CAMBRIDGE
– The United States’ economy is approaching full employment and may
already be there. But America’s favorable employment trend is
accompanied by a substantial increase in financial-sector risks, owing
to the excessively easy monetary policy that was used to achieve the
current economic recovery.
The
overall unemployment rate is down to just 5.5%, and the unemployment
rate among college graduates is just 2.5%. The increase in inflation
that usually occurs when the economy reaches such employment levels has
been temporarily postponed by the decline in the price of oil and by the
20% rise in the value of the dollar. The stronger dollar not only
lowers the cost of imports, but also puts downward pressure on the
prices of domestic products that compete with imports. Inflation is
likely to begin rising in the year ahead.
The return to full employment reflects the Federal Reserve’s strategy of “unconventional monetary policy”
– the combination of massive purchases of long-term assets known as
quantitative easing and its promise to keep short-term interest rates
close to zero. The low level of all interest rates that resulted from
this policy drove investors to buy equities and to increase the prices
of owner-occupied homes. As a result, the net worth of American
households rose by $10 trillion in 2013, leading to increases in
consumer spending and business investment.
After
a very slow initial recovery, real GDP began growing at annual rates of
more than 4% in the second half of 2013. Consumer spending and business
investment continued at that rate in 2014 (except for the first
quarter, owing to the weather-related effects of an exceptionally harsh
winter). That strong growth raised employment and brought the economy to
full employment.
But
the Fed’s unconventional monetary policies have also created dangerous
risks to the financial sector and the economy as a whole. The very low
interest rates that now prevail have driven investors to take excessive
risks in order to achieve a higher current yield on their portfolios,
often to meet return obligations set by pension and insurance contracts.
This reaching for yield has driven up the prices of all long-term bonds
to unsustainable levels, narrowed credit spreads on corporate bonds and
emerging-market debt, raised the relative prices of commercial real
estate, and pushed up the stock market’s price-earnings ratio to more
than 25% higher than its historic average.
The
low-interest-rate environment has also caused lenders to take extra
risks in order to sustain profits. Banks and other lenders are extending
credit to lower-quality borrowers, to borrowers with large quantities
of existing debt, and as loans with fewer conditions on borrowers
(so-called “covenant-lite loans”).
Moreover,
low interest rates have created a new problem: liquidity mismatch.
Favorable borrowing costs have fueled an enormous increase in the
issuance of corporate bonds, many of which are held in bond mutual funds
or exchange-traded funds (ETFs). These funds’ investors believe –
correctly – that they have complete liquidity. They can demand cash on a
day’s notice. But, in that case, the mutual funds and ETFs have to sell
those corporate bonds. It is not clear who the buyers will be,
especially since the 2010 Dodd-Frank financial-reform legislation
restricted what banks can do and increased their capital requirements,
which has raised the cost of holding bonds.
Although
there is talk about offsetting these risks with macroprudential
policies, no such policies exist in the US, except for the increased
capital requirements that have been imposed on commercial banks. There
are no policies to reduce risks in shadow banks, insurance companies, or
mutual funds.
So that is the situation that the Fed now faces as it considers “normalizing” monetary policy.
Some members of the Federal Open Market Committee (FOMC, the Fed’s
policymaking body) therefore fear that raising the short-term federal
funds rate will trigger a substantial rise in longer-term rates,
creating losses for investors and lenders, with adverse effects on the
economy. Others fear that, even without such financial shocks, the
economy’s current strong performance will not continue when interest
rates are raised. And still other FOMC members want to hold down
interest rates in order to drive the unemployment rate even lower,
despite the prospects of accelerating inflation and further
financial-sector risks.
But,
in the end, the FOMC members must recognize that they cannot postpone
the increase in interest rates indefinitely, and that once they begin to
raise the rates, they must get the real (inflation-adjusted) federal
funds rate to 2% relatively quickly. My own best guess is that they will
start to raise rates in September, and that the federal funds rate will
reach 3% by some point in 2017.
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