A James Alexander post
A very long and rambling interview with John Williams, Governor of the SF Fed and a current voting member of the FOMC, highlighted one crucial feature of Fed monetary policy.
“The argument that we should wait until we reach 2% inflation before we start raising interest rates, I don’t agree with that. If we waited until inflation was 2%, unemployment by that point would be probably down to low 4s or something. We would be behind the curve and we would need to tighten monetary policy at that point very rapidly.”
Thus the 2% inflation target is very much a hard ceiling. Any move up towards anywhere near 2% will be met by a very rapid raising of interest rates, especially when unemployment is low.
This threat of massive retaliatory action guarantees that nominal growth will remain highly constrained. This is because the market treats such strong language with a high degree of credibility. Investment and spending decisions will be put off. Expected nominal growth of no more than 3%, made up of 1% or so inflation and 2% or so real is not worth businesses chasing after. Better to throttle back and live within existing means.
There will still be winners with business growth, ie sales and revenue growth, of 5% or more. But the iron logic of 3% or lower, economy-wide, nominal growth means just as many businesses will have sales growth of zero or lower. And they won’t feel good due to downwardly sticky wages and prices. Look at the big retailers, for instance.
Lay on top of this overall subdued outcome any potential or actual negative shocks, like China now or the EuroZone in the recent past, and the downside to even 3% nominal growth increases. And businesses will recognise this and act accordingly.
Williams reluctantly recognises the rise in these downside risks over recent months.
“My interest and my focus is trying to understand, has China’s growth outlook slowed significantly? Is there real information about what’s happening in Asia? Is there real information about any economic or other developments that then feed into my view on the forecast for employment, inflation in the U.S., and obviously the risks around those forecasts?”
But what Williams can’t see is that the potentially damaging effects of these threats are directly increased by his and the Fed’s own hypersensitivity around any moves in inflation towards 2%. The threat of the Fed yielding its rates sledgehammer to crack a low but rising inflationary nut is very scary, and totally counter-productive.
This is just like Japan over the last two decades, until recently. And leads the U.S. directly to the same sort of self-induced low growth trap.
Strong leadership at the Fed is needed to break this psychology. The evidence from Japan is that central banks are totally incapable of generating this change internally. It needed outside political leadership to do it in the form the new Prime Minister, Mr Abe, sacking the head of the Bank of Japan and appointing his own man. Step forward Mr Trump? Or Mr Sanders?