Taking a risk

The US Federal Reserve is taking a risk.  Yesterday the Fed’s Monetary Policy Committee raised its so-called ‘policy’ interest rate that sets the floor for all interest rates for borrowing in the US and often overseas.  This means the cost of borrowing to spend in the shops or to invest in business expansion will rise.

Sure the increase was only 25bp (0.25%), from 1% to 1.25% but the Fed clearly intends to continue with further hikes (up to a target of 3% eventually). It has already stopped its quantitative easing programme (boosting bank reserves).

and now it is raising the price of money as well as reducing the quantity available.  Money is getting ‘tighter’ to get.

The Fed is doing this because it believes (or hopes) that the US economy is now set on a sustained acceleration of real GDP growth back to the trend levels of 3%-plus seen before the Great Recession.  The Long Depression, at least in the US, is over, according to the Fed.

But there are indicators in the US economy that the Fed has got it wrong.  First, the Fed thinks that price inflation in the shops and for household services will eventually average 2%-plus a year and so it needs to raise rates to control rising inflation.  And yet the very latest figures for inflation released this week show that it is slowing down, not accelerating.  In April, US personal consumer inflation dropped back to 1.7% a year (core inflation is just 1.5%), with three months of little or no rise.  Although the labour market is ‘tight’ with the unemployment rate very low, there is little or no acceleration in wage rises and consumer spending is weak.

This is very much against the traditional Keynesian economic thinking that tight labour markets lead to rising wages and inflation, in the so-called Phillips curve. The trade-off between low unemployment and rising inflation was exposed as wrong in the 1970s when capitalist economies had both high unemployment and inflation: stagflation. Now the Fed faces low unemployment and low inflation: ’secular stagnation’?  The Phillips curve is not operating.

The Fed committee is ignoring the low inflation data and instead is emphasising the proposed pick-up in US economic growth that is to come.  Yet the latest real GDP data do not justify that optimism.  In the first quarter of 2017, annual real GDP growth was just 1.2%.  Most forecasts for the current quarter (April-June) suggest a annualised growth rate of 2.5%.  That means in the first half of the year, the US economy would be growing at around 1.8% a year, actually slower than in 2016.

The Fed is forecasting 2.2% for the whole of 2017 – hardly matching pre-crash growth rates.  But even reaching that would require an annual growth rate of 2.6% for the second half of 2017.  Indeed, the Fed expects a growth rate of only 2.1% next year and 1.9% in 2019, with a long-term growth rate of only 1.8%.  This is hardly Trump-type projections of 3-4% a year that Trump claims he can achieve. Indeed, as John Ross shows in an excellent post, US capitalism has consistently shown a declining trend in growth rates, particularly in the 21st century. And that is due to the slowdown in business investment.

All this assumes no new recession before 2020.  And that is the risk. Hiking the cost of borrowing when the economy is only growing moderately and inflation is low will put pressure on corporate debtors, causing a new reduction in investment and even bankruptcies. US corporate debt has never been higher as companies have piled up bonds and loans at very low rates of interest.  Rising costs of borrowing could begin to turn the boom into bust.

Some Keynesians reckon the Fed should change its target for inflation to 4% so its policy rate would not be hiked until inflation reaches that level.  Others say that letting inflation rise to that level and keeping interest rates low for much longer would create a huge financial credit bubble that could be uncontrollable as the economy accelerates.  In other words, mainstream economics is flying blind, unsure what to do.

When the Fed started its hiking plan last December, I warned that the Fed was taking a risk that, given weak business investment, hiking interest rates might push a layer of US companies into difficulty and trigger a new recession or slump.  Indeed, that was why the Fed held off further hikes for a while.  But now it is taking a further leap into the unknown.

It’s true that, after falling in most of 2016, US corporate profits recovered a little towards the end of 2017.  But corporate profits fell back again in Q1 2017, although they were up 3.7% from a year ago. But only including financial sector gains: non-financial sector profits were down on the year.

Globally, corporate profits have also picked up.  Investment bank JP Morgan now follows closely the connection between global corporate profits and business investment (at least one set of mainstream economists who recognise the importance of profit in capitalist economies!).  Readers of this blog will know that there is a close connection between profits, investment and growth in capitalist economies.  JPM finds that global profits are now rising at 5% a year and thus project a similar rise in investment and growth.  So maybe the improvement in profits, investment and growth in Japan and Europe will compensate for the continued weakness in the US.  We shall see.

Moreover, the interest rate set in the US also drives interest rates globally, given the powerful role of US capital.  There has been no real reduction in the build-up of private-sector debt in the major economies that took place in the early 2000s and culminated in the global credit crunch of 2007. That accumulated debt took place against a backdrop of favourable borrowing conditions—low interest rates and easy credit. Between 2000 and 2007, the ratio of global private-sector debt to GDP surged from about 140% to 163%, according to the IMF.

In the emerging economies, after the Great Recession the increase in private sector debt has been massive. Most of this extra debt is the result of corporations in these countries borrowing more to increase investment, but often in unproductive areas like property and finance.  And much of this extra borrowing was done in dollars.  So the Fed’s move to raise the cost of borrowing dollars will feed through to these corporate debts.   The relative recovery in global corporate profits and economic activity in the last part of 2016 may not last through 2017.