CFR experts Robert Kahn and Benn Steil discuss whether the Federal Reserve made the right decision in not changing interest rates. Along with the presider, Michael Levi, the speakers discussed the unusual role that international developments are now playing in determining Fed policy.
LEVI: Thank you. Good morning, everyone. I’m delighted to welcome you to this morning’s call on the Federal Reserve’s interest rate position that came yesterday, and in particular to dive into its international drivers and international consequences. This is an on-the-record call, and I am very happy to be joined for it by two colleagues who are true experts in this area.
Benn Steil is senior fellow and director of international economics at the Council on Foreign Relations. He is editor of International Finance. His latest book, if you haven’t heard of it you haven’t been reading any newspapers or book reviews for the last year or two. His latest book is “The Battle of Bretton Wood: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order,” which has received an extraordinary number of awards. He also writes the Council’s geographic economic blog which has often weighed in on these sorts of issues that we’re going to be talking about today.
Rob Kahn is the Steven Tananbaum senior fellow for international economics at the Council on Foreign Relations. He has a wide range of experience in the—in public sector institutions and in private markets. He writes the Macro and Markets blog here at CFR, which also often tackles these issues. He also addresses them often in Global Economics Monthly, which you can subscribe to. He was at one point in his career a senior economist at the Federal Reserve Board as well.
So why don’t we start with the obvious? To each of you—first Benn then Rob—did they get this right?
STEIL: Yeah, I think they definitely got it right. I think the downside risks in the economy right now are far more serious than the upside ones. China market turmoil, in particular, I think has the potential to be a major drag on the international economy going forward, while on the flipside there are very few signs of the economy in any sense imminently overheating. All measures of inflation look extremely tame. There’s some reason to believe that we may even see disinflation in the coming months. There’s certainly a lot of forces pressing in that direction. They should emphasize that if the Fed had hiked, I think we would have had even more downside risk, because they would have been extremely reluctant going forward, if the economy softened, to lower rates back down to zero, admitting they were wrong. And I think that itself would have been a big problem. So this is the right decision.
LEVI: That’s interesting. Let me just push you a bit on that. So in principle, if I build an economic model it’s as easy to raise rates as to lower them, and vice versa. But what you’re saying is that the politics and the credibility piece of this actually make this asymmetric.
STEIL: Yeah, I think it’s—I wouldn’t say it’s feeding too much into Fed decision making. On the flipside, both Chair Yellen and New York Fed President Bill Dudley have signaled that when they do raise rates it’s likely to be what the markets are calling one and done. In other words, a small quarter point rise, after which we may sit pat for maybe even a half a year or more while the Fed sees how the markets digest that. Now, since Chair Yellen emphasized that the reason you do raise rates is because of signs of inflationary pressure, one and done really makes no sense. If inflationary pressures are real, then you need to react to them.
LEVI: All right, Rob. Right decision, wrong decision?
KAHN: Wrong decision, in my view. I think the economy is proceeding on the track the Fed expected, in some dimensions even better. The labor market’s doing quite well. And given the long and variable lags that monetary policy works on the economy, you have no alternative but to be forward-looking. In that regard, I think that if the Fed had yesterday moved 25 basis points, but at the same time—touching on what Benn emphasized—if at the same time the Fed had made very clear that they have—their intention and their expectation is to move very slowly to interest rates that are very low by historical standards, that would have actually I think in many ways have been stabilizing to the global economy and, more importantly, for the Fed participants for the U.S. economy as well. I still would have been an extraordinarily easy monetary policy that would have provided a great deal of support for the U.S. economy.
LEVI: So, Rob, you took—talked about the international implications. I want to pick up on this with both of you. Benn, you’ve written about the taper tantrum a couple years ago. In recent weeks, we’ve had debate where on one side there are being calls for delays because a rate rise could lead, in some people’s minds, to taper tantrum 2.0. Others, including some in emerging markets, have said the uncertainty is a dominant problem and a rate rise would have done away with that, and actually put them on more solid ground. I think to each of you, Rob and then Benn, how do you weigh that argument? How should policymakers be thinking—or how should analysts be thinking about the impact of these Fed decisions on the international economy, in particular on emerging markets?
KAHN: Well, it’s always a tough decision. But I’ll kick off, it’s a tough decision. The Fed has—should and does look how international factors weigh on the U.S. activity in terms of meeting its own mandate, right?
LEVI: But let’s set aside for a moment whether the Fed should pay attention to this or not. Just as an analyst, how would—what do you think—how do you think about what the consequences would be?
KAHN: Of? The—
LEVI: Of the different choices the Fed could make, yeah.
KAHN: Well, I am—I think you can argue it both ways. I mean, there certainly were some central banks around the world, including in emerging markets, that felt that the uncertainty associated with the debate over liftoff had actually become counterproductive. And so a first move could actually be stabilizing for global markets, as they face them. But certainly, you know, the counterargument that any tightening of U.S. monetary conditions and expectations of more is going to exacerbate a capital outflow, which, you know, is underway, has more room to go, and is obviously challenging for countries that had pretty weak policies. So it definitely forces these countries to assess whether the policies are adequate.
I think what we’ve seen over the last week is a very differentiated response by markets to these economies, depending on whether the assessment is their underlying policies are adequate or not, because ultimately that’s what they’ve got to address.
LEVI: And my sense, from your initial comments, is that you thought that the—that taking away some of the uncertainty, the benefit of that would outweigh any possible international response on the downside. (Inaudible)—but you seem to—
KAHN: Well, I think it’s the path of rates that’s far more important than—you know, the path of rates is far more important than rather the first rate hike is in September or December of not. And I think clarity about where we’re going and the like, as I think it should be more important to these guys.
LEVI: Benn, you’ve written and thought a lot about what the international fallout might be from different potential decisions. What’s your take?
STEIL: Yeah. I think it’s important to emphasize, first of all, that the Fed is not specifically interested in what happens in emerging markets for their own sake. Nice piece of evidence going back to October 2008, when the Fed had a rather animated discussion about whether to extend central bank swap lines to emerging markets. At the time, you could see that the FOMC was very much focused on the fact that the crisis was spreading globally, but that was not specifically what they were trying to prevent.
What they were trying to prevent was blowback into the United States. And they identified four countries, and only four countries, that they thought were systemically important to the United States. That is, if there were specific turmoil that forced those countries to find disruptive means of acquiring dollars, such as selling U.S. agency securities, that that could feed back into the U.S. markets, push up mortgage rates and hold back the economy. And they were determined to stop that.
Now, as to what’s going on in emerging markets now, I think it’s worth noting that we’ve already seen a slow-mo, you might call it a rate ruckus over the past few months as the markets have gotten, you know, worried about whether the Fed was going to tighten this month. And it’s basically the usual suspects, many of the same countries that were hit back in 2013, countries with large current account deficits. And had the Fed raised yesterday, I do think there would have been even more of a market reaction.
Having said that, going forward, I think—
LEVI: Benn, what are some of those countries that you have in mind?
STEIL: Well, the ones that were hit by far the hardest in 2013 were Ukraine, naturally, Turkey, Indonesia, Colombia, Brazil, South Africa, Peru. A number of these countries are still on the firing line today. I should note that there’s been very, very little improvement in current account balances in most of these countries since 2013. So in that regard, they’re still vulnerable. There is one factor, though, that I haven’t seen getting any attention, that I think is significant going forward, that weighs against this notion that there should be a rate ruckus if and when the Fed decides to start hiking.
And that is that over the course of the next two years, the ECB and the BOJ are actually set to inject more liquidity into the global economy—about $2.5 trillion worth—than the big three central banks injected combined over any two-year period since the beginning of the crisis back in 2007, 2008. And there’s no reason to believe that investors who are displaced by ECB or BOJ asset purchases will be any less likely than investors displaced by Fed asset purchases to put their money in emerging markets. So there’ll still be plenty of global liquidity out there.
LEVI: I’m curious, you touched on Fed—Rob, you wanted to follow up on that.
KAHN: Yeah, can I just follow up? So what—the way I tend to—if I wanted to put the countries Benn’s mentioning into kind of boxes, and starting from the idea that China is patient zero to the shock we’ve seen over the last month, right, that we’re looking at a transmission shock that’s coming from China originally and passing through emerging markets. You know, you have a set of countries that have—where there are concerns about policy, they are commodity exporters being badly hit by the price shocks that China has catalogued. And there obviously countries like Brazil and Turkey should be pretty high on your list, maybe South Africa, some of the countries in Southeast Asia that are big commodity exporters.
But you also have a set of countries that have strong financial linkages to China, to emerging markets more generally, and perhaps, as legacy of the financial crisis and other—and cheap interest rates, have a lot of leverage in the private sector. And I think in Southeast Asia in particular this idea of high, private corporate leverage being a source of vulnerability if this shock reduces growth prospects and profitability longer term. I think that is transmission mechanism that we’ve got to be watching pretty closely.
LEVI: All right, let’s—China keeps coming up, for very good reason. Let’s talk about that a bit. Certainly the narrative the last several weeks has focused on uncertainty in China and what that means for the broader global economy. To each of you, maybe starting with Rob and then Benn, how prominently do you think China figures in the decision that was just made, and how prominently do you think China will figure in—either directly or indirectly—in the decisions or non-decisions that we see in the coming months?
KAHN: Well, I think China’s most of the story, even though, as I said, it plays through EM. We knew about the yuan vulnerabilities at the time of the June meeting, and yet it wasn’t an inhibition to suggesting the possibility of a move in September. I think that the tension here on China is if you look at actually the macro shock that manifest over the last month, what did we see? We see something like a 3 percent movement of the renminbi against the dollar, which is miniscule.
We can all debate what Chinese growth was before the shock. Most people have marked down their growth estimate, you know, ½ to 1 percent. So if you were at 5 percent before you went to 4. If you were at 4, maybe you went over to 3 ½ or something like that. If you take a macro model of the U.S. economy and you take a 3 percent renminbi depreciation and ½ to 1 percent reduction in Chinese growth, the effects on the U.S. economy are miniscule. You’re talking about a tenth of a percent over a couple of quarters. It can’t explain the market reaction and it certainly can’t explain that decision yesterday.
So if we take the Fed’s statement and Chair Yellen’s press conference at her word, that this did weigh heavily in this decision, then you either have to say we’re—you know, this is very early days of a Chinese crisis that’s going to get much worse, or that the contagion through to the emerging markets is likely to be far more destructive, because obviously if their response to that is depreciation and growth prospects fall, then you get a trade-weighted dollar move. And you get a global growth move that you could plug into a U.S. model and say this is material enough to delay a decision. But it’s all very much perspective. And I don’t see it going—that kind of uncertainty being resolved any time soon.
STEIL: Well, empirically, I think it’s very clear that China did weigh heavily on the Fed’s decision yesterday. Chair Yellen certainly emphasized it, first and foremost, in her comments about international developments. China figures very heavily in the most recent Fed so-called beige book on economic indicators. So, rightly or wrongly, there’s clearly a lot of focus within the Fed on China. My personal view is that it’s justified—although China represents about 1 percent of U.S. exports, it’s not that significant. I think the potential contagion effect, particularly though emerging markets but even though developed markets in Europe, are potentially quite significant in the United States.
Now, when you talk about what China’s growth rate might be going forward, remember in the short term the Chinese government can make that growth rate whatever it wants, just by continuing to press on with the excessive levels of investment. The problem with that is I think that the markets have realized that the Chinese government is not going to be able to orchestrate unlimited 7 percent growth rates going forward. And that’s really been reflected in market turmoil. So I think the focus on China is really justified right now.
LEVI: So a question to both of you. You both focused on how China feeds through into U.S. growth. How about the feed-through into the inflation picture, which is obviously significant in how the Fed makes its decisions? Does that look any different or is the analysis essentially the same? To either of you.
STEIL: So I’ll go first. You know, no doubt the trade weighted—to the extent that China and the action elsewhere contributes to a further appreciation of the dollar on trade-weighted terms, that’s a deflationary shock. Now, of course, we’ve already had a pretty big run-up in the dollar last year, mainly because of Europe not because of China. The lags are pretty long in terms of how that feeds through to the U.S. economy. It takes time. So we already have some pipeline effects that are deflationary from that. If you did get a significant additional trade-weighted move, I get the point that it’s nominally deflationary, but it would—could last for a while.
But it is—it is interesting in the sense that if you think about the channels through which a China shock does bring about deflation, and part of it is the dollar. Part of it, of course, directly is through commodity prices. And you know, we in the—like energy—and in the past we’ve sort of taken the view that these type of moves are transitory, cannot have lasting effects on inflationary expectations, and the Fed should look through that. And so there is a bit of a tension, in that much of the conventional wisdom about Fed policymaking is that these kind of shocks really shouldn’t be—shouldn’t weigh heavily on their decision, because they tend to be one-off. But certainly we heard, I think, a mixed story from Janet Yellen yesterday on that.
KAHN: Looking forward, I think all the price pressures coming from abroad right now are in a downward direction. And indeed, if you listen to FOMC members talking about where upward pressures might come from, they’re almost entirely domestic, having to do with the labor market. And they should emphasize that we’re not really seeing a labor—upward labor market pressure on prices yet in the United States. Of course, Chair Yellen has emphasized that we’re getting closer to what the Fed would consider to be full employment. But the so-called Phillips curve, which relates the unemployment level to inflation, is notoriously unstable. Plus, we have the—a factor that has to feed into the Fed’s thinking here of the labor market participation rate being considerably lower than it was before the crisis. So we’re really not seeing heavy upside pressure on prices right now, which feeds back into my first comment. I don’t—I don’t see any basis on which the Fed should have been deciding to go forward with a rate hike yesterday.
LEVI: So it’s striking, we’re talking a lot about international dimensions. That’s probably because this is a Council on Foreign Relations call, but it’s partly because that’s very prominent in the broader environment. And the press release yesterday and the press conference talked a lot about international factors. How unusual is that historically? Both of you have been looking at the Fed for a long time. Rob and then Benn, is this unusual? And if it is unusual, is it a sort of temporary thing or is this the new way of—or the new world of monetary policy?
KAHN: Well, I’ll also defer to Benn’s historical knowledge on this. But to me, yesterday’s press conference was striking in the heavy emphasis that was placed on international factors. Obviously in a time of great crisis—for example, 2008—international factors are going to be at the center of everyone’s mind, but we’re not in that kind of environment now. And the—and the idea that in—at times when the U.S. economy is essentially doing pretty well that a range of international shocks would impart a more-than-offsetting deflationary effect in terms of their calculation, to my mind, was quite unusual.
And as—and as I mentioned earlier, I mean, my concern with that is that a lot of these international shocks take a long time to resolve and play out. And so if it’s a reason for not moving now, when will it not be a reason for moving? I’m not entirely sure. I think China’s with us for a long time. I can list—you know, here at the Council we spend a lot of time thinking about the next round of risks, be they Greece election and program negotiations, or Catalonian elections, or migration crisis, and the like. We have a debt limit problem here at home. So once—but once you start taking these international shocks in a qualitative sense as a—as a significant risk, it’s very hard to turn that off.
So, to me, the Fed has understandably, for the reasons Benn mentioned, historically been very cautious about giving heavy weight to international factors in normal times. And to me, yesterday was a pretty significant change.
STEIL: I agree with—
LEVI: Benn, you have great historical knowledge here.
STEIL: Well, I agree with Rob that, historically, it was striking yesterday how much emphasis was given to international factors. But I don’t think that’s in any way a reflection of new thinking within the Fed. I think it’s just an accurate reflection of what’s going on in the current environment.
If you looked at the United States as a—as a sort of domestic bubble, you don’t really get terribly much information that would push you in one direction or the other. Growth is moderate. We don’t see any signs that the economy is really accelerating, nor do we see signs that it’s headed back to recession. Inflation, very moderate, no heavy pressures in one direction or the other. The labor market has certainly been improving, but again, you have the factor of the abnormally low labor force participation rate. So the domestic economy really doesn’t tell you very much right now.
Having said that, when you look outside the borders of the United States, what you see is all disinflationary pressures. And so I think that rightly weighed into the Fed’s decision going forward that we want to wait a bit and see how these factors play out, because the risks of waiting right now in terms of the—for example, the U.S. economy overheating or inflationary pressures building very rapidly are very, very low.
KAHN: And, Michael, can I jump in? And maybe this is a question to Benn; I know that breaks the rules a bit.
LEVI: By all means.
KAHN: But let me just follow up, kind of, on what the world looks like in that environment. Because if we’re in an environment now where we’re saying that because of those deflationary pressures—and particularly the exchange rate as being an important channel that’s long-lasting, right, so it can’t be dismissed like a temporary energy shock, that—something that needs to be kind of given weight—if we’re in an environment where markets are now going to expect that any time we get a big run-up in the dollar we’re going to see markets push back the expected date of liftoff for exactly the reasons Benn just mentioned, what does that do to Japan and ECB and the others? Because, as you mentioned earlier, we expect more QE from those countries, or extensions of their program, in the coming months. We expect them to try to stimulate. And we—and we know that the exchange rate’s one of the main mechanisms through which their economies are affected. What is it—I mean, it would be interesting—I’m interested in knowing what Benn thinks, both about what it means for how monetary policies interact and policies coordinate, you know, and generally how the global economy’s going to work in a world where, in a sense, we may be—markets may think we’re turning off the exchange rate as an adjustment tool.
STEIL: Yeah, I think that’s a—that’s a great question. I think the ECB is naturally going to look, after the Fed’s decision yesterday and the market’s reaction, and say we need to keep the pedal to the metal. And the Bank of Japan, as well, I think they’re going to want to see more downward pressure on the yen. So we may very well see more QE out of both Japan and the eurozone.
Now, what concerns could come out of that? Well, you’ve got all this talk of a renewed so-called currency war. But we have to—I think we have to be clear what currency war actually means. If countries around the world are all trying to stimulate their economies through a lower exchange rate, that in and of itself is not destructive. What’s potentially destructive is what they do if they’re not able to achieve a lower exchange rate. If they then turn to trade protectionism, then we have a genuine problem for the global economy. And I think that’s something potentially to worry about down the road, but I don’t think it’s an imminent political problem.
LEVI: That would be a fascinating thread to follow down.
So we were talking about the macro economy. Another piece of this discussion has been financial market risk. And there was a—there was a current I saw before that rates needed to start to rise in order to deter excessive risk-taking. In recent weeks, the argument has almost been turned on its head, and people have started to argue that the prospect of the rate rise is leading to all sorts of risk-aversion in financial markets and that the Fed ought not pile onto that. Maybe starting with Benn, how do you—how do you think about the—about the financial risk piece of this equation?
STEIL: You know, that might have been the strongest argument to start thinking about raising rates if you go back, say, to the spring. You know, the stock market is booming, volatility as measured by the VIX, for example, is extremely low. In fact, the Fed has in the past expressed concern about abnormally low levels of volatility. They view it as a—as a sign of complacency in the market. But that’s all gone now. The stock market has taken a big step back, of course. It’s taken another step back so far today. Volatility is right back on the table. I don’t think there’s a strong case in terms of preventing overheating in asset markets for raising rates right now.
LEVI: Rob, what’s your take?
KAHN: Yeah, I agree with Benn on that.
LEVI: So you’ve all been—Benn, Rob, you’ve been analyzing, and now I want you to turn to your crystal balls and each tell us what you think is the most likely policy path over the coming, let’s say, four months. Benn?
STEIL: At the beginning of the year, I was in the minority thinking that it was more rather than less likely that we’d see the first rate hike in early 2016. I think on the basis of what we saw yesterday I would stick with that. There is clearly significant support within the Fed for moving forward with a rate hike.
Having said that, I think it’s notable that there was only one dissent yesterday, from Jeffrey Lacker. That means that the chair is still keeping the group together, and that right now the more dovish forces are still predominant.
Now, if going forward over the next few months we see continued weakness from China, I think the case for raising rates this year will, in fact, weaken. And so, if I were a betting man, I would bet on early 2016.
LEVI: And, Benn, as you look out at that, am I right to infer that your greater source of uncertainty comes from the state of the broader economy rather than from uncertainty over how the—how the committee is actually translating that into policy?
STEIL: Can you express the second part again? What was the—was the second part? I was—
LEVI: So one way to be uncertain is to say we don’t know what the data is going to be and so we don’t know what the decision will be. The other is to say we do know what the data will be, but we don’t know how the Fed will actually act on that data.
STEIL: Right. I think both factors, clearly, weigh into this.
There are—the FOMC is a committee of human beings that have very different perspectives on the numbers and on which things we should be focusing on, I think. In fact, I think that’s been one of the problems with monetary policy over the past year, that it’s no longer clear what touchstone the Fed is actually using to decide whether to raise rates.
But on the other side, there really is genuine uncertainty about where the international economy is headed right now. And given those uncertainties, you have to ask whether the risks are primarily on the upside or primarily on the downside. And as I’ve argued so far, I think they’re primarily on the downside, and that weighs in favor of waiting on the first rate hike.
LEVI: Rob, you get the last—you get the last word here. And again, what does your crystal ball say? And where—what are the sources of cloudiness in it?
KAHN: Yeah, well, my crystal ball’s pretty cloudy. I suppose, based on yesterday, I’d have to say the chances of a rate hike this year are, at best, 50 percent. Part of it is, as I have argued before, simply my expectation that the world is a dangerous place and the uncertainties we’ve been talking about today are unlikely to resolve themselves in the next couple of months—and, if anything, we may have new risks to add on, too.
And partly, I think it may be an inherent, almost conservative bias that comes from this data dependency that Benn’s touched on. In a world where we don’t—we don’t really have great confidence in the Phillips curve and our other macroeconomic models, you know, we end up kind of looking at everything that’s coming up and using them as excuses to wait. And I think that that will tend to push, all else equal, a Fed that is divided to put off to the last possible minute. But then, of course, the risk is that policy then is reacting to an inflationary pressure that finally does emerge.
STEIL: Can I throw one more idea into the mix, Michael? And this is a kind of radical one.
I would argue that it’s at least as important as what the Fed does how the Fed communicates what touchstones it’s using, what’s driving them. You can actually get Fed decisions moving in the same direction from different principles. And I think one of the problems that the market is having right now is that they can’t discern a guiding principle anymore that the Fed is using.
Chair Yellen continues to emphasize the inflation target framework, the 2 percent target. But if you listen to the comments of FOMC members, it’s not clear that they’re all really focusing on that. A lot of them focus on the performance of the labor market. A lot of them focus on financial market indicators. I think we could get very similar policies using very different principles that might have a more stabilizing effect on the market.
For example, there have been proposals—as you know, Michael—to guide monetary policy with so-called NGDP targeting, targeting nominal growth domestic product. And if you—we had done that in recent years, you would have seen a similar trajectory of Fed policy. But I think if the markets knew that something tangible, something clear that they could see was guiding Fed policy, that that itself would be stabilizing going forward.
Don’t know what Rob thinks about that.
LEVI: Well, I think we’re at—we’re at the line where we need to wrap this call up. But we at the Council on Foreign Relations are always known for our radical proposals, and I think this will be an important line to dig down into at a future date.
I want to thank everyone for joining this call. I invite you to go to the Council on Foreign Relations website—www.cfr.org/CGS—to get more on these issues and others on the international economy from Rob and Benn and other scholars here. Thank you, everyone, for joining the call. Thank you, Rob and Benn, for your time and for your insights.