Martin Wolf: Keep US interest rates low – the world is still abnormal

After nearly seven years of zero interest rates, the inflation of which critics warned is invisible

How close is the US Federal Reserve to normalising monetary policy? This was the question addressed by Stanley Fischer, vice-chairman, at the Jackson Hole Symposium. So will the Fed raise interest rates this month? On that, I can only guess – and that guess is no.

Another question is whether the Fed should raise rates this month. My answer to that is also no.

In itself a rise might seem unimportant. The Fed’s intervention rate has been 0.25 per cent since December 2008. One must doubt whether a jump to 0.5 per cent would be significant. After all, the Bank of England’s base rate has been 0.5 per cent throughout the crisis. This point is correct, but too limited.

Any increase would be significant: first, it would indicate the Fed’s belief that the policy can be “normalised” after almost seven years of post-crisis healing; second, it would indicate the beginning of a tightening cycle.


One of the reasons for believing the latter is that this is how the Fed has historically behaved: the last such cycle began with rates at 1 per cent in June 2004 and ended with rates at 5.25 per cent two years later.

Without doubt, beginning a tightening cycle for the first time in more than 11 years would be a significant moment. It would also signal more than an immediate rise in rates.

The likely destination and speed of travel are also enigmas because the US economy is not behaving normally. After nearly seven years of zero interest rates, the inflation of which critics warned is invisible. This is not normal.

For the same reason, the correct timing of that first tightening remains uncertain. Yes, US unemployment is down to 5.1 per cent. And, yes, the private sector has added 13.1m jobs over 66 months.

But core inflation is firmly under 2 per cent, inflation expectations are well under control and nominal gross domestic product is growing steadily at around 4 per cent. Little of this suggests an urgent need to tighten. An inflation-targeting central bank is not forced by the data to move now.

A broader perspective than this is needed, especially because any first tightening is so significant. A necessary condition for making this move is confidence that it will not need to be reversed in the near future. But it is impossible at present to have such confidence.

This is particularly important when interest rates are near zero. It would be desirable to move above this level to create room for manoeuvre in future. But, if the prospect of persistent tightening weakened the economy, the Fed might be forced back to the lower bound in worse circumstances. As Andy Haldane of the Bank of England has put it, "the act of raising the yield curve would itself increase the probability of recession."

The decision on when to raise rates, then, has to be seen as one of risk management under asymmetric pay-offs: if the Fed is too late, inflation might rise; if the Fed is too early, it might diminish future room for manoeuvre. Given the strength of the dollar, which is likely to last, and recent market turmoil, the balance is clear: it is necessary to be more confident than we now are that the tightening cycle would prove sustainable.

In addition, the view that low real interest rates are a long-term feature of the world economy looks quite plausible. Events in China suggest the condition could even worsen. In fact, these ultra-low rates seem to be the lowest rates ever. Yet, if real rates and inflation remained so low, nominal interest rates would remain exceptionally low, too.

Some worry that low rates are somehow unnatural. Arguing in this vein, the author William Cohan insists: "Like any commodity, the price of borrowing money – interest rates – should be determined by supply and demand, not by manipulation by a market behemoth." But: money is not like any commodity. It is a state monopoly for whose creation the central bank is responsible. The central bank does determine short-term rates.

Mr Cohan is not alone. Plenty of people have wanted tighter monetary policy for years, for one reason or another. Some focus on quantitative easing more than on low short-term rates, believing it is sure to lead to high inflation in the end. But belief that the expansion of central bank balance sheets ensures a surge in credit and spending is wrong. The presumed link between bank reserves and lending can be managed.

A more sophisticated view is that of the Bank for International Settlements. It believes that monetary policy should be targeted not at equilibrium in the real economy, but at equilibrium in the financial sector. Thus, one should be prepared to tolerate prolonged cyclical unemployment over the medium term, in order to prevent a build-up of damaging financial excesses over the longer term.

This raises two big questions. First, does anybody know what monetary policy would stabilise our financial casino? Second, what is the point of a deregulated financial system that creates such profound dilemmas? It surely makes better sense to cage it, instead.

In sum, central banks should continue to focus on stabilising the real economy, though more needs to be done to curb financial excesses. Meanwhile, as an inflation-targeting central bank, the Fed has no strong reason to start a tightening cycle now. And, when it does start, rates will not reach previous cyclical highs. Our world is not normal. Get used to it.

– (Copyright The Financial Times Limited 2015)