Sir, Lawrence Summers raises an important questions related to the Federal Reserve’s exit policy at a time when economic data are diverging (“ Only raise rates when the whites of inflation’s eyes are visible”, February 9). He specifically favours a wait-and-see approach for the first rate increase, essentially to ensure that Fed action does not choke off the recovery. Others argue that the economic data are strong enough to justify a rise sooner rather than later, and this not least because the current ultra-accommodative policy stance is helping fuel unhealthy asset price bubbles.
Both arguments are compelling and at face value they point to very different policy responses. A better approach however, might be for the Federal Open Market Committee and other central banks in similar positions to test the water with a smaller than usual rate increase, say 5-10 basis points instead of the standard 25-50bp. There are several advantages to this.
First, a different rate-raising strategy will signal to the markets that this first increase is not necessarily a trigger for a series, as was the case in past tightening cycles. A signal such as this may well prevent a repeat of the 1994 experience when US long-term bonds sold off aggressively in response to policy rate rises, which then led to an economic slowdown and a subsequent reversal in Fed policy.
Second, there is nothing to stop the central bank from speeding up the rate-increase cycle should economic data strengthen and the financial market response remain benign. Equally, the central bank will barely suffer any credibility loss should this tiptoe strategy derail the recovery and the Fed is required to reverse the rate increase.
Third, historically the typical size of the rise/cut has depended on the level of the policy rate. For example, in the 1970s and 80s when the policy rate was high, the change in the policy rate was significantly larger than the 25-50bp that has come to characterise action for most of the past 20 years. With the level now tantalisingly close to zero, history prescribes a smaller than usual rate increase.
Surbiton, Surrey, UK
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