The Fed Should Raise Rates Because Brazil Has Low Unemployment?

by: Mark Thoma

Wow. Raghuram Rajan says the Fed should raise rates because hiring in Brazil is robust:

Moreover, even if corporations in the US are not hiring, corporations elsewhere are. Brazil’s unemployment rate, for example, is at lows not seen for decades. If the Fed were to accept the responsibilities of its de facto role as the world’s central banker, it would have to admit that its policy rates are not conducive to stable world growth.

The Fed has made it very clear that it worries about conditions in other countries only to the extent that they feed back upon conditions within the US. That is, while I think US should consider the welfare of other countries when implementing policy (though in this case, the effects of low interest rates on Brazil would not be much, if any, of a concern), the Fed has made it clear that's not how it operates. It's charter has different instructions and it must abide by them. Legislators would not stand for the Fed raising rates based upon conditions in Brazil and other countries in any case, that would be a sure way to lose independence.

Some parts of the essay are OK, e.g. the parts about the need to modernize the social safety net, but for the most part it is a complaint about the Fed holding rates too low:

Equally deleterious to economic health is the recent vogue of cutting interest rates to near zero and holding them there for a sustained period. It is far from clear that near-zero short-term interest rates (as compared to just low interest rates) have much additional effect in encouraging firms to create jobs when powerful economic forces make them reluctant to hire. But prolonged near-zero rates can foster the wrong kinds of activities.

His main arguments against low rates are that they distort investment toward high risk assets:

For example, households and investment managers, reluctant to keep money in safe money-market funds, instead seek to invest in securities with longer maturities and higher credit risk, so long as they offer extra yield. Likewise, money fleeing low US interest rates (and, more generally, industrial countries) has pushed up emerging-market equity and real-estate prices, setting them up for a fall (as we witnessed recently with the flight to safety following Europe’s financial turmoil).

The problems in Greece and other countries were caused by low interest rate policies? I'll have to think about that, but with respect to the flight into long duration, risky assets he discusses, I thought the current problem was an excess demand for safe assets, not an excess demand for risk.

He is also not much of a fan of fiscal policy:

Much of what is enacted as stimulus has little immediate effect on job creation, but does have an adverse long-term effect on government finances. For example, the 2009 stimulus package enacted by the Obama administration had many billions of dollars devoted to cancer research, though such research employs few people directly and is spent over a long time horizon – far beyond that of even a prolonged recovery.

I think it's a bit disingenuous -- and perhaps telling that he doesn't have much of an argument -- that he points to such a small portion of the stimulus package as his big example (the spending for cancer research was $1.26 billion of the $787 billion package). He is also making an assertion about "little effect on job creation" that is contrary to the evidence. The CBO says (and these numbers are consistent with a wide range of other estimates) the stimulus package generated 2 million jobs (1.2 million to 2.8 million is the range they report). It could have been better with a larger, better constructed package, but 2 million is far from "little immediate effect."

We need more fiscal policy not less, and more aggressive monetary policy to combat unemployment, not an increase in rates. Monetary policy should stay on hold if more aggressive policy is not possible for political reasons or because of objections within the FOMC, but we should not give in to the immediate increase in rates that Raghuram Rajan and others are calling for. That's not the best possible path to recovery.