo whatever recovery there is
The voting members of the US Federal Reserve and their coterie of 350 PhDs are most likely going to make a significant policy mistake next quarter. An academic-minded Fed, aided and abetted by the Taylor rule, now seems to think that US rates should be well north of the zero bound they currently inhabit.
The strong US employment report last week will further strengthen their resolve. They seem eager to raise rates, to be able to say they have begun their exit from the infamous "liquidity trap".
One can see why they think this way. Seventeen central banks so far this year have been drawn into the vortex of what seems to be a black hole - moving rates down towards zero, and a few of them below - as they try to combat the global deflationary forces at work. Having been at zero rates for six years and having shored up growth, the Fed wants to be the first out.
The Fed should be paying close attention to the signals emanating from the US bond market.
In the US, fourth-quarter real gross domestic product growth slowed to 2.6 per cent. More alarmingly, the GDP price index printed zero two weeks ago. This puts the US in a position where real and nominal GDP growth rates have converged. This combination is a dangerous trap the Fed should be wary of. In a debt-laden society, the nominal growth rate - helped by positive inflation - is critically needed to reduce the burden of debt. So it should come as no surprise that long-term rates in the US have, during the past few weeks, moved sharply down to reflect this and the huge debt burden.
Over the past 12 months, the US bond markets have been signalling to the Fed that this recovery does not feel as real as it looks. It has been an asset price recovery that has benefited a fraction of the top 1 per cent of the US population, with little to no real wage or income growth for the rest.
This phenomenon of low long-term interest rates in the bond market seems to perplex the Fed, which appears to be trying to pressure this inanimate entity called the "bond market" into submission by getting it to move rates higher.
At this stage of the recovery, the Fed is looking for meaningful wage growth, which in turn would create the product-price-led inflation it wants. It has had to settle for asset-price inflation instead. Falling well short of its inflation target, the Fed, through its hawkish stance, has managed to reinforce a dollar bubble in the world economy.
Attaining the goal of a 2 per cent rise in prices has now become tougher due to the slowdown in growth globally and the ensuing collapse in energy prices.
This is why the Fed can afford to, and must, be patient in raising rates. This Fed is ideologically clinging on to the traditional models of inflation like the Phillips curve trade-off. It has yet to understand the true implications of globalisation and the long-term disinflationary impact that a globalised work force from China and India have had on prices of products and services.
The right thing for this Fed to do is to declare to the markets that short-term rates will be on hold for the next two years unless the cumulative inflation rate during this period exceeds 5 per cent. This will abate the Fed-related volatility in the markets. With little to no inflation in sight, long-term rates will stay anchored at around 2 per cent due to the strong demand for yield internationally. This declaration will give the economic recovery in the US a strong chance of success and not foil the five years of hard work that the Fed has put in to get here.
A rapid rate rise would not only strengthen the dollar further, it would risk capital outflows from emerging markets and be severely detrimental to their GDP growth. For growth in the US to continue at this stage, it needs a stronger global economy as well. China's rapid slowdown in imports this week signals weakening demand from the most important growth economy in the world.
However, this move is not without risk for the Fed. One significant danger is that asset prices in general will continue to move higher. However, this risk is surely worth taking compared to the alternative, which would call into question the credibility of the Federal Reserve itself.
The Fed should take comfort that the termination of quantitative easing last October and the recent decline in inflation expectations have served as an effective tightening in terms of moving real interest rates higher.
Despite the quantitative easing last year, the growth in real GDP in 2014 ended at a paltry 2.4 per cent. For the Fed to believe that raising rates - even by a "modest" 50 to 75 basis points - will not slow this growth further is truly wishful thinking. The Fed would soon be left with no alternative but to stop and/or lower rates back to the zero bound, destroying any credibility it has with market participants.
The Fed has already lost some credibility with its exaggerated growth forecasts over the past 12 quarters. The loss in credibility from a policy flip-flop would be the ultimate black swan event for markets.
Securing growth over the next couple of years by keeping rates on hold will give the markets a chance to let fundamental factors (earnings) catch up to current valuations. The markets can focus on assessing the quality of the economic recovery and watching the progress on the inflation front.
The Fed can then use its macro prudential tool kit to manage asset bubbles rather than having to clean up the inevitable mess that would be caused by raising rates prematurely.
The members of this Federal Reserve Board need to remember two things. First, having checked into the Hotel of Zero Interest Rate Policy, you can try to check out any time you like, but you can never leave - at least not that easily; case in point, Japan.
Second, don't fight the bond market, which is telling you to tread carefully and stay on hold.