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Is a cautious Fed causing more harm than good?

Et tu, Janet?

As panic gripped many of the world's central banks in recent weeks, Janet Yellen's Federal Reserve appeared to remain calm. With the United States economy powering ahead, the Fed signalled that it was edging away from its emergency interest-rate setting. That struck many as the right thing to do. The U.S. economy has averaged an annual rate of growth of about 3 per cent since the middle of last year and the unemployment rate was 5.7 per cent in January. A benchmark interest rate of zero is no longer required.

The Fed's policy committee markedly upgraded its assessment of the economy at its last meeting at the end of January. That created the impression that the Fed was on track to raise interest rates by the middle of the year. It turns out that impression may be wrong. The Fed on Wednesday released the minutes of its January policy meeting. They reveal a hint of panic at the Fed, too. The data are positive, yet "many participants indicated that their assessment of the balance of risks associated with the timing of the beginning of policy normalization had inclined them toward keeping the federal funds rate at its effective lower bound for a longer time."

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A "longer time" could simply mean the months between January and June. But the U.S. dollar fell after the release of the minutes as traders bet – or at least hedged – that "a longer time" could mean a period beyond current expectations. The minutes also stated that "some" policy makers believe the time for liftoff from zero already has arrived. But in Fed speak, "many" is more than "some," suggesting the majority of policy makers are more worried about the prospects for short-term growth than they are about anything else.

Like Bank of Canada Governor Stephen Poloz, the Fed may be inclined to take out some insurance, and with its benchmark rate at zero, the Fed's way of doing it is to signal that money remain ultra-cheap for longer still. But one wonders about the psychological damage central banks could be causing by running crisis-era monetary policies in the absence of a crisis. Christine Lagarde calls it the "new mediocre." Mediocre is not a recession, yet the world's central banks are behaving like the sky is falling. What is an executive or an investor to do but take cover? "Who would be bold enough to make a long-term commitment in such an environment?" Stephen Lewis of ADM Investor Services International Ltd. stated earlier this month. In Sweden, Annika Winsth, chief economist at Nordea Bank, was particularly harsh of the Riksbank's recent attempt to help the economy. "Cutting the rate to negative and the bond purchases give the signal of being in a crisis, and Sweden's economy is not in a crisis," she said. And now the Fed, which oversees an economy that grew at an annual rate of 5 per cent in the third quarter, appears reluctant to return to normal. Ms. Yellen, the chair, risks hurting business confidence unless she can find a convincing way to persuade investors to spend in an economy so fragile that the Fed refuses to discharge it from the hospital.

There is another explanation. As Bloomberg News cheekily asked in a headline, what if Ms. Yellen has joined the currency wars? The minutes called the U.S. dollar's strength as "a persistent source of restraint" on exports. The U.S. dollar is at its highest level in a decade, hurting the profits of American corporations because the value of overseas sales is reduced when converted to their home currency. If the exchange rate is restraining the economy, then the Fed would have room to leave borrowing costs lower for longer. But while exports have become a more important part of the U.S. economy, they still equate to only about 13 per cent of GDP. Household consumption accounts for more than 70 per cent of GDP. A stronger dollar helps consumers by lowering the cost of imported goods and services.

Whatever the reason, any decision by the Fed to delay an interest rate increase can only be read as negative.

If the issue is the dollar, then the Fed is sending a terrible signal to the rest of the world. "Unless the Fed starts doing it, others aren't going to follow suit," Reserve Bank of India Governor Raghuram Rajan told Bloomberg in an interview earlier this month. "And the Fed, when it does that, will have to accept some appreciation of the dollar simply because it's the first one out of the box."

But if the issue simply is excessive caution, then the Fed may be causing more harm than good. We may have reached a point where higher interest rates boost the economy by sending a message to investors that it is okay to come out of their bunkers.

Kevin Carmichael is a senior fellow at the Centre for International Governance Innovation, based in Mumbai.

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