Janet Yellen Faces a 'No-Win Scenario' on Interest Rates

Just like the Kobayashi Maru in Star Trek, the Fed is tested by a difficult conundrum, RBC says

Are There Enough Uncertainties to Push Back Fed Hikes?

In Star Trek, top cadets at Starfleet Academy face a terrible training scenario: Do they abandon a civilian vessel to annihilation in the Neutral Zone or risk war with the Klingons—and their own demise—by embarking upon a rescue mission?

In her quest to save the U.S. economy from deflation, Federal Reserve Chair Janet Yellen faces a similar challenge to that faced by then-cadet James T. Kirk, according to RBC Dominion Securities Inc. Strategist Matthew Barasch.

Yellen can elect to head into the Neutral Zone—that is, deliver more rate hikes—supported by a variety of modified Taylor Rule models that suggest policy rates should be higher. Doing so would risk damaging emerging market economies, including China, and cementing deflationary forces around the globe.

Conversely, she can leave her Kobayashi Maru (the phantom ship in Star Trek lore) to its fate, foregoing hikes in light of sluggish economic activity. But that strategy risks having inflation rise above the central bank's 2 percent target. If that were to happen, a series of rapid rate hikes to tamp it down could send the U.S. economy into recession.

"The Fed has been facing a no-win situation for the past couple of years, but especially in the past six to 12 months," wrote Barasch. "On the one hand, the underlying economic data in the U.S. has been supportive of raising rates off of what would be categorized by most as emergency levels; on the other hand, global growth remains broken."

Yellen's speech in Philadelphia on Monday, which emphasized uncertainties on the evolution of economic data, the neutral level of interest rates, and the Fed's course of action, can be viewed as a nod to this dilemma.

Several decades ago, former Fed Chair Paul Volcker faced his own version of the this situation (Extending his Star Trek analogy, Barasch compared him to Kirk's mentor, Captain Christopher Pike). While Volcker's severe tightening regime, aimed at bringing inflation to its knees, proved unpopular at the time, "today he is viewed by many as one of the saviors of the U.S. economy," said Barasch.

If Yellen elects to hold off on rate increases, perhaps her actions will someday be seen as heroic, too, the strategist mused.

"The right answer here is hard to pin down, just as it was over 35 years ago when the high levels of inflation argued for very high rates, but the slow rate of growth in the economy argued for the opposite," he wrote. "The easier course of action is maintain rates at very low levels, risk some inflation and worry about cleaning up the inflation problem down the road."

Now, if this were Star Trek, Yellen could try to follow Captain Kirk's lead by finding a way around the no-win scenario. But unlike the simulator at Starfleet Academy, there's no reprogramming this conundrum.

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