Economist: Major Portions of the Fed's Case for Liftoff Are Way off Base
Since their latest statement and the blockbuster October jobs report, Federal Reserve policy makers have been conditioning market participants to expect a December rate hike.
But Michael Darda, chief economist and market strategist at MKM Partners, believes some of the arguments that members of the Federal Open Market Committee are making stretch the bounds of credulity.
One paragraph in particular from the minutes of October's meeting, published on Wednesday, in which participants detailed why abstaining from raising rates could be detrimental to achieving the Fed's goals, drew Darda's ire:
One concern was that such a delay, if the reasons were not well understood by market participants, could increase uncertainty in financial markets and unduly magnify the perceived importance of the beginning of the policy normalization process. Another concern mentioned was the increasing risk of a buildup of financial imbalances after a prolonged period of very low interest rates. It was also noted that a decision to defer policy firming could be interpreted as signaling lack of confidence in the strength of the U.S. economy or erode the Committee's credibility. Some participants emphasized that progress toward the Committee's objectives should be assessed in light of the cumulative gains made to date without placing excessive weight on month-to-month changes in incoming data.
"There's so much wrong here one hardly knows where to begin," he fumed.
Uncertainty would rise regardless of whether the Fed stayed on hold or hiked rates absent a reasonable explanation for why monetary policymakers elected to pursue said course of action, Darda notes. While uncertainty stemming from Federal Reserve policy is path independent, making the wrong decision has a certain—and negative—outcome.
"[I]f uncertainty over a potential policy error (tightening too soon into the teeth of a slowdown in nominal growth and tighter financial conditions) turns into certainty over a potential policy error, it is hardly likely to boost confidence," Darda wrote. "All we need to do is to look back at launch failures from the ZLB, Japan in 2000 and then again in 2006-2007 or the ill-fated ECB rate hikes in 2011 to recognize why such arguments utterly fail under close scrutiny."
Therefore, he believes that this attempt to shift the burden of proof onto policymakers who want to maintain the status quo is poorly conceived. And as for the case that liftoff would help prevent asset bubbles from forming or growing, the economist says that doesn't square with what he's seeing in fixed income markets, where investment-grade corporate bond spreads are elevated relative to their long-run average.
Aside from the aforementioned points, members of the FOMC inclined to raise interest rates would likely point to the decline in the unemployment rate as evidence that the current stance of monetary policy is indeed accommodative and will soon lead to a pickup in inflation, as it has resulted in a seemingly rapid reduction in slack.
But Darda takes exception with the premise. The most commonly cited U3 unemployment rate—and even the broader U6 rate—are overstating the extent to which the labor market has recovered, he contends.
"For example, the prime age [25 to 54 years old] employment-to-population ratio has been flat all year and remains 260 basis points below its pre-crisis, two decade average," the economist points out. "The much more hesitant recovery in this labor market barometer is consistent with only modest NGDP and wage growth over the last five years."
The lack of improvement in this metric supports the notion that U.S. monetary policy may not have been sufficiently accommodative despite the low nominal level of rates.
"[T]he entire argument about the Fed following an 'easy money' policy simply because rates are low is dead wrong if the natural rate (the rate that sets output at potential and inflation at its target) has also been low or negative," he asserts. "That both NGDP growth and inflation have been low on average during the ZLB period would ipso facto lend credence to this argument."
If the Fed really had been easy, there'd be more evidence that the economy was overheating.
And in the absence of that, liftoff at the present moment could prove to be premature, says Darda, though he thinks the Federal Reserve will indeed raise rates in December.