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In a world characterised by flagging growth, the US is leading the transatlantic economies from their deepest post-second world war recession thanks in large measure to the Federal Reserve’s historically unprecedented stimulus policies.
But nearly seven years after the central bank cut rates to near-zero, policymakers from the Fed’s crisis-era response team say low rates and quantitative easing have failed to generate the vigorous economic bounceback they expected.
Deepening the conundrum over whether to raise rates from their historic lows, inflation figures have stayed moribund even as the economy hits what the Fed believes is full employment. Meanwhile, patches of the financial markets are heating up, buoyed by historically cheap borrowing costs, and challenging the economic models central bankers traditionally rely upon.
Donald Kohn, who was vice-chairman of the Fed’s board of governors at the height of the crisis and one of the handful of officials to shape its response, says the rebound, which has seen average annual growth of 2.2 per cent for six years, has been underwhelming.
“I expected a slow recovery, but I expected credit to become more available over time, and zero interest rates to have more of a stimulative effect on spending than they appear to have had,” says Mr Kohn, a senior fellow at the Brookings think-tank.
“This has been a disappointing recovery.”
By some measures the US is doing well. Unemployment is just 5.1 per cent. Second-quarter growth at 3.7 per cent was well above the long-term historical trend. But the picture is marred. Annual wage growth at 2.2 per cent is well below the pace many Fed officials expect at full employment, and the labour force participation rate is at the lowest level since the 1970s.
The latter is partly because of the retirement of baby boomers, but also because many potential workers have given up looking for a job. Inflation has languished below the Fed’s target since 2012, meanwhile, despite the stimulant of low rates and quantitative easing.
The disappointments of recent years can be attributed to a range of factors, among them tighter fiscal policy in the US after an initial surge, the drag on confidence from the European debt crisis, tight credit conditions in the US, and depressed productivity growth.
Kenneth Rogoff, a professor at Harvard, has closely studied the disappointing aftermaths of financial crises. He says the Fed would in a normal cyclical upswing have lifted rates at least six months ago given the firm labour market signals it is getting.
“However, it is not a typical business cycle,” he says, arguing the Fed cannot be confident in models showing that inflation is just round the corner. “Output is doing better, but finding out that after seven years inflation is a little high for a while seems a minor issue compared to [the risk of] pushing the economy back into recession.”
What complicates the picture is that even as many Americans complain about a sluggish recovery, hotspots are emerging. One example is commercial real estate where values have long exceeded their pre-crisis peaks in a sector — property — which has been the locus of financial stability troubles in the past.
“Low interest rates are definitely increasing demand for commercial property — people are looking for high returns,” says Don Capobres, a developer for Grosvenor Americas, standing next to a large hole near Washington DC’s Nationals Stadium that will become a high-end apartment project called F1rst.
The possibility of an increase in rates “does concern us in terms of valuations,” he acknowledges, adding, however, that in so-called gateway cities such as Washington DC and San Francisco he expects prices to stay high “for the foreseeable future”.
Corporate debt markets are also simmering. There has been $568bn of investment grade bond issuance by US companies already this year, smashing previous records for the same period, as treasurers have rushed to lock-in cheap funding ahead of any interest rate rise, or to finance many of this year’s mammoth merger and acquisition deals.
More than $211bn of junk bonds have been sold so far in 2015, and there has been more than $200bn of issuance for the first eight months of the year for every single year since 2011. Even in 2007, at the peak of the pre-crisis credit bubble, there was only $115bn of junk bond issuance over the same period.
Jeremy Stein, a former Fed governor now at Harvard University, says that the Federal Open Market Committee, the body that implements Fed monetary policy, made the right call in pursuing its ultra-low rates policy at a time when unemployment was at punishing levels of more than 8 per cent.
“However, it was not riskless,” he cautions. “When you push up asset prices and compress credit spreads, that comes with an inherent downside in terms of financial stability risks. At some point risk premia may bounce back up again, which could create a mild recession down the road.”
Recently, tempestuous moves in the financial markets associated with worries about Chinese growth have given the central bank pause as it contemplates a rate increase at its September meeting. Charles Plosser, the former president of the Philadelphia Fed, says the central bank needs to make sure it does not look too beholden to financial markets.
“The more the FOMC or the chair talks about asset prices, the more they give the impression that asset prices are something we care about and will react to. This is a bad place for a central bank to find itself,” he says.
Mr Plosser’s comments highlight a broader problem. Eight years after a financial crisis brought the world economy to the brink of collapse, and forced transatlantic governments to throw hundreds of billions of dollars at their banks to save them from imploding, central bankers are no wiser about what mixture of monetary, fiscal and financial market regulatory policy can best assure stable long-term growth.
The old theoretical and practical approach of targeting inflation failed in the years leading up to 2007-09 in part because it ignored asset price inflation. But today, low levels of inflation in goods markets are encouraging policymakers to hold back on raising interest rates even as some asset price valuations are high.
No one needs reminding of the power at the Fed’s disposal. Memories are still relatively fresh of how Paul Volcker, the former Fed chairman, triggered a recession in the early 1980s to defeat inflation.
Once again, the fate of the global economy rests on the judgment of a few individuals without reliable economic models to guide them.
Additional reporting by Robin Wigglesworth