Better late than later
Yellen has flunked once on rates - she must not do so again
by Meghnad Desai
Thu 29 Oct 2015
Janet Yellen flunked the test in September when she led the Fed to postpone the much expected rate rise. This time, after the relatively hawkish statement from the Federal Open Market Committee’s 28 October meeting, the Fed chairman may be about to show she has courage and convictions.
The reason advanced for last month’s hesitancy was the turmoil in the markets following the Shanghai share price collapse and the reaction of western markets. This however was a failure to separate signal from noise. There is always, in financial markets, a lot of noise and short-run volatility. There was little logic in western markets reacting to Shanghai except the usual Gadarene rush to disaster.
This time around the Fed has read the signals and ignored the noise. On Wednesday it could have cited trouble in South China Sea or President Putin in Syria but did not do so. We are back into the territory of economic signals. It has been obvious for a while that low or zero interest rates have overstayed their welcome. There are worrisome signs of irrational behaviour in M&A activities, share buy-backs and some outlandish valuations on business start-ups.
There is also palpable impatience among emerging market central banks wishing a clear steer from the Fed. As Raghuram Rajan, governor of the Reserve Bank of India, has repeatedly urged, the Fed has to look beyond the local scene and take its global responsibility into account. In this case, local concerns which are a part of the Fed's mandate dovetail with global needs. It’s time to signal an end to uncertainty.
The Fed looks at macro signals of the standard kind: employment numbers, GDP growth, inflation. These signals have been flashing red for a while. Thus, even ignoring the signs of financial instability, the macro numbers warrant a move on rates.
When Yellen was appointed at the end of 2013, a worry often expressed was whether she would have the courage to be tough or whether she would always err on the soft Keynesian side. In backing her candidature for the job, I then argued that Yellen had what it takes and would be clear-sighted about the likely dangers in financial markets. September was thus a surprise. Now there seems to be a welcome correction and the Fed is signalling a rate rise in December.
We have had nine years of no rate change from the Fed. After a long recession, the US and UK have recovered to pre-crisis levels. There should now be a well-designed return to normalcy in money markets. A long run of low rates has created excessive risk-taking as investors search for high yields in distant markets.
Central banks need to rethink their mission and incorporate into their mandates the goal of financial stability as well as macroeconomic balance. Western central banks need, too, to factor in the impact of their actions on emerging economies. Instability has global dimensions. That is the very least the Great Recession should teach us. Perhaps we need the Fed to begin some serious thinking on how central banks can adapt their policies to this new agenda.
Meghnad Desai is Emeritus Professor of Economics at the London School of Economics and Chairman of the OMFIF Advisory Board.
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