Yellen must set the route back to normalcy

Policy-makers should take note of China – but not too much

The US Federal Reserve has been criticised for ending the zero interest rate era. Indeed, its minuscule rise in December has been blamed for the stock market jitters. I hold the opposite view. The Fed took too long to raise rates and then raised them by too little.


Janet Yellen has invoked China as one of the variables the Federal Reserve must examine in setting interest rates. The Fed chair’s statement is good news. But China-watching can go too far. The problem is at home, in the US heartland.


The crisis of inflated asset values has been coming for some time. The upheaval may have been hastened by the Fed or the price collapses in Shanghai. But the answer is not to stop or reverse the rate rise as some people are saying – talking even of negative interest rates in the US as well as Europe. Instead, Yellen must continue firmly to lay out a route map back to normalcy.


China has shaken global markets. The Fed can no longer ignore the rest of the world. That has been a long journey, worth making. Chinese stock markets are small in terms of China’s economy and even more so in terms of the global economy. But volatility is a psychological not a logical phenomenon.


If western stock markets are still looking fearfully at China, it because of what it has done to confidence as much any real impact. There is now a new transmission mechanism for financial fear. A landmark came in May 2013, when Ben Bernanke, then Fed chair, caused a stock market flurry with talk of the Fed ‘tapering’ quantitative easing (asset purchases). Raghuram Rajan, now governor of the Reserve Bank of India, reacted by saying that, in determining policy, the Fed ought to look at the impact on the rest of the world.


Some chance, I thought. The statement of John Connally, Treasury secretary in the early 1970s, seemed still true: ’The dollar is our currency and your problem.’ In fact, the world has now become more interconnected. Neither Chinese nor international policy-makers can any longer ignore Chinese citizens’ preferences. China has suddenly become a complex economy.


But we have to keep wider financial matters in our focus. Central bankers must give, and adhere to, a clear signal for investors. There is no going back to the good old days. We will then see markets return to sensible valuations.


Some punters have taken irresponsible long bets. They may go out of business. Many shadow banking entities have taken on unsustainable liabilities against the promise of high returns. Shaking out these operators is the best thing the market can do. That’s why the market is there.


Let’s hope a full-blown crash can be averted. Aggressive monetary expansion seems likely to continue in the euro area. Some Keynesians are cheered that the refugee crisis is loosening governments’ purse strings. But we can hardly rely on refugees to generate sustained fiscal expansion. Poor European demographics are depressing demand. Refugees may add a bit to the population, but hardly enough to change either demand or supply sufficiently to generate growth.


The impact of new technology is highly deflationary. A new industrial revolution may be in the offing, with robotics, artificial Intelligence and advances in transport. Though this will not all come at once in a Schumpetarian gale, products will get cheaper and more efficient. Whether more creative destruction will be uniformly negative for employment creation is hard to judge. Car driving is American males’ largest single occupation. If driverless cars become normal, we will have to reskill.


There will be much churning of activity and investments over the medium term. Once interest rates return to some sort of normal – say 2-3% in real (inflation-adjusted) terms – things could settle down. We may be in the early years of the next Schumpetarian wave, or merely at the tail end of the last one. Whatever happens, life will remain precarious.

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