“We have to be sure that the recovery is final, that domestic demand is self-sustaining and the peak in unemployment is on the foreseeable horizon,” Dominique Strauss-Kahn, managing director of the IMF, said yesterday in London yesterday in connection with a speech he gave at a British industry conference.
The topic of discussion was the exit strategy, and the ever-topical question of when to begin retreating from the massive liquidity injections that remain the status quo in the global economy, particularly in the U.S. Straus-Kahn emphasized that “a premature exit is the main danger,” and that’s probably true. But the risk associated with keeping the stimulus running too hot for too long isn’t exactly chopped liver either.
Waiting for absolute certainty is waiting for the impossible in central banking. As we discussed last week, prescience is the stuff of dreams in a world where mortals manage monetary policy. Mistakes are inevitable, which implies that central bankers should hedge their bets if only slightly.
Should the Fed start hiking rates immediately by a large degree? No, but it’s time to begin the inexact science of sending a message to the crowd that the price of money will climb in the months and years ahead. A 25-basis-point increase in Fed funds wouldn’t derail the stimulus efforts but it would send a timely reminder of things to come.
The soaring price of gold suggests it’s time for a nudge upward in the price of money. A similar message arises from the internal discussions at the Fed these days. As discussed in the FOMC earlier this month, “members [of the Fed] noted the possibility that some negative side effects might result from the maintenance of very low short-term interest rates for an extended period, including the possibility that such a policy stance could lead to excessive risk-taking in financial markets or an unanchoring of inflation expectations.”
But while the Fed is on record as worrying about irrational exuberance and the possibility that the central bank might be promoting the next bubble, the official position is that such a risk is at present “relatively low.” And the Fed funds futures market is inclined to agree. Futures are priced in anticipation that the current 0-0.25% target rate will endure at least through next year’s first half.
That’s no surprise, of course. Central banks prefer to err on the side of inflation, modestly so if possible. It’s what they know and monetary policy works better with a little pricing juice. That implies that even a small 25-basis-point hike is probably far off in the future. Ultimately we won’t know for sure if the Fed made a timely decision to keep inflationary pressures at bay until several years down the road. Of course, by that time it’ll difficult to retroactively correct any mistakes. Waiting for absolute clarity is a nice idea, but only if it works.