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Will the Fed Act?

Nov 10, 2015
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SMITH BRAIN TRUST — Last week, Fed chairwoman Janet Yellen said that raising interest rates before the end of the year was "a live possibility," given what she described as the relatively strong performance by the economy. The pronouncement was immediately felt in the market for Treasury securities. Other Fed governors, however, have said that low levels of inflation meant that a rate hike would be premature. A division over interest-rate policy was also evident in a recent panel discussion among finance experts at the University of Maryland's Robert H. Smith School of Business.

At an Oct. 29 lunchtime debate, organized by the school's Snider Center for Enterprise and Markets, two fellows of the Smith School's Center for Financial Policy, Albert "Pete" Kyle and Haluk Ünal, said that raising rates would be a mistake, with Ünal going so far as to call it "suicidal." A third panelist, Phillip L Swagel, said he was modestly in favor of raising the rate, but all agreed that the chief problems facing the U.S. economy were beyond the power of the Fed to solve. In theory, they said, fiscal policy such as infrastructure spending or tax cuts had the potential to re-energize a lagging economy, although they wondered if the U.S. government was up to the task.

The Fed has a so-called dual mandate: To keep employment rates high and inflation low. Since the 2008 crisis, low rates seem to have stimulated employment while — to the surprise of many observers — not introducing inflation into the system.  (It stands well below 2 percent.) Swagel, a professor of public policy, provided the closest thing to an argument for raising rates in December, the next opportunity. "Imagine that you are Matt Damon coming back from Mars," he said, and you read in the paper about 64 consecutive months of private-sector job creation and the other developments touted by the Obama administration. "Given all of these positive trends, why would you have interest rates at zero? Inflation is low, but it's not at zero. It seems as though the Fed policy is not consistent with what we're seeing in the economy. I'm not saying raise to three percent tomorrow, but we have an opportunity to normalize policy."

If interest rates remain at zero, he added, the Fed will have no tools in its arsenal with which it can respond if the economy experiences a negative shock.

Kyle, a professor of finance, conceded that he had expected that inflation would re-enter the system several years after the advent of low rates — by 2012, say. But given that inflation remains "benign," there was no good reason to raise rates.  Kyle also pointed to the strong dollar, which has hurt U.S. exporters, as another reason to keep rates where they are. Raising rates would boost the dollar further, a prospect that few people think would be good for the economy. "That's another justification for keeping low interest rates in place for a long period of time — and that long period of time hasn't ended yet," Kyle said.

Given that the Fed seems to be on top of both parts of its mandate, why is raising rates even on the table? Kyle suggested a third, unspoken goal: Keeping the prices of assets in check. Some analysts have begun to speak ominously of another stock-market bubble. "The Fed in the U.S. has pretended to look the other way, but it does worry about asset prices," Kyle said. Yellen's bearish comments about raising rates, he said, may help to suppress stock prices, even if she intends all along to pursue a low-rate strategy. "One thing she doesn't want is to create an asset price bubble that makes rich people richer and doesn't create a lot of jobs," Kyle said. "I think that has been coloring the way the Fed has been announcing its policies."

Ünal, a professor of finance, was even more insistent that rates should not rise. In the wake of the recovery, he noted, labor-force participation remains low by historic standards (the official employment rate aside), productivity gains are meager, and corporate investment lags. Domestically and globally, savings remains high and consumption remains low. In such an environment, "It would be suicidal to raise rates," Ünal said. "If you raise the rate you will have an even lower investment demand and higher savings rate."

All three panelists agreed that commentators are placing too much weight in what the Fed does. Whether rates stay at zero or move up to .25 percent is unlikely to have much of an impact on job creation or GDP.  What could make a difference are fiscal levers. Which policy you prefer may depend on your ideological disposition: Democrats may favor infrastructure spending and investment in Pre-K education, for instance, while Republicans may prefer tax cuts and a regulatory rollback. "Everyone has their own list," Swagel said, "but both approaches are legitimate."

"We shouldn't look to the Fed to solve our problems," he said. "The Fed has solved the problems that it can solve."

Kyle largely agreed, suggesting that more government debt would help to "soak up" the excess savings in the economy. (His preferred policy solution was debt caused by tax relief.)

Ünal also pointed to something external to the U.S. that might help jolt the world economy out of its current stagnation: "China's consumers entering the economy — buying more US cars, more US products, so that we reach our full productive capacity." China's recent announcement that it is abandoning its one-child policy suggests that the nation's leaders know they need more workers, and more consumers, he said.

SMITH BRAIN TRUST
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The Robert H. Smith School of Business is an internationally recognized leader in management education and research. One of 12 colleges and schools at the University of Maryland, College Park, the Smith School offers undergraduate, full-time and part-time MBA, executive MBA, online MBA, specialty master's, PhD and executive education programs, as well as outreach services to the corporate community. The school offers its degree, custom and certification programs in learning locations in North America and Asia.

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