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Let normalcy resume: Fed must lead

Let normalcy resume: Fed must lead

Why central banks should focus on the real interest rate

by Meghnad Desai

Mon 9 Nov 2015

In September, in its deliberations on interest rates, the US Federal Reserve paid more attention to noise than to signals. It rewound slightly last month when the data were a bit clearer. There were hints that rates may rise in December. Even so, the message was hedged. Now the data are shouting rather than whispering.

Friday’s figures showing October’s very strong rate of job creation confirm that the US economy is reaching its normal equilibrium with unemployment at the long-run Nairu level of 5%. At this stage, all excuses need to be set aside. Had Janet Yellen shown bold leadership, the Fed chair would have ended the uncertainty in September. That is what we at OMFIF said back then and have said since (read the articles here and here).

It’s time to end the drift and uncertainty. At its next policy meeting on 15-16 December the Fed should raise rates and supply a map of how they will rise further in coming months.

More broadly, central banks around the world need to rethink their target inflation rate of 2%. Maintaining easy monetary policies for too long, in a struggle to achieve a higher rate of inflation than the economy generates, may be highly destabilising for financial markets and the economy generally, as shown by recent excesses in mergers and acquisitions.

Policy-makers should shift attention to the real (inflation-adjusted) rate of interest. A long-run target of a 2% real interest rate may be a better goal than a rate of inflation.

The Fed must give a firm steer to the global economy. The US central bank will need to take emerging market economies' anxieties into consideration. But we should remember that many leading representatives of Asian and Latin American countries have been telling the Fed for weeks to get on with the task of raising rates.

The global economy is in a long downward phase of one of the ‘super-cycles’ identified in the 1920s by Nikolai Kondratieff. We will have low GDP growth and near-zero inflation for some time. The really profound change concerns inflation. Under the latest Kondratieff wave, the long period of secular inflation which began in 1939 has now been reversed, nearly 75 years later.

During the era of secular inflation, financial markets grew, especially since the collapse of the gold exchange standard in 1971 when the US reneged on its commitment to exchange dollars for gold at $35 an ounce. The explosion in foreign exchange transactions began then. Countries went in search of an inflation anchor to regulate their money supply since there was no longer an external restraint from the International Monetary Fund or the gold standard. This is where policy rules became popular such as the formula devised by economist John Taylor balancing inflation and unemployment.

We now have a different economy. Much like the long cycle of 1871-96, there will be growth without inflation. All the innovations driven by information technology are disinflationary. Commodity prices, a big influence on inflation during the first decade of the 21st century, seem to have lost momentum as the oil price shows.

In such a world, Mark Carney, governor of the Bank of England, has unnecessarily prolonged uncertainty with last week’s statement hinting that UK rates may not be raised until 2017, in spite of strong UK growth. I only hope that, if the UK central bank cannot lead, it will at least become a good follower of the lead given by the Fed.

The European Central Bank may have reason to wait a bit longer to tighten credit, as the euro area economy, even now, is growing only tepidly. But the Bank of England has no such excuse.

Let us welcome the beginning of the end of near-zero interest rates. Let normalcy resume.

Prof. Lord Meghnad Desai is Emeritus Professor, London School of Economics and Political Science, chairman of the OMFIF advisory board and author of Hubris: Why Economists Failed to Predict the Crisis and How to Avoid the Next One.

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