The Fed, interest rates and recession | Michael Roberts Blog

On Friday, US stock markets fell to their lowest level since August 2015 in its third consecutive weekly decline.

S&P 500

In many previous posts, I have argued that stock markets are really still in a long-term secular ‘bear market’ of decline.  Stock market values follow the profitability of capital and, as I have argued in other posts, the profitability of US capital has not yet reached the bottom of its current downwave that, in my view, began in 1997, with various upturns (2001-6, 2009-13).  If that is correct, then the US stock market (and others as well) have yet to reach the bottom of this secular bear market that began in 2000 with the hi-tech bubble bust.

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This latest stock market collapse has taken place within weeks of the decision of the US Federal Reserve’s monetary policy committee (FOMC) deciding for the first time for nearly ten years to raise its policy rate that sets the floor on interest rates in the US and abroad. At the time, Fed chief Janet Yellen said that the US economy “is on a path of sustainable improvement.” and“we are confident in the US economy”, even if borrowing rates rise.

As I commented at the time “This was ironic because just before the Fed hiked its interest rate, the figures for US industrial production in November came up and they showed the worst fall since December 2009 at the end of the Great Recession.”  Since then we have had further poor data on the US economy with weak retail sales and industrial production for December, suggesting that US real GDP growth in the last quarter of 2015 was likely to be as low as just 1%.

Stock markets falling and the US economy slowing, with the rest of the world stagnating and China apparently imploding: this is putting egg on the face of Janet Yellen, as the UK Guardian’s economic correspondent put it, Larry Elliott.

I have argued that there was a serious danger that the US Fed would repeat the mistake it made in 1937 during the last Great Depression of the 1930s.  Then it concluded that the US economy had sufficiently recovered to enable it to start raising interest rates.  Within a year, the economy was back in a severe recession that it did not recover from until America entered the world war in 1941.

So should the Fed be hiking interest rates at this time?  This question was debated at the recent annual meeting of the American Economics Association (ASSA 2016) by the great and the good of mainstream economics.  There were two sorts of the responses to this question from mainstream economics.

The first was to ignore the fact of the weak global and US economic recovery or argue that it didn’t matter.  At the main debate on the issue among leading luminaries of the mainstream, Martin Feldstein, former economics advisor to Bush, reckoned that the US economy was recovering well with unemployment down and incomes rising.  So there was nothing to worry about.

John Taylor, leading economist from Stanford University, took a different tack.  Yes, the US economy was very weak but this was the fault of economic and monetary policies of the current US administration and the Federal Reserve.  What was needed was toreduce regulation of the banks and large companies so they can grow and for the Fed to end its cheap money policy.  Let’s just get back to business as usual and things will be fine.  Taylor appeared oblivious to the fact that it was the failure to regulate the banks and financial system or to stop the introduction of speculative financial instruments that contributed to the global financial crash in the first place!

But the main response of the other debaters at the mainstream meeting was to conclude that we just don’t know why the economic recovery was so weak and now seems to be faltering.  Vice chair of the Fed, Stanley Fischer, offered several possible reasons, but said he did not know which was right.  Fischer was worried that the ‘equilibrium rate of interest’, (now called R*) where savings and investment are matched with full employment and moderate inflation looked very low, as inflation was near zero.  This was another way of saying that the equilibrium rate could be ‘zero bound’ and thus the economy was in some form of ‘secular stagnation’, as argued by Keynesians like Larry Summers.

But Olivier Blanchard, former chief economist of the IMF, ever the optimist, offered Fischer a positive answer.  Actually, the US economic recovery was beginning to look normal, after all.  You see, the infamous Phillips curve of the 1970s, namely that when unemployment fell, inflation would rise, was still operating weakly.  So as labour markets tightened, inflation would rise and the Fed would be justified in raising its policy rate as it had started to do.

Source and full article: The Fed, interest rates and recession | Michael Roberts Blog

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