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Christmas Time for the Fed

Irwin M. Stelzer

Christmas came early this year for Janet Yellen and those of her monetary policy committee colleagues eager to begin raising interest rates. Just a tiny bit, but enough to show that they remember how to do that after eight years of holding rates to just about zero. First gift: Santa, disguised as a European Central Banker with a decidedly Italian accent, misjudged the markets. His plan to drive down the euro and thereby drive up European exports fell so short of expectations that the euro actually rose, to the wailing of traders who shorted it in anticipation of Mario Draghi’s announcement. That allowed the dollar, already at a 12-year high and by Fed estimates knocking 0.5 percent off GDP growth, to sink a bit, and removed Fed fears that if it raised interest rates just when the ECB was lowering them – tightened just when the ECB was loosening – the dollar would jump and our exports would become less competitive in overseas markets. Draghi’s misstep ended that worry.

The second early gift was delivered when the government reported yesterday that the economy had added 211,000 jobs in November, and raised job-creation estimates for the previous two months by 35,000. With the major exception of mining, which has lost 123,000 jobs in the past year as oil prices plunged and the Obama administration continued its war-to-the-death on the coal industry, most sectors added jobs, including retailing (+31,000), which means retailers are approaching Christmas in an optimistic frame of mind, even though Thanksgiving weekend sales were more ho-hum than ho-ho-ho. The Fed has always claimed that it is data-driven, and the steady revving up of the U.S. job-creation machine seems to be the last bit of data Yellen needed to begin raising rates as she and a majority of her colleagues long have hinted they would when the economy strengthened. She used speeches in the past weeks to tip her hand – provide “forward guidance” in Fedspeak. “The labor market has improved … real GDP has increased at a modest pace … household spending growth has been particularly solid… increases in home values have pushed up the net worth of households…”. Never mind that the manufacturing sector seems to be contracting. The rate rise will be announced in a few weeks, along with a promise to put any future increases on a long, slow glide path back to something resembling levels once considered normal. Kevin Mahn, president of Hennion & Walsh Asset Management, expects the Fed to follow its 2004-2006 pattern, when it took rates up in 17 equal increments of 0.25 percent.

So think of Yellen and Draghi as if on escalators, rather like those you use in department stores. Yellen is headed up to the floor with higher interest rates and a faster growing economy, Draghi down towards the floor with bargain prices – indeed, negative interest rates – and a slower growing economy. Central bankers being a close-knit bunch, they wave to each other as they head in opposite directions, Draghi hoping that his low prices (a falling euro) will attract business away from the high-price alternative (rising dollar) over which the Fed chairman will preside. This divergence of direction – less politely, this currency war — describes U.S.-EU and indeed U.S.-Japan monetary policy.

This week’s focus on monetary policy can be more than a little misleading to anyone trying to guess the future course of the U.S., EU and world economies. If monetary policy alone could produce prosperity, life would be simple: run the presses and sit back and watch an economy grow. That doesn’t work in Zimbabwe, or Venezuela, or anywhere else. Of course, monetary policy does have its uses. As Bagehot long ago explained, central banks can provide credit when the credit markets stop functioning properly and banks are unable to lend. Central bankers can drive interest rates down, asset values up, and create a wealth effect that stimulates spending, as Ben Bernanke and Yellen have done. They can, if successful, drive the value of their nations’ currency down, which is what Draghi has tried to do, so as to boost growth and give serious economic reformers the breathing space in which to make labor markets work better, repeal growth-stifling regulation, and lower taxes that make work and risk-taking not worth the after-tax incomes they produce. Even achieving such limited goals requires central bankers to avoid creating asset bubbles, or sugar-highs as they are sometimes called, and to be willing to withstand criticism, already being levelled at Yellen, for taking away the punch bowl just as the party gets going, as one former Fed chief put it.

As the economy moves forward, the Fed will be sharing center-stage with a gaggle or two of presidential wannabees. Yellen seems satisfied with an economy growing at 2.0 percent to 2.5 percent. Politicians are not, at least during campaign season. They profess dissatisfaction with our slow-speed recovery, especially since the fruits of that growth are ending up in the already well-stocked larders of “the rich”. The Republican candidates, or at least those who have a coherent policy platform, propose to stimulate growth – to a 4 percent annual rate, claims Jeb Bush in an effort to revive his faltering campaign — by cutting taxes, rolling back the regulatory and entitlement states, repealing Obamacare, and ending the war-to-the-death on the nation’s fossil fuel industries. Hillary Clinton, the certain Democratic candidate barring an unlikely indictment for her flagrant misuse of her private email system, has different policies in mind. She would raise taxes on the wealthy and transfer income to groups she deems deserving and hopes to weld into a new governing coalition (blacks, Hispanics, women, college students), and also re-empower trade unions, recent victors in their effort to raise auto-industry wages to a point where GM has announced that it will begin selling Chinese-made vehicles here in America.

Both parties would end up increasing the already- swollen debt we are leaving as our gift to future generations, the Republicans by not fully replacing revenues lost by tax cuts – growth alone won’t do that – Clinton by launching multiple spending programs (ten so far and counting), and reconstructing the nation’s pothole-ridden infrastructure. Of course, in the most likely event – a President Clinton facing off against Republican majorities in the House and Senate – gridlock will in the end water down Republican tax cuts and Democratic spending. A messy but perhaps fortunate result of next year’s election.

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