The Fed Did Not Make A Mistake In December

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Includes: CNY, CYB, FXCH, RINF, UDN, USDU, UUP
by: David Beckworth

Many observers are now viewing the Fed's decision in December to raise interest rates as a "policy error". With volatility in financial markets, falling commodity prices, and a now-apparent fourth quarter slowdown, many believe the Fed got ahead of the recovery with the December interest rate hike. Some even are even calling it a "huge mistake"or a "historic rate hike mistake". One person even called it an "epic mistake".

I see things differently. The Fed did not make a mistake in December. It made a mistake all last year by talking up interest rate hikes and signalling a tightening of future monetary policy. Since markets are forward looking, this expectation got priced into their current asset prices and affected current decision making. The Fed did this though even though the economy was not back at full employment. The December rate hike was just a confirmation of these expectations.

The Fed, in other words, got ahead of the recovery well before December. Damage was already being inflicted on the economy by the time the actual rate hike occurred. This can be seen in the figures below. They all show the 12-month ahead expected federal funds rate plotted against various indicators.

The first one shows the future federal funds rates alongside the trade weighted value of the dollar. Unsurprisingly, both start rising at about the same time in late 2014.

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The trend growth of the stock market also began turning down about the same time as the expected tightening cycle began.

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The expected tightening also coincided with a sustained decline in expected inflation as seen below. Yes, this is not a perfect measure of expected inflation. It has a risk premium in it that could be overstating the decline. But as Narayana Kocherlakota notes, if this is the case it only underscores the point that Fed has been overly tight. For a rise in the risk premium means an increase in the demand for safe assets and a decrease in aggregate demand growth.

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The next figure show that the risk premium--as measured by the spread between BAA yield and 10-year treasury yield--did in fact coincide with the expected tightening signaled by the Fed.

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The slowdown in industrial production that began last year also roughly tracks the expected tightening by the Fed as seen below.

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Other indicators like the GDP in the fourth quarter, retail sales, or personal consumption also show a softening. In general, the point is that the Fed appears to have gotten ahead of the recovery well before December simply by talking up a rate hike.

Though the focus of this post is on the domestic U.S. economy, it is worth briefly noting the international implications too. As shown above, the dollar rose in step with the expected tightening of Fed policy. The stronger dollar, in turn, has pulled up the yuan with it and this can explain why problems in China first emerged last August. China is dealing with deep structural problems and is doing so by violating the macroeconomic trilemma. That is, China is pegging its currency to the dollar, it is easing domestic monetary policy, and is allowing some capital flows in an attempt to stabilize its economy. This is an unsustainable policy mix and is already creating financial market volatility.

Though it takes two to tango, the dollar surge over the past year helped push China into this predicament. China is now bleeding foreign reserves faster than ever and the timing of it can ultimately be traced backed to the expected tightening of Fed policy.

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So no, the Fed did not make a mistake at its December meeting. It made a mistake over the entire past year and now we are seeing the fruition of this error.