Can the US Fed get out of this one?

us federal reserve interest rates

The US Federal Reserve has left the interest rates unchanged at 1% to 1.25%. No surprise there.

The thing is, there is something not quite right in the US economy, so the Fed is hesitant to make any sudden moves.

While unemployment has stayed low in recent months, salaries are not growing at 4.4% inflation. Inflation was at 1.4% in July, much lower than the Fed´s 2% long term objective.

What’s causing this?

According to the US Federal Reserve Janet Yellen (emphasis mine):

However, we believe this year’s shortfall in inflation primarily reflects developments that are largely unrelated to broader economic conditions. For example, one-off reductions earlier this year in certain categories of prices such as wireless telephone services are currently holding down inflation, but these effects should be transitory.

Erm…mobile phone plans?

We have heard every possible explanation, mobile phone plans…globalization…Eastern Europe workers joining the workforce…

The truth is that nobody really knows why inflation is not picking up. Or why employment has been increasing but the line of pay has stayed the same.

You see, when unemployment decreases, companies struggle to find workers, as the pool of employees to choose from decreases. So companies increase salaries to attract more people into the workforce, which in turn, fuels inflation and salaries.

The explanation that rings truer to me is that there are not enough jobs in the economy to employ workers at their full earning potential.

What I mean by this, is that people are taking on part time employment or lower skilled jobs to make ends meet since they cannot find a full time job that matches their skill set.

According to research from The Washington Center for Equitable (WCE) between 2000–2014, employment growth for college educated workers has increased much faster in lower-paying industries than in higher-paying ones.

Statistics count these people as ‘employed’ even though they are on temporary jobs, not working at their full potential skill set.

Yellen gave some indication of this in her remarks:

Participation in the labor force has changed little, both recently and over the past four years. Given the underlying downward trend in participation stemming largely from the aging of the U.S. population, a relatively steady participation rate is a further sign of improving conditions in the labor market. We expect that the job market will strengthen somewhat further.’

That is, baby boomers are retiring later, which will affect employment opportunities for younger generations.

And the Fed is not expecting things to change much in the future.

According to the release, they expect that it will take two more years to hit their inflation target. Meanwhile growth will decrease from 2.4% this year, to 1.8% by 2020.

Interest Rates to Stay Low

The Fed is planning to keep interest rates low for a while:

Even so, the Committee continues to anticipate that the longer-run neutral level of the federal funds rate is likely to remain below levels that prevailed in previous decades.

The Fed also took the opportunity to make another unsurprising announcement. They will start unwinding their balance sheet in a ‘gradual and predictable manner’.

The Fed currently holds a whopping US$4.5 trillion in their balance sheet — a third of US’s 2016 GDP. No central bank has ever held a balance sheet so high…

To produce the recent ‘recovery’ since 2008 the Fed has gone on a buying spree. Cheap money has propped up asset prices like stocks, bonds and real estate. Long term low interest rates have allowed leveraged households to refinance their debts and to keep spending future earnings today.

All at the expense of growth, salaries and savers.

And meanwhile, there is no sign of inflation.

The thing is, no central bank has ever tried to clear out that amount of money.

How much will the Fed unwind?

To reach levels prior to 2008 — around US$900 billion — they would have to unwind five times the amount they currently own. That is US$3.6 trillion in assets…a lot of assets.

The other concern is, who will be left to the task of pulling off this unprecedented experiment?

The Fed is emptying. Recently, Federal Reserve Vice Chairman Stanley Fisher resigned, leaving four out of seven chairs empty. Yellen´s term expires in February, with the decision to reappoint her coming in the next few months. Things could look very different in the next few months.

For now, markets have faith the Fed will succeed. After the announcement, the Dow and the S&P closed at record highs.

If they succeed, central banks around the world will follow. If they fail…well, things could go unbelievably wrong.

PS: If you are interested in finding out how a global crisis could affect the Australian economy, editor Vern Gowdie has prepared three possible scenarios. You can read more about them here.

Regards,

Selva Freigedo

Selva Freigedo

Selva Freigedo

Selva Freigedo is an analyst with a background in financial economics. Born and raised in Argentina, she has also lived in Brazil, the US and Spain.

She has seen economic troubles firsthand, from economic booms to collapses and the ravaging effects of hyperinflation, high unemployment, deposit freezes and debt default

Selva Freigedo

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