The Federal Reserve is at a crossroads, and it doesn’t know where it’s going. After holding short-term interest rates near zero for six years, Fed policymakers, led by chair Janet Yellen, are prepared to raise them — but when, how much and with what consequences they haven’t said.
Higher short-term rates might trigger turmoil in stock and bond markets, as investors adjust to tighter credit. But it’s also possible that the reaction would be muted. The Fed mainly controls short-term rates, and there is only a loose relation between these rates and rates on long-term home mortgages and bonds. These matter more for the economy, and they might barely budge. In economic lingo, the “yield curve” — the gap between short and long rates — would flatten.
Would this happen? We don’t know.
There was a time when we were more confident. We didn’t pay attention to details, because the experts had matters in hand. During the Alan Greenspan era (1987-2006), the Fed was routinely seen as an economic superman. Its surgical shifts in the federal funds rate seemed to stabilize the economy: Expansions were long, recessions rare and mild. (The funds rate is the rate at which banks lend overnight money to each other — and the main rate the Fed manipulates.) Now the Fed often seems a 200-pound weakling.
It’s true that during the 2008-2009 financial crisis, the Fed arguably averted another Great Depression. It supplied credit when frightened private lenders wouldn’t. Since then, it has been less successful. To revive the economy, it unleashed massive amounts of financial stimulus. The federal funds rate has stayed near zero since late 2008, and the Fed bought more than $3 trillion of government and mortgage bonds to reduce long-term rates. For this energetic exercise in money creation, all it got was a sluggish and frustrating recovery.
Policy has been neither a glorious success nor an abject failure. It’s been a pragmatic muddle. The plodding recovery has reduced the unemployment rate from 10 percent in October 2009 to 5.5 percent now. Extravagantly easy money seems less defensible. The Fed has ended its program of bond buying. Yellen is saying that — assuming the recovery continues — the Fed should wean the economy of near-free money.
This seems a good idea, but how it can be done is an open question. The answer depends on more than the United States. We think of the Fed as America’s central bank. It is. But to the extent the world has a central bank, it’s also the Fed. Its influence reflects the dollar’s role as the main “global currency,” which — among other things — is used to make loans to foreigners.
Most of these loans do not come from the United States; the dollars circulate in the rest of the world and are lent and borrowed. In mid-2014, foreigners (excluding banks) had $9 trillion in dollar loans and bonds, reports a study from the Bank for International Settlements. That was up by about $3 trillion since 2008. This means that the Fed inevitably influences global credit conditions.
The danger in tightening too much or too soon is that it might drive many weak international borrowers — including firms and governments in emerging-market countries such as India and Mexico — to the wall. Already, the prospect of tighter money has raised the dollar’s exchange rate; for many foreign borrowers, this makes repayment more expensive. In the United States, tighter money risks damaging credit-sensitive sectors, led by housing and vehicles. The specter of higher rates could also prompt a preemptive sell-off in the bond market, which would (almost certainly) spill into the stock market.
At best, confidence would suffer; at worst, panic would ensue. It’s an ugly picture. On the other hand, the danger of not tightening is that more dubious loans will be made — domestically and internationally — and raise the odds of a large financial crackup in the future. The choice seems to be between present pleasure and future prudence, except that future prudence might also inflict present pain. There’s a knowledge gap that limits our ability to see and shape events.
Yellen recognizes the dismal choices and strives to cultivate confidence as a way of blunting the conflicts. At her recent news conference, she emphasized that the Fed, though it wants the freedom to tighten policy, will not be hurried into premature or sharp rate increases. Even after the initial change, she said, “our policy is likely to remain highly accommodative.” Money will continue to be cheap. Investors need not make market-disruptive changes in their portfolios.
So far, this soothing strategy has succeeded. Whatever happens, there remains a larger historic question: How did an agency that seemed so powerful and commanding in one era become so limited and tentative in the next?
Read more from Robert Samuelson’s archive.