US Federal Reserve (Fed) Chair Janet Yellen’s speech on Sept. 24 at the University of Massachusetts clearly indicated that she and the majority of the members of the Fed’s Federal Open Market Committee (FOMC) intend to raise the short-term interest rates by the end of this year. It was particularly important that she explicitly included her own view, unlike when she spoke on behalf of the entire FOMC after its meeting last month. Nonetheless, given the Fed’s recent history of revising its policy position, markets remain skeptical about the likelihood of a rate increase this year.
The Fed had been saying for several months that it would raise the federal funds rate when the labor market approached full employment and when FOMC members could anticipate that annual inflation would reach 2 percent. However, although both conditions were met earlier last month, the FOMC decided to leave the rate unchanged, saying that it was concerned about global economic conditions and about events in China in particular.
Some people were unconvinced. They have believed for some months that the Fed should start tightening monetary policy to reduce the risks of financial instability caused by the behavior of investors and lenders in response to the prolonged period of exceptionally low interest rates since the 2008 financial crisis. Events in China are no reason for further delay.
Consider, first, the US’ domestic economic conditions, starting with employment. By the time the FOMC met on Sept. 16, the unemployment rate had fallen to 5.1 percent, the level that the Fed had earlier identified as full employment. Although there are still people who cannot find full-time jobs, driving the unemployment rate below 5.1 percent would, according to the Fed, eventually lead to unwanted increases in inflation.
The inflation picture is more confusing. The annual headline rate over the past 12 months was only 0.2 percent, far short of the Fed’s 2 percent target. This reflected the dramatic fall in energy prices during the previous year, with the energy component of the consumer price index down 13 percent. Core inflation (which excludes energy purchases) was 1.8 percent. Even that understates the impact of energy on measured inflation, because lower gasoline prices reduce shipping costs, lowering a wide range of prices.
The point is simple: When energy prices stop falling, the overall price index will rise close to 2 percent. And the FOMC members’ own median forecast puts inflation at 1.8 percent in 2017 and 2 percent in 2018.
So if the Fed, for whatever reason, wanted to leave the interest rate unchanged, it needed an explanation that went beyond economic conditions in the US. It turned to China, which had been much in the news in the past weeks. China was reducing its global imports, potentially reducing demand for exports from the US. The Chinese stock market had fallen sharply, declining about 40 percent from the high points it reached in the summer. And China had abruptly devalued the yuan, potentially contributing to lower import prices — and therefore lower inflation — for the US.
However, when it comes to the impact of China’s troubles on the US economy, there is less than meets the eye. China’s import demand is slowing in line with its economic structure’s shift away from industry and toward services and household consumption. This means that China needs less of the iron ore and other raw materials that it imports from Australia and South America and less of the specialized manufacturing equipment that it imports from Germany and Japan. The US accounts for only 8 percent of China’s imports and its exports to China represent less than 1 percent of its GDP. So China’s cut in imports could not shave more than a few 10ths of a percentage point from US GDP and even that would be spread over several years.
As for the stock market — widely viewed as a kind of casino for a small fraction of Chinese households — only about 6 percent of China’s population own shares. The Shanghai stock market index soared from 2,200 a year ago to a peak of 5,100 in mid-summer and then dropped sharply, to about 3,000 now. So, despite the sharp drop that made headlines recently, Chinese shares are up more than 30 percent from a year ago. More importantly, wealth and consumption in China are closely related to real-estate values, not equity values.
Finally, the yuan’s recent decline against the US dollar was only 2.5 percent, from 6.2 yuan to 6.35 yuan — far below the double-digit declines of the Japanese yen, the euro and the British pound. So, on an overall trade-weighted basis, the yuan is substantially higher relative to the currencies with which it competes.
Even more relevant, the decline of the yuan and other currencies in the past year has had very little impact on US import prices, because Chinese and other exporters price their goods in US dollars and do not adjust them when the exchange rate changes. While official US data show overall import prices down 11 percent in the 12 months through August, this is almost entirely due to lower energy costs. When energy products are excluded, import prices are down only 3 percent.
So the Fed is right to say that inflation is low because of the drop in energy prices; but it need not worry about the effect of major trading partners’ lower currency values. When the price of energy stops declining, inflation will rise close to the core rate of 1.8 percent.
So, unless there are surprising changes in the US economy, we can expect the Fed to start raising interest rates later this year, as Yellen has proposed, and to continue raising them through next year and beyond. It is hoped that it raises them enough over the next 18 months to avoid the financial instability and longer-term inflation that could result from the long era of excessively easy monetary policy.
Martin Feldstein, a professor of economics at Harvard University and president emeritus of the US National Bureau of Economic Research, chaired former US president Ronald Reagan’s Council of Economic Advisers from 1982 to 1984.
Copyright: Project Syndicate
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