Saturday, 30 July 2016

U.S. Federal Reserve Breaks Bad

Blog Post 12| 27th December 2015

U.S. Federal Reserve Breaks Bad

In the wind up of 2015 the Federal Reserve (FED, U.S. Central Bank) has made a counter logical (logical, in terms of their theoretical mandate) decision to increase interest rates, effectively reducing the amount of liquidity that will be available into 2016. On 17th December 2015 the FED made the decision to raise he Federal Funds Rate from a range of 0-0.25% to 0.25-0.5%, the first increase since 16th December 2008 in light of the Global Financial Crisis (GFC). In making this pivotal decision of U.S. monetary policy the FED have effectively broken their directive to target 2% inflation, which in their words:

‘…inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve's mandate for price stability and maximum employment.’

Although this is a relatively small increase to the rate at which U.S. private banks borrow from the FE, and future increases are forecast to be gradual; inflation only averaged 0.07% from January 2015 to November 2015. And, the FED did say in their 16th December press release:

‘…it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.’

However, modern central banking theory and empirical evidence only support the use of, what is conventionally known as contractionary monetary policy (reducing the money supply through raising interest rates), to invoke a decrease to inflation. This is exactly the opposite outcome the U.S. FED is looking to achieve through its monetary policy efforts.

What is the issue with low inflation or deflation?

An economy naturally requires more real (inflation adjusted) spending in the current period relative to the previous period to achieve real growth. If prices are stagnant or decreasing, it removes the incentive for consumers and investors to purchase in this current period with the knowledge that they can pay the same amount or even less in the next period. This decreases spending and subsequently economic growth.

Japan has experienced these very economic phenomena since the 1990’s when they began on a course of low inflation/deflation on the back of asset bubbles bursting in both the share markets and the real estate markets. Resultantly, real GDP stagnated in Japan, though they were able to alleviate some of this downward pressure to growth through being a net exporter of goods and services. From January 2000 to March 2014 monthly inflation of consumer prices averaged -0.01%, and over this same period quarterly GDP growth averaged a mere 0.2%.

What is the probable outcome?

Through increasing interest rates the FED will impose lower inflation on the U.S. economy, reducing inflation to lower levels than before the interest rate rise that will likely bring about a situation of no inflation or deflation to U.S. prices. The overall effect of this is probable to be lower GDP growth and a greater risk of a recession in 2016.