JOHN MASON: The responsibilities of the Fed


Well, it looks as if the Federal Reserve System has sufficient justification for another increase in its policy rate of interest this month.

The markets are saying that the probability that the Fed will move again is quite high.

And, with Tuesdays release on US factory activity coming in so strong, analysts continue to receive signs that the American economy will continue along showing even further growth.

The Institute for Supply Management announced that its manufacturers index increased in August to 61.3, the highest level achieved since May 2004. Economists surveyed by The Wall Street Journal had expected only a 57.5 number to be released for August.

The US economy grew at a 2.8 percent rate of growth, year-over-year, in the second quarter of 2018, and with all the new information coming in, economists have the expectation that the economy will grow even faster, year-over-year, in the third quarter.

This strength just adds further support to the belief that the Fed will go ahead in September and raise its policy rate once againand, its adds fuel to the argument that another rate increase will take place in December.

Furthermore, this strength points to the fact that the economies of the other major nations are not doing nearly that well.

Whereas up until early this year, it appeared that the economies of the eurozone were tracking the growth rates being posted by the United States, it has become apparent that this is no longer the case.

And, with the European Central Bank holding off terminating its quantitative easing program until the end of this year, interest rates in the United Stats and Europe will be heading in different directions.

In particular, the economic policies being implemented by the new populist coalition government in Italy seems to be threatening the whole European Union and with the failure of the leadership in England to build a functional Brexit, the Euro and the British Pound face weak futures unless something happens to turn things around.

And, if you want to look further for trouble, look no further than the emerging nations. Many of these countries have recently gone into a tail-spin due to the stronger US dollar and the impacts it has had on their dollar-denominated debt.

A stronger dollar will not do these countries well.

But, I believe that a stronger dollar is in store for the world.

The reason for this conclusion is that I believe that the US economy will continue to grow relative to other advanced countries and will maintain its lead over these other countries in terms of overseeing interest rates in the United States returning to more normal levels.

During the Great Recession, the Federal Reserve System moved faster than other central banks to provide liquidity, not only to the United States, but to other major countries in the world.

The Bank of England and the European Central Bank got on board with their own kind of quantitative easing later on in the game, but by then the Federal Reserve was way ahead of them.

This allowed the Federal Reserve to attempt to return to more normal levels of interest rates and reduce its securities portfolio to more normal levels, than the central banks elsewhere in the developed world.

In moving faster, the Fed flooded the world with US dollars. In flooding the world with US dollars, the Fed bailed out other countries and also allowed other countries to benefit from the flood of liquidity and historically low interest rates to buy themselves out of trouble by issuing truckloads of dollar-denominated debt.

In the process, the Federal Reserve became, de facto, the central bank of the world, something I have written about on View from the Peak.

The problem with this arrangement is that neither the Federal Reserve nor other central banks have much of a feeling for how this arrangement should work.

The Federal Reserve has done a pretty good job over the last few years, moving its policy rate of interest, incrementally, as the data seemed to support such a move. At the same time, Fed officials provided others with forward guidance to indicate to others what they were trying to do and over what time horizon they were working within.

The thing that didnt happen during this time period is that other central banksand nationsdid not perceive the impact that these Federal Reserve actions would have on their decisions.

For, example, when there were lots of US dollars around and world interest rates were extremely low, quite a few of the emerging market nations took advantage of these characteristics and issued lots and lots of dollar-denominated debt.

The assumption was that world markets would stay very liquid and the value of the US dollar would remain relatively weak because of the slow economic growth in the US and the fact that interest rates in the US would remain low to facilitate faster economic growth and to keep the dollar weak.

And, these emerging market nations stayed with this assumption because, for the short-run it supported their undisciplined budgets and because they did not feel the Fed officials could achieve their goals as stated in their efforts of forward guidance.

For this new system to work, however, both the Federal Reserve and other nations or central banks need to realize the position the Fed is now in.

First of all, the Federal Reserve must understand how its actions impact the rest-of-the-world. This does not mean that the Federal Reserve must divorce itself form achieving high employment and low inflation within the United States, as it is mandated to do. But, it does mean that its actions do need to take into account the situation that exists in other countries and the world, and, it needs to make sure that it improves its forward guidance capabilities so as to keep others informed in terms of what they might be facing.

Second, other nations and other central banks must take Federal Reserve guidance seriously and operate in a fashion that will benefit from Federal Reserve actions, but will not put their countries or their financial institutions into situations that will be hard to reverse ifand whenthe Federal Reserve achieves their objectives.

The world has become more global over the past fifty years, both in terms of trade and in terms of financial institutions and financial markets. In my view, that is the way the world is going to remain, in spite of the attempts of some to reverse this trend. I furthermore believe that a more global world is the best thing for the world and should be supported. But, it is a brand new world that we are all going to have to learn about, work with, and improve.


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