Fed Holds Rates Steady in Bid for Credibility

Yesterday, the Fed’s Open Market Committee released its decision on US interest rates. Despite the fact that the Dow is off 10% year to date, the S&P 500 and NASDAQ are off by slightly less, the Fed has decided that rates will stay right where they are. The Fed Funds rate was raised 25 basis points last month to 0.50%. If the market moves over the last month are anything by which to go, the increase was pure error. The Fed should reduce rates again (and encourage fiscal stimulus across the global economy), but that would require the central bank to admit it got things wrong. It prefers to retain a shred of credibility through stubbornness to implementing the correct policy.

The Fed’s insiders say that the market can still expect an economy with moderate growth and a strengthening labor market. Along with that are prospects for “gradual” rate increases from here. Indeed, there is still a chance of a further rate increase in March.

The Fed said in its policy statement following a two-day meeting, “The committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation.” In addition, it dropped language from the previous statement regarding a “balanced” economic outlook.

Taking the positive view of the FOMC decision, Joe Manimbo, an analyst at Western Union Business Solutions, stated for Reuters, “The Fed has maintained its composure in the face of global pressures.” A less charitable wording would have called the Fed stubborn or perhaps bloody-minded, but the fact remains that the Fed has chosen to stay the course.

However, it is certain that the members of the committee are feeling less certain than they were before Christmas.”It is clear that several FOMC members have become more worried,” said Harm Bandholz, an economist at Unicredit in New York. Mike Whitney at Counterpunch stated, “The Fed has wasted the last seven years trying to reinvent the wheel when the solution was always right under its nose. Are we really going to waste another seven implementing the same failed strategy?” He argues cogently that Lord Keynes was right about fiscal policy being vital here, “you can’t pull the economy out of a severe slump by tinkering with interest rates or pumping up bank reserves. It doesn’t work. What’s needed is ‘good old fashion’ fiscal stimulus mainlined into the economy through ambitious federal infrastructure programs . . . .”

The slowdown in China, the collapse of oil prices, the race to the bottom in the currency wars all add up to a diagnosis that the global economy is not as strong as the Fed thinks (or perhaps thought given the recent market actions might have wised the central bank up). Reversing course when one is stuck in the big muddy only makes sense. However, Art Cashin of UBS told CNBC “They [the FOMC] don’t want to yield too much and say, ‘Yes, you’re right, we were wrong,’ he said. “They’re going to fight to maintain what they think is their credibility.”

There would be a heavy cost to such a reversal so soon after a hike. Wall Street would lose any faith it still has in the Fed’s ability to manage monetary policy. That would take some time to restore. Nevertheless, the Fed’s hike in December was a mistake, and one doesn’t recover from a mistaken move by denying that it was wrong.

In the end, however, a huge opportunity to fix things for a generation or two is slipping through the world’s fingers. With interest rates at near zero, massive infrastructure spending project as Mr. Whitney suggests will never be cheaper, and the multiplier effect on making the backbone of the global economy more efficient will be huge. The world’s unemployed and its poor are now the victims of timid politicians who fear to build. Their knowledge of the costs is interfering with understanding the value of it all.