The bad news is that the great American job creation machine may be downshifting. The good news is that, because of the bad news, the Federal Reserve is unlikely to raise interest rates at their current meeting, in progress here in Washington.
Chair Janet Yellen and the Fed reasonably claim to be “data driven,” meaning that like a football quarterback calling an audible from the line when he sees the defense shift, they’ll change their interest rate plans as per movements in key variables.
The question is, which variables are key? Based on the Fed’s dual mandate to target the lowest unemployment rate consistent with stable inflation, that may sound obvious.
But in the age of globalization, very low interest rates and volatile international capital flows, a recent strain of economic research and reporting in the Wall Street Journal serve up two serious warnings. The first one is to the Fed: Even a small rate hike could have large negative growth effects. The second is to the governments across advanced economies, including our own: By restraining government spending, you are keeping your economies stuck in a slow growth trap.
In a recent series of articles, the Wall Street Journal has shown interest rates are at rock bottom in countries across the globe. The yield on both German and British 10-year debt just fell to the lowest levels on record, 0.02 percent and 1.14 percent respectively. The Swiss just announced the issuance of a 13-year bond with a zero yield. These unusually low rates are a result of weak growth, low inflation and aggressive bond buying by European central banks, some of which are setting their interest rates in negative territory (the forthcoming Brexit vote is also rattling markets).
U.S. rates are low, too, but not nearly as low as elsewhere, and that means international capital is flowing in, seeking yields well above those on offer in Europe and Japan (Monday, the nominal yield on 10-year Japanese debt was -0.16 percent compared with 1.61 percent here). That’s pulling in foreign capital, as shown in the figure below: 70 percent of the bids for recent 10-year Treasuries were from overseas investors. A rate hike at the Fed would exacerbate this trend, pulling in even more foreign capital.
But what’s wrong with that? If foreign investors want to pour money into America, bring it on, right?
If it were only that simple. What actually happens is that both the rate hike and the capital flows strengthen the dollar and worsen the trade deficit. The mechanics are pretty straightforward. Countries that consume or invest less than they produce finance those of us who spend more than they produce through precisely these capital inflows. The exchange rate mechanism — stronger dollar — facilitates the flows.
In fact, these dynamics are well underway. Since mid-2014, the real value of the dollar is up about 15 percent against a broad index of other currencies, a change that has had a quick and damaging effect on our trade balance and factory sector (a stronger dollar makes our exports more expensive to others and their imports cheaper to us). The worsening trade balance has shaved an annual average of about a half percentage point off real GDP growth since 2014, and manufacturing employment, after growing solidly before the dollar began strengthening, is down by 35,000 jobs this year.
Okay, but surely this exchange rate problem can handily be offset by policy: The Fed can lower the interest rate it controls, right, thus boosting the other parts of GDP, like consumer spending and investment?
Well, put aside for a moment the fact that our Fed is committed to moving in the other direction — it wants to raise rates, though cautiously. The other problem we and other countries have faced in recent years is that when the Fed rate is already at or near zero, they can’t lower it further (true, some countries have been fooling around with negative interest rates, but that hasn’t changed the outlook and Yellen doesn’t appear to want to go there). When central banks lose this adjustment mechanism, things get weird, and not “good weird.”
Or to put it slightly more technically, as Fed governor Lael Brainard did in a recent speech: “The financial transmission is likely to be amplified in economies with near-zero interest rates, such that anticipated monetary policy adjustments in one economy may contribute more to a shifting of demand across borders than a boost to overall demand.”
When rates are really low everywhere, capital, starved for even a mildly positive return, quickly books a ticket for wherever yields are safest and highest. In normal times, with strong demand and high “animal spirits” among investors, such incoming capital gets put to good, productive use, financing domestic investment, jobs and growth that offset the economic drag created by the larger trade deficit. But what if, as has been the case in our economy, even before the recent apparent slowdown in job creation, demand is none too strong and investors have little use for extra capital?
If the Fed wasn’t stuck near zero, it could lower rates until the price of investing was low enough even to meet the weakened demand. But when stuck at zero, we’re stuck with an imbalance that has to come out somewhere, and if the excess capital can’t be absorbed through lower rates, it gets absorbed through bigger trade deficits and weaker growth.
Moreover, when global low rates block other economies from making similar, needed adjustments, we’re into a zero sum game where everyone’s trying to steal demand and jobs from everyone else, trying to drive down their exchange rates and export their way out of the slump.
Obviously, this can’t work. At the end of the day, one country’s exports are another country’s imports. The solution over the past couple of business cycles has been for the United States to be the world’s “growth engine.” Sounds great until you realize that in the real world, that’s meant demand-zapping trade deficits and large capital flows inflating one bubble after the next.
This is a good way out of this mess. The federal government can make a feature out of a bug by taking advantage of the extent to which all those capital flows have jammed down interest rates, borrow extremely cheaply, and jump-start our sputtering jobs machine with a deep dive into infrastructure investment. If the private sector can’t find non-bubbly places to invest its cheap capital, I guarantee you the public sector has many great options, including our water systems and public schools.
But here, of course, we run head on into dysfunctional government. Last week, I testified in the House for almost three hours against Republicans who wanted to overturn the updated overtime rule. That’s how these folks are choosing to spend their time.
These global dynamics should lead the Fed to strenuously avoid unnecessary rate hikes. Right now, higher interest rates will finance larger trade deficits, and the Fed may find that what it thought was a tap on the brakes was more of a slam. On infrastructure investment, it’s probably too much to hope that Congress will act, but both of our presumptive presidential nominees have infrastructure plans. And one of those plans is actually coherent.
Globalization, unmanaged, is a bear. Both fiscal and monetary policymakers must quickly incorporate these dynamics into their plans and actions.