# Another "Unconventional" Monetary Policy for America

ITO Hiroyuki
Visiting Fellow, RIETI

On September 17, 2015, the Federal Open Market Committee (FOMC) of the Federal Reserve Board (FRB: the central bank of the United States) decided against raising the target range for the federal funds rate. That is, it decided to maintain the zero-interest rate policy that has been in effect since December 2008. The FRB ended quantitative easing in October 2014. As 2015 began, there was speculation that it would end the zero-interest rate policy by the September meeting, bringing an end to all of the so-called "unconventional monetary policies." However, stock markets around the world have been unstable since the summer as the outlook for China's economy, the world's second-largest, has become uncertain. This had led many to wonder, even before the meeting in September, whether a rate hike would be put off till later in the year.

While there are both pros and cons to the FRB's decision, one thing for sure is that the FOMC, which traditionally tends to focus only on domestic factors for deciding monetary policy, considered global economic situations and the possible impact of a rate increase on the rest of the world. This in itself is a significant change in the FRB's policy making which can be viewed as "unconventional." Looking ahead, what can we expect for the U.S. monetary policy in the near future? The following is a discussion of the direction of U.S. monetary policy, starting with a look at the pros and cons of an interest rate hike.

## Arguments for an interest rate hike

1. Considering that "unconventional monetary policy" was implemented as an emergency measure to cope with the global financial crisis of 2008, and also that the U.S. economy--along with some other advanced economies--has been on a recovery path, monetary policy should be normalized as soon as possible by raising the federal funds rate to some level higher than zero. As long as the policy interest rate continues to be 0%, monetary policy continues to be unavailable as a policy option.
2. The zero-interest rate policy keeps the cost of borrowing in the United States extremely low, and, therefore, helps drive up the prices of financial assets such as stocks as well as real assets such as housing. Share prices are already more than 20% higher than their peak before the global financial crisis. Housing prices are also rising in many major cities. In some cities, prices have already passed, or are approaching, their peaks during the housing bubble (including Boston, Denver, Portland, and San Francisco as of July 2015). If the zero interest rate policy continues, another bubble could happen. One lesson learned from the experience of former Fed Chairman Alan Greenspan is that policy interest rates should not be kept too low for too long.
3. As of September 2015, the unemployment rate in the United States is 5.1%, lower than the natural rate of unemployment (the rate of unemployment that does not entail either upward or downward pressure on the inflation rate) of 5.8%. This means that the labor market and the economy as a whole are prone for overheating.

## Arguments against an interest rate hike

1. In the last few months, uncertainty over the Chinese economy has had disruptive impacts on the major stock markets around the world. As of September 30, the Shanghai Stock Exchange (SSE) Composite Index is 41% lower than its peak of June 12, 2015. During the same period, the Dow Jones Industrial Average fell by 10% and the Nikkei Stock Average by 14.8%. The price of crude oil also fell from $54 a barrel to$46.30, a drop of 15%.
2. U.S. policymakers need to consider the state of the faltering world economy rather than focusing on normalizing monetary policy. Although Europe has been relatively stable lately, it is still vulnerable. The Japanese economy has not yet broken out of the (two-decade long) deflationary spiral. The decline in commodity futures resulting from the drop in crude oil prices and the slowdown of the Chinese economy have caused emerging market economies that are major exporters of natural resources (e.g., Brazil, Russia, and Argentina) to stagnate.
3. Since all of the major advanced economies have had zero-interest rate policies in place or maintained policy interest rates extremely low in the aftermath of the global financial crisis, the world's capital had flown to emerging market economies with higher interest rates. According to the International Monetary Fund (IMF), corporate debt (except for those held by financial institutions) in 40 major emerging market economies surged four and a half times in 2014 compared to a decade earlier (from about $4 trillion to about$18 trillion). That is mainly due to easy access to credit, both domestic and foreign. Given this situation, if the United States raised its interest rates, capital would flow back to the U.S. markets, causing the currencies of emerging market economies to depreciate, making it difficult for them to pay off their debt, especially dollar-denominated foreign debt. That could cause these emerging economies, including China, to stagnate.
4. Market indicators such as the price-earnings ratio suggest that U.S. stock markets are not experiencing a bubble. According to the Case-Shiller Home Price Indices comprising 20 U.S. metropolitan areas, housing prices have been rising since 2012 with the level of July 2015 higher than that of August 2008 immediately before the crisis, but housing prices are still 12% lower than the June 2006 level at the peak of the housing bubble. Some argue that even if housing prices continue to climb, another subprime mortgage crisis is unlikely to occur because new government regulations have made banks' screening criteria much stricter since the financial crisis.
5. In spite of the low unemployment rate, there is no sign of rising inflation. Inflation has remained below the FRB's target of 2%, and wages are not rising. Hence, no interest rate hike is necessary at this point.

As can be seen above, it is not easy to make a judgment about the pros and cons of the no-rate hike decision. If the FOMC had made a decision as it had in the past at the last September meeting, it could have raised the policy interest rate by focusing only on domestic factors. However, a big environmental change outside the United States this past summer was too big for the FOMC to ignore and just focus on domestic factors, namely, China's stock market crash.

Shanghai's share prices started to drop in mid-June 2015. By the first week of July, the SSE Composite Index had plunged by 30%, followed by another 8.5% decline on July 27 and an aggregate fall of 16% on August 24-26. The market has been somewhat stable recently, but, as mentioned above, Shanghai share prices have fallen by 45% since their June peak.

Considering that Chinese households invest only 15% of their assets in stocks and that China's total stock market capitalization is only about one-third of its gross domestic product (GDP) (compared to about 100% or more among industrialized countries), some observers have argued that even if a stock market bubble were to bust, that would not impact the rest of the economy or, not to mention, the rest of the world.

However, in our highly globalized world, even the U.S. economy, the world's largest, can be affected by the Chinese economy, the second largest. In fact, since the Shanghai market started falling this summer, share prices in New York have also become more volatile. Generally speaking, the more volatile share prices become, the harder it becomes for individuals and corporations to forecast the economy, causing businesses to hesitate on making decisions on investment and hiring. In fact, although the U.S. unemployment rate remained at 5.1% in August and September, the number of nonfarm jobs created in September dropped sharply to below 150,000, a big fall compared to figures between 200,000 and 250,000 from May through July. Wages also do not show any signs of rapid increases.

The situation in China has also affected its biggest trading partner, the European Union. The German economy, in particular, has been nervous about conditions in the Chinese economy. The fact that China is the world's largest importer of natural resources also affects developing countries that export natural resources. Stagnation and weaker demand in these economies, both developed and developing, would certainly rebound to China, the hub of the supply chain, possibly dragging down the world economy in a spiral. Thus, the economic situation outside the United States rather than at home exerts a greater risk in raising the policy interest rate.

In sum, the United States, China, and the rest of the world all share a common fate. Given that, it is understandable for the FOMC to incorporate overseas factors in its decision making, though that would not have happened in the past. In that sense, the recent decision of not raising the policy rate is another example of the FRB's "unconventional" policy.

## Is a rate hike possible at the October or December FOMC meeting?

Most observers expect that there will be no rate hike at the October 27-28 FOMC meeting. The Chinese situation will most likely not improve by the next meeting, nor will the situation in emerging market economies. These economies' performance could even further deteriorate while the Chinese economy continues to slide down.

So, what about the December 15-16 meeting? Janet Yellen, chair of the Board of Governors of the Federal Reserve System, has mentioned that the policy interest rate should rise by the end of the year. The prospect of U.S. monetary policy will surely depend on how asset markets (stocks, bonds, housing, etc.) and macroeconomic conditions such as employment and wages perform. But it will also depend on the performance of developing countries, which now make up more than half of the world GDP. This is especially the case for major emerging market economies such as China, Brazil, and Russia. Probably, the FRB continues to maintain expectations of a possible rate hike for as long as possible while also retaining flexibility and leaving room for continuing the no-hike option depending on the conditions of the U.S. and the world economy.

Interestingly, the FRB is trying to put an end to the "unconventional" monetary policy stance with an "unconventional" process. After all, even economic superpowers are not immune to the waves of globalization.

October 9, 2015

October 9, 2015

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