America’s Risky Recovery
CAMBRIDGE – The
United States’ economy is approaching full employment and may already be
there. But America’s favorable employment trend is accompanied by a
substantial increase in financial-sector risks, owing to the excessively
easy monetary policy that was used to achieve the current economic
recovery.
The
overall unemployment rate is down to just 5.5%, and the unemployment
rate among college graduates is just 2.5%. The increase in inflation
that usually occurs when the economy reaches such employment levels has
been temporarily postponed by the decline in the price of oil and by the
20% rise in the value of the dollar. The stronger dollar not only
lowers the cost of imports, but also puts downward pressure on the
prices of domestic products that compete with imports. Inflation is
likely to begin rising in the year ahead.
The return to full employment reflects the Federal Reserve’s strategy of “unconventional monetary policy”
– the combination of massive purchases of long-term assets known as
quantitative easing and its promise to keep short-term interest rates
close to zero. The low level of all interest rates that resulted from
this policy drove investors to buy equities and to increase the prices
of owner-occupied homes. As a result, the net worth of American
households rose by $10 trillion in 2013, leading to increases in
consumer spending and business investment.
After a very slow
initial recovery, real GDP began growing at annual rates of more than 4%
in the second half of 2013. Consumer spending and business investment
continued at that rate in 2014 (except for the first quarter, owing to
the weather-related effects of an exceptionally harsh winter). That
strong growth raised employment and brought the economy to full
employment.
But the Fed’s
unconventional monetary policies have also created dangerous risks to
the financial sector and the economy as a whole. The very low interest
rates that now prevail have driven investors to take excessive risks in
order to achieve a higher current yield on their portfolios, often to
meet return obligations set by pension and insurance contracts.
This reaching for yield has driven up the prices of all long-term bonds
to unsustainable levels, narrowed credit spreads on corporate bonds and
emerging-market debt, raised the relative prices of commercial real
estate, and pushed up the stock market’s price-earnings ratio to more
than 25% higher than its historic average.
The low-interest-rate
environment has also caused lenders to take extra risks in order to
sustain profits. Banks and other lenders are extending credit to
lower-quality borrowers, to borrowers with large quantities of existing
debt, and as loans with fewer conditions on borrowers (so-called
“covenant-lite loans”).
Moreover, low
interest rates have created a new problem: liquidity mismatch. Favorable
borrowing costs have fueled an enormous increase in the issuance of
corporate bonds, many of which are held in bond mutual funds or Exchange-Traded Funds (ETFs). These funds’ investors believe – correctly
– that they have complete liquidity. They can demand cash on a day’s
notice. But, in that case, the mutual funds and ETFs have to sell those
corporate bonds. It is not clear who the buyers will be, especially
since the 2010 Dodd-Frank financial-reform legislation restricted what
banks can do and increased their capital requirements, which has raised
the cost of holding bonds.
Although there is
talk about offsetting these risks with macroprudential policies, no such
policies exist in the US, except for the increased capital requirements
that have been imposed on commercial banks. There are no policies to
reduce risks in shadow banks, insurance companies, or mutual funds.
So that is the situation that the Fed now faces as it considers “normalizing” monetary policy.
Some members of the Federal Open Market Committee (FOMC, the Fed’s
policymaking body) therefore fear that raising the short-term federal
funds rate will trigger a substantial rise in longer-term rates,
creating losses for investors and lenders, with adverse effects on the
economy. Others fear that, even without such financial shocks, the
economy’s current strong performance will not continue when interest
rates are raised. And still other FOMC members want to hold down
interest rates in order to drive the unemployment rate even lower,
despite the prospects of accelerating inflation and further
financial-sector risks.
But, in the end, the
FOMC members must recognize that they cannot postpone the increase in
interest rates indefinitely, and that once they begin to raise the
rates, they must get the real (inflation-adjusted) federal funds rate to
2% relatively quickly. My own best guess is that they will start to
raise rates in September, and that the federal funds rate will reach 3%
by some point in 2017.
Martin Feldstein, Professor of Economics at Harvard University
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