Some thoughts on US monetary policy*

The US central bank – the Federal Reserve – has trimmed its key interest rate again, marking a further step forward down a new track. Its monetary policy is now developed independently of the US economic situation, as the Fed’s strategy is dictated by worldwide uncertainty that could hit the domestic economy and push it off its current robust path. Uncertainty on world trade, the impact of the administration’s trade policy and concerns on world growth are all prompting the Fed to adjust it strategy.

In the past, the country usually adopted a more accommodative stance in response to a sharp economic slowdown. In 2007/2008, the Fed changed its policy when liquidity dried up on the money market, but this was the exception rather than the rule, with the Fed only reacting to changes in the US economy with little concern for the rest of the world. This approach was only natural as world trends at the time were dictated by the US.

Fed backtracks after rate hikes in 2018

This shift in focus raises a number of points:
The Fed is backtracking after its upward trend in 2018, when it raised its key rate four times. These were the right moves at the time as the White House had implemented a very aggressive fiscal policy at a time when the economy was close to full employment, so it was vital to keep on a lid on tension that could have surged and dented the economy.
This rearrangement in the economic policy balance was perfectly plausible given economic conditions.
However, fiscal policy was not as effective as expected, and made a smaller contribution to driving the economy than anticipated, so the Fed no longer needed to continue its monetary tightening policy.
The outlook changed when the international context became more risky, particularly as a result of US trade policy.
The combination of these two factors prompted the Fed to maintain the status quo, then start easing, with a very clear timeline: on January 30, 2019 the Fed hit the pause button, then started easing on July 31, and again on September 18. Its policy is now highly accommodative as the real Fed Funds rate is only very slightly positive.

The US policy mix is now very accommodative, while the economic cycle is at a peak

It is interesting to take a closer look at economy policy measurements. The US policy mix is now very accommodative at a time when the country is still at the peak of the economic cycle. The public deficit stands at $1,000bn (almost 5% of GDP) and the real Fed Funds rate is only just slightly positive. Well might we wonder how the Fed will steer economic policy in the event of a shock on growth – can we expect an even bigger public deficit and should we anticipate negative interest rates from the Fed?

We could well think that the Fed rushed to change its accommodative strategy due to this unfortunate combination, as the economy is still robust and does not require monetary stimulus. It is also still very closed to outside influences, with trends and activity heavily dependent on the domestic market. This means that the role of external factors in the way monetary policy is managed is too high. In 2018, the degree to which the US economy was open[1] to outside factors was slightly under 14%, which is barely above the average since 2000 i.e. 13.7% vs. 13.4% average since 2000. The economy is no more dependent on the outside world than it was 10 or 15 years ago. So why change the factors that determine monetary policy by overlooking domestic aspects and only taking on board external dynamics?

Further questions on factors driving monetary policy

Questions to Jay Powell during press conferences should seek to address this question. Does this change reflect pressure from investors to get their hands on ever higher financial valuations? Is it the result of pressure from the White House as it wants the Fed to push interest rates ever lower? Is it because Powell has not set a clear doctrine on what monetary policy should be in this topsy-turvy world? These three factors can all be taken on board, but this rushed move makes for an economic policy error.

We can find another explanation for the Fed’s strategy

World growth is weaker than everyone would like. The world looks more fragmented than before and no longer has the coordination and cooperation momentum we saw just a few years back during the period of globalization. In other words, the dynamics of our world are increasingly diverging and this leads to uncertainty and dents growth.

Meanwhile, there no longer seems to be a way to conduct coordinated fiscal policy worldwide, and stimulus initiatives undertaken in 2009 seem to belong to a very distant past. The US, China and Europe have very differing views on this issue, so we should not expect a worldwide economic stimulus program, despite the fact that it would probably provide strong and sustainable support for the economy.

Central banks are all applying very accommodative policy to avoid putting any limitations on the world economy

In light of this situation, central banks worldwide are all applying highly accommodative policies to make sure they do not put any limitations on the economy. The aim is not to spur economic growth at any cost: growth projections from the ECB and the Fed most definitely do not point to this. Rather the goal is to limit the risks on world growth, and the ECB, the Fed, the Bank of Brazil and several other emerging country central banks have taken up this strategy, which can help explain why the aspects dictating US monetary policy focus on external factors.

Waiting for impetus from fiscal or technological factors

The only problem here is that this joint effort is admittedly necessary, but collective impetus looks a bit like a last-chance strategy while waiting for fiscal or technological stimulus to change the situation on a long-term basis. So central banks’ interest rates are set to stay low for a very long time to come: in this respect, the ECB indicated that its leading rate would stay where it is for such times as inflation does not move towards 2% on a structural basis. This could take a very long time – much longer than anyone expects. The Fed still has some leeway as compared to the euro area, but this could narrow very quickly.
The central banks are giving governments time to come up with some answers, but they will not necessarily hold on for as long as many would like.


* This document was posted on LeGrandContinent website. Le Grand Continent is a French think-tank on the geopolitical backdrop See the original post here in French
[1] The degree to which an economy is open to outside factors is the ratio between half of the total of imports and exports to GDP

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