The Fed’s Dangerous Deferral

Despite the sound economic situation, the U.S. central bank is sticking with its policy of zero interest rates, which is difficult to understand and is more associated with risks than opportunities.

The Fed decided on Thursday not to raise interest rates. Many very young investors, who only know a world with [perpetually] falling and record-low interest rates, have thus been denied an expansion of their horizons. The fact that the price of gold can also go up is something this generation only knows from hearsay. The last time this happened in the U.S. was June 2006, a time that seems almost prehistoric today — when there was no Twitter or WhatsApp, the U.K. was governed by a certain Tony Blair, Saddam Hussein was stewing in a Baghdad prison and Alan Greenspan was still considered a successful central banker.

The monetary policy deferral is difficult to understand from an economic point of view. The U.S. is currently in very sound shape. The economy grew by a respectable 3.7 percent in the second quarter, consumers appeared to be in a mood to spend, businesses created new jobs at a rapid pace, and at 5.1 percent the unemployment rate is at a level that is very close to the objective of full employment, and can probably hardly be lowered any further with a monetary policy that is still expansive. Keeping interest rates at zero in this context requires an extremely good explanation.

But for the Fed, which likes to present itself as a data-led institution, there are still some flaws: Alongside the recent financial market turbulence, this includes low inflation, which is due not least to the nosedive of traditionally volatile energy prices. What is irritating is that the Fed is placing greater emphasis on this flaw and the worries about China than the clear progress that has been made. It is a confirmation of the impression of a central bank acting in a strongly asymmetric manner — reacting quickly and aggressively to slowdowns — whereas improvements have to be as clear as day for it to tighten the extremely loose reins even minimally.

This asymmetry means the Fed is jeopardizing more than its credibility. Putting off monetary policy normalization has once again suspended the steering function of interest rates for the foreseeable future. When money doesn’t cost anything, bad investments and exaggerations in the markets continue to occur, which plant the seed for future financial crises. The longer the wait for a correction of a completely twisted incentive structure, the worse these crises will turn out to be. The Fed, which increasingly seems to be the source of instability, must be conscious of this.