The economy is worse than the Fed may think, and policymakers should therefore end all discussions about an eventual rate hike and consider actions such as expanding the central bank’s balance sheet.
That stark assessment comes from the conservative American Enterprise Institute’s John Makin, an economist who has been arguing since last year that a crippling new round of deflation is a more serious threat to the economy than inflation.
Rather than setting targets for a rate hike meant to curb a currently unrealistic risk of inflation, Makin argues that the Fed should preoccupy itself with boosting a weak economy.
(The economist wrote his policy analysis after the U.S. Department of Commerce last week released its third revised estimate of first-quarter GDP growth, which it reduced to -2.9%, but before Thursday's robust payroll data.)
“That is a Japan lost decade-style number,” Makin says.
The AEI scholar says that confidently stated predictions earlier this year of a 3 to 4% annual GDP growth rate were turned on their head.
“Right up to the initial release of the first-quarter 0.1 percent growth rate in April, forecasters had been calling for a 2.3 percent growth pace,” Makin writes. “Now, on the third try, the Department of Commerce is telling us that the economy actually shrank in the first quarter at a dismaying 2.9 percent pace.”
Failure to reckon with wide gap between expectations and reality, he says, portends “some nasty surprises.”
One such surprise involves overall economic performance for the first-half and for the year. The Fed and other forecasters are expecting an economic rebound.
But, Makin points out, “if second-quarter growth ‘rebounds’ to an on-trend 2% pace, the average growth rate during the first half of 2014 will be -0.5%.”
Such a low figure, even with a positive second quarter, is sure to revive recession worries, he says (though a recession involves two consecutive quarters of negative growth). Even above-trend growth of 2.5% in the year’s second half will yield a “sickly” annual growth rate of 1% GDP growth.
What all this dismal performance suggests to Makin is the “nonsense” of continued worries about future inflation.
The AEI economist views the recent jump in CPI inflation as a fluke that can’t be indicative of a trend in light of economic performance that has been weak because of fundamentals, not weather, which has been widely blamed for first-quarter weakness.
Makin cites another of fundamental factors, including a collapse of inventories (“companies that fear weak growth tend to run down inventories”) and wide-of-the mark consumption spending, expected to be a source of growth but which rather subtracted from it: “The contribution to consumption arising from Obamacare had to be revised down once it was discovered that signups for health insurance did not necessarily transfer into purchases,” he observes.
Another factor militating against a focus on inflation is that the recent spike was driven by the volatile food and energy sector that is rightly stripped out of more stable core inflation measures. There is nothing the Fed can do about drought conditions driving up food costs or disarray in Iraq that is causing oil price hikes.
Indeed, the Fed experimented with tightening during the OPEC energy crisis in 1974, thereby adding a demand shock to the already existing supply shock. The U.S. economy collapsed as a result, Makin recalls.
A still further reason for relaxing inflation anxiety is that “an inflation rate that stabilizes in the 1.5 to 2.5% range would be optimal for a U.S. economy struggling to” gain a growth foothold. Core inflation today stands at just 1.5%.
The economist worries that “inflation Cassandras” will do to the U.S. what the Bank of Japan’s overreaction did—lock “the nation into a 15-year period of stagnation after a 1997 tax increase”—or what the ECB’s current policy of allowing inflation to drop to 0.5% is doing—namely, keeping growth a 1.1% rate, thus risking deflation.
Prematurely hiking U.S. interest rates out of fear of inflation also risks a sharp collapse of markets, household wealth and the economy, he adds.
Makin laments that the Fed has said “virtually nothing” about weak GDP growth, merely hinting that it might further delay the first expected interest rate hike.
“Markets have set that date at about mid-2015,” he says. “It will no doubt slip further to 2016, given the weakness of the U.S. economy.”
But the AEI scholar argues the Fed could be more helpful but cutting the inflation and rate-hike talk altogether and start considering policy that might promote growth.
That could “include purchasing a wider range of assets than those currently being purchased under the Fed’s quantitative easing program,” he writes.
“But before that happens, the Fed will have to stop dreaming about 3% growth and wake up to the reality that 2014 will be a slow growth year,” Makin concludes.
