20.09.2016 |
- USA: Fed FOMC in the spotlight: Governor Brainard’s compelling arguments against a rate hike in September
Ahead of the meeting of the U.S. central bank’s federal open market committee (FOMC) taking place on 20th/21st September, uncertainty has cumulated about whether the Fed will further increase the federal funds rate or whether it would leave it unchanged (Figure 1). Market instruments imply that market participants give a hike of the key policy rate by 25 basis points a chance of 20 %, while in late August odds stood around 40 % for a September hike.
Market implied probabilities appear rather low, given that three weeks ago at the Jackson Hole symposium Fed Chair Yellen said that “In light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months”. Parts of the market had interpreted this as Yellen’s willingness to proceed soon – as early as this month – with the rate hiking cycle that had started in December 2015.
Somewhat contrary to that, another member of the Fed’s Board of Governors, Lael Brainard, called for “prudence in the removal of policy accommodation” in a closely followed speech last week. To that respect, Brainard described five key features of what she called the “new normal”, referring to the contours of the U.S. economy in the aftermath of the 2008/09 financial crisis.
Why does Brainard call for prudence?
First, she argued that the Phillips curve has been flattening and that inflation has consistently been undershooting. Since 2012, the unemployment rate went from 8.2 % to 4.9 % currently (Figure 2), while inflation has undershot the Fed’s 2 % inflation target implying that the Phillips curve – the conceptual framework governing the unemployment-inflation relationship – has flattened over that time. In a short-term view entailing sticky wage contracts, economists would usually have in mind a downwardly sloping Phillips curve: lower unemployment coinciding with rising or higher inflation. Governor Brainard challenges that view in light of recent evidence. In addition, softening private agent’s (households and firms) inflation expectations – a key variable for every central bank – may make it more difficult for the Fed to fulfill its price stability mandate.
Second, she argued for greater labor market slack than anticipated. The argument is supported by the Fed’s own changing assumption about the longer-run natural rate of unemployment (NAIRU) that has come down significantly from a range of 5.2 to 6.0 % in 2012 to between 4.7 % and 5.0 % in 2016 implying that slack in the labor market has been higher than previously thought. The NAIRU is a concept sometimes referred to as the level of unemployment consistent with neither upward nor downward pressure on inflation. It is a structurally implied as compared to a cyclically determined level of unemployment. As long as under-utilization is apparent in the labor market, wage pressure remains muted (firms are still able to hire at a given labor cost, low employee’s bargaining power). Recently, wage growth hovered around 2.5 % in the U.S. and was below historical recovery periods.
Third, Brainard pointed to foreign vulnerabilities and its transmission via the exchange rate channel into the U.S. economy. She referred to Europe’s sluggish recovery and banking sector, Japan’s low growth trap and China’s challenging transition process arguing that resulting movements on the exchange rate influence negatively U.S. economic activity and inflation.
Fourth, Governor Brainard drew attention to the lively debate among economists about the real neutral rate of interest. It appears increasingly clear that the neutral rate of interest remains considerably and persistently lower than it was before the crisis. The neutral rate of interest is the level of interest rates that is supposed to have neither an expansionary nor a contractionary effect on the economy. The Fed would usually refer to it as the longer-run level of the federal funds rate assuming that the economy is growing at its potential (steady-state or sustainable) growth rate depending on the full use of productive capacities (the supply side) and the absence of demand fluctuations. Since 2012, the Fed’s estimate of the long-run federal funds rate has declined from 4.25 % to 3.0 % implying a real neutral rate of 1.0 %. For comparison, several econometric models (including the widely cited Laubach and Williams approach) have recently suggested a real neutral (‘natural’) rate of interest of the U.S. economy close to zero. In a more theoretical sense, the ‘natural’ rate of interest also tells us something more about the economy: It is the real interest rate depending on the intertemporal preferences of economic agents. For example, it has something to do with demographic changes and changing savings (and investment) plans. Moreover, as long-term growth ultimately depends on technological progress, so does the natural rate of interest.
Lastly, Lael Brainard discussed the asymmetric nature of policy options. With policy rates near zero and likely to return there more frequently and due to the low level of the neutral rate, there is an asymmetry in the policy tools available to respond to adverse developments. Therefore, Brainard concludes that from a risk-management perspective, this asymmetry would make policy tilted in favor of guarding against downside risks relative to “preemptively raising rates to guard against upside risks”. As has been said, Brainard finally concluded that today’s ‘new normal’ as described by means of the five key features “counsels prudence in the removal of policy accommodation”. Among nine others (two positions remain vacant), Lael Brainard is currently a voting member of the federal open market committee.
- CEE: Ukraine: IMF approved 1 bn USD tranche under the stand-by arrangement
The IMF executive board completed the second review under the extended fund facility with Ukraine and disbursed 1 bn USD. The total disbursement sums up to 7.62 bn USD. The four-year arrangement (about 17.5 bn USD) was approved on 11th March 2015. The IMF’s press release stated that the Ukraine economy is showing welcome signs of recovery, notwithstanding a difficult external environment and a severe economic crisis. Activity is picking up, inflation has receded quickly and confidence is improving.
The IMF also noted that determined policy implementation remains critical to achieve the program objectives. This includes further progress in fiscal reforms to ensure medium-term debt sustainability and further strengthening of the banking system. A sustainable recovery requires completing the structural transformation of the economy (combating corruption and improving governance, strengthening the rule of law, restructuring of state-owned enterprises). On the positive side, the IMF noted that monetary policy has been skillfully managed and financial sector reforms have started to yield results. Last week, the National Bank of Ukraine (NBU) lowered the key policy rate by 50 basis points from 15.5 % to 15 % as inflation has steadily been falling to 8.4 % (y/y) in August (from 48.5 % last year). Official FX reserves amounted to 14.1 bn USD in August (Figure 3) and will increase to around 16 bn (including 1 bn USD IMF disbursement and an EU loan) providing further support for the currency, financial stability and the economy.