Fed, seeking to leave zero behind, grapples with Catch-22

5 min read

If we define a “Catch-22” as being in need of something that you can only get by not being in need of it, then the Federal Reserve, mulling a rate hike off the zero lower bound in September, is kind of caught.

The minutes from the July meeting of the Federal Open Market Committee, besides showing a genuine split about when to proceed with the first interest rate hike since 2006, also betrayed nervousness over the limitations it faces given unprecedentedly low official interest rates.

Check out this puzzler of a passage from the minutes:

“Another concern related to the risk of premature policy tightening was the limited ability of monetary policy to offset downside shocks to inflation and economic activity when the federal funds rate was near its effective lower bound.” (http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20150729.pdf)

In other words, if we tighten from interest rates of virtually zero to just a bit higher we still have insufficient room to cut if it all goes wrong. This rather implies that the Fed is well aware that, as in the old story, given where they want to end up, they shouldn’t be starting where they are.

On that logic, the Fed might never be able to tighten, as whenever it wrenches interest rates to 25bp or 50bp above zero, it would still lack ammunition.

But this is a counsel of despair only if the Fed chooses to follow it. The Fed isn’t constrained by the zero lower bound, but would have, instead, to rely on asset purchases or other extraordinary policy measures as a way to get extra leverage if it needs to cut more than the 25bp or 50bp it will likely hike in coming months.

Of course Fed policymakers call them “extraordinary” measures because they are supposed to be just that, and it will betray the weakness of the Fed’s position if they are forced to resort to more QE to deal with a garden-variety recession, rather than a full-scale clean-up after a financial crisis.

For that reason it is understandable that these issues are worrying the Fed. But it would be a mistake if it tipped the balance by very much. That’s especially true if what the Fed is worried about is financial market reaction to policy changes. Financial markets are never going to react well to tighter money and at a certain point will just have to re-price.

Lend me US$20 and I’ll lend it back. We’ll both be up

Interestingly, there is a related line of thinking making the rounds that the Fed is hurrying to get a rate hike or two in before it next wants to cut.

“I keep hearing the argument that the Fed needs to hike, so that if the US economy slows down again it will have room to cut rates once more. In other words, it needs to get away from the zero bound so that the traditional monetary policy tool of rate cutting comes back into play in the future,” Jim Leaviss, a fund manager at M&G Investments in London, wrote in a note to clients.

“Surely for this to make sense you’d have to argue that a, say, 50bp hike from 0.25% to 0.75% is less powerful in slowing the economy than a 50bp cut from 0.75% to 0.25% is in stimulating it? Or believe that hiking rates is a sign of confidence in the economy and is therefore stimulative (on the other hand a later emergency cut back down from 0.75% if growth stalled might not send the best signal either).”

While this nails the circular logic surrounding much of this debate, it leaves out one factor that may actually be playing a role: the Fed’s need to demonstrate that it remains in control.

There is a twitter feed I particularly enjoy, called “Hold my Beer GIFs,” in which people, almost always men, are filmed coming to spectacular grief while attempting to demonstrate prowess in unwise manoeuvres. (https://twitter.com/HoldMyBeerGif)

While Janet Yellen isn’t trying to impress the kids at the skate park, she, and her peers at the Fed, must be aware that the eyes of investors are on them, and that some think they are trapped and some think, obliged to hike. There is some pressure to show control, and with that comes some risks.

For that reason, I would tend to look through the concerns about China, energy prices and the rest of the global economy in the minutes. The Fed makes monetary policy not for emerging markets, or for the rest of the globe, or even for financial markets, but for the US. That argues for tightening sooner rather than later.

They probably shouldn’t start from here, but the Fed hasn’t many other options.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft