(Bloomberg Prophets)—The U.S. Federal Reserve believes it faces a dilemma. Despite more than quintupling its balance sheet from about $800 billion in September 2008 to $4.5 trillion in an effort to stimulate the economy, growth continues to be subpar. A federal funds rate at near zero up until December 2015 did little to encourage consumers to borrow and spend. And although the surge in equity prices boosted consumer wealth, it didn’t lead to increased spending, higher incomes or “a virtuous circle (to) further support economic expansion,” as former Fed Chairman Ben Bernanke wrote in a Washington Post op-ed article in November 2010.
Hand-wringing at the Fed got more intense last week as inflation numbers for July showed that the target of 2 percent annual inflation hasn’t been attained despite years of easy monetary policy. The consumer price index in July rose only 0.1 percent from the prior month, well below consensus expectations. Even more distressing to the central bankers, the monthly inflation rate measured by the producer price index was negative, which could be transmitted to consumer prices in coming months. It isn’t surprising that, in a speech this month Federal Reserve Bank of Minneapolis President Neel Kashkari likened his colleagues’ concern about accelerating inflation to a “ghost story.”
Why haven’t wages surged and inflation picked up despite the economy being in the ninth year of economic recovery, and the unemployment rate matching a 16-year low of 4.3 percent? Are the low inflation rates in recent months just a transitory factor resulting from falling rates for mobile-phone plans and lower prices for prescription drugs, as Fed Chair Janet Yellen suggested in June?
There is, in fact, no puzzle in the picture. While the Fed stuck with low interest rates to try and spur bank lending, a concomitant increase in regulations by the Obama administration after the financial crisis largely nullified any positive affect of the monetary easing. As the following chart shows, excess reserves with the U.S. commercial banks increased from a little more than zero at the onset of the financial crisis to more than $2 trillion by May. Had sensible regulations been introduced to boost lending to creditworthy borrowers, the excess reserves would have declined markedly, financing much-needed investments in businesses and infrastructure.
Consumers, on the other hand, were shortchanged by Fed policy that penalized interest earners. Interest income of U.S. households fell from almost $1.4 trillion in September 2008 to less than $1.2 trillion by September 2010 (chart below). And between September 2008 and June 2017, the increase was a mere 4.7 percent - - over almost nine years! During the same period, the Standard & Poor’s 500 Index more than doubled. The wealth effect of higher equity prices that Bernanke had written about bypassed the retirees and low-income earners who couldn’t take the risk of being in the stock markets.
And since U.S. low-income earners are more numerous than those in the top income brackets, their reduced interest earnings marked the start of a vicious cycle involving lower incomes and lower spending, holding back the economic recovery and contributing to underemployment. It isn’t surprising that retail, hit by competition from online giants such as Amazon.com Inc., has been buffeted by anemic income growth at the lower end of the income spectrum. Despite the pickup in retail sales in July, they have risen by only 1.6 percent during the first seven months of the year. Consumer spending, adjusted for inflation, was unchanged in June, the last month for which we have data.
All of these developments carry an important message for the Fed: Want to boost employment as the central bank’s mandate requires, in addition to supporting equity prices? Rather than the slow pace of rate hikes so far that has kept interest income at a low level, increase rates by a half or three-quarters of a percentage point in one shot. Yes, that would initially shock the stock market into a correction, but once the impact filters through to savers, the virtuous cycle that Bernanke envisioned would actually take place.
In short, the Fed doesn’t face a conundrum with sticky wages and prices; they were just the result of mistaken policy. Correcting it would be a boon for both stock market investors as well as for those too risk-averse to participate in it.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Komal Sri-Kumar is the president and founder of Sri-Kumar Global Strategies, and the former chief global strategist of Trust Company of the West.
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