Fed, seeking to leave zero behind, grapples with Catch-22

by **Cals** Sun 23 Aug 2015, 23:02

Fed, seeking to leave zero behind, grapples with Catch-22

Saturday, 22 August 2015

IF we define a “Catch-22” as being in need of something that you can only get by not being in need of it, then the Federal Reserve, mulling a rate hike off the zero lower bound in September, is kind of caught.
The minutes from the July meeting of the Federal Open Market Committee, besides showing a genuine split about when to proceed with the first interest rate hike since 2006, also betrayed nervousness over the limitations it faces given unprecedentedly low official interest rates.
Check out this puzzler of a passage from the minutes: “Another concern related to the risk of premature policy tightening was the limited ability of monetary policy to offset downside shocks to inflation and economic activity when the federal funds rate was near its effective lower bound.”
In other words, if we tighten from interest rates of virtually zero to just a bit higher we still have insufficient room to cut if it all goes wrong. This rather implies that the Fed is well aware that, as in the old story, given where they want to end up, they shouldn’t be starting where they are.
On that logic, the Fed might never be able to tighten, as whenever it wrenches interest rates to 25 or 50 basis points above zero, it would still lack ammunition.
But this is a counsel of despair only if the Fed chooses to follow it. The Fed isn’t constrained by the zero lower bound, but would have, instead, to rely on asset purchases or other extraordinary policy measures as a way to get extra leverage if it needs to cut more than the 25 or 50 basis points it will likely hike in coming months.
Of course Fed policymakers call them “extraordinary” measures because they are supposed to be just that, and it will betray the weakness of the Fed’s position if they are forced to resort to more QE to deal with a garden-variety recession, rather than a full-scale cleanup after a financial crisis.
For that reason it is understandable that these issues are worrying the Fed. But it would be a mistake if it tipped the balance by very much. That’s especially true if what the Fed is worried about is financial market reaction to policy changes. Financial markets are never going to react well to tighter money and at a certain point will just have to re-price.
Interestingly, there is a related line of thinking making the rounds that the Fed is hurrying to get a rate hike or two in before it next wants to cut.
“I keep hearing the argument that the Fed needs to hike, so that if the US economy slows down again it will have room to cut rates once more. In other words, it needs to get away from the zero bound so that the traditional monetary policy tool of rate cutting comes back into play in the future,” Jim Leaviss, a fund manager at M&G Investments in London, wrote in a note to clients.
“Surely for this to make sense you’d have to argue that a, say, 50 basis-point hike from 0.25% to 0.75% is less powerful in slowing the economy than a 50 bps cut from 0.75% to 0.25% is in stimulating it? Or believe that hiking rates is a sign of confidence in the economy and is therefore stimulative (on the other hand a later emergency cut back down from 0.75% if growth stalled might not send the best signal either).” – Reuters