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I’m certainly an optimist. I think the expected interest rate increase is a mistake, but on balance I don’t think it will push the US back into recession. I suppose I’d say I’m 80-20 growth in 2016. But even that is an unnecessary risk in my view, with essentially no upside from raising rates:

1. It will hurt the unemployed.

2. It will move the Fed further from its 2% PCE inflation target.

3. If you are worried about savers (I’m not) it will lead to lower interest rates in years 2 through 20 than would an easier money policy that led to faster NGDP growth.

The only argument in favor seems to be that rates for savers would be 1/4% higher for a year or two. And that gain is worth all the downsides?

I’m 80% sure this will not push us into a double dip recession, despite the fact that history shows exactly the opposite. Of the 5 previous attempts to exit the zero rate bound (or perhaps I should say what Keynesians regard as the zero bound) 4 were failures, which pushed the economy back into recession and/or deflation. The failures were the US in 1937, Japan in 2000 and 2006, and the ECB in 2011. (That 2011 rate increase wasn’t quite at the zero bound, but generally regarded as close.) In three cases it was a 1/4% increase, and in 2011 a 1/2% increase. The only success was in 1951, when the Treasury-Fed Accord ended the low interest rate pegging policy.

And yet despite all of this history, Alan Greenspan is “baffled”:

Greenspan also said he’s “baffled” that a 25 basis point hike by the Fed would have a major impact on economic conditions around the world.

So almost every previous time central banks do a tiny interest rate increase at the zero bound, it blows up in their face. And yet we are shocked that markets might be a tad worried?

What’s the downside of waiting until the Fed actually needs to raise rates to achieve its target path?

It’s really very simple. Basic monetary theory says that interest rate pegging makes the price level indeterminate. A peg slightly above the natural rate eventually sends you into deflation. A peg slightly below the natural rates starts a cumulative process that sends the economy into hyperinflation. Monetary theory says that a 1/4% can make a massive difference, or it might make very little difference at all (it depends what happens next). If you read any news or opinion articles where the writer wonders how a 1/4% change can be such a big deal, just stop reading. You are wasting your time.

PS. Just as I am a US economy optimist, perceived as a pessimist, I’m a China pessimist perceived as an optimist. I’m currently more pessimistic about China’s growth prospects for 2016 than every single member of The Economist’s expert panel. Every one of them expects at least 6.3% growth for China in 2016. What a bunch of pollyannaish apologists for the Chinese Communist Party!

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This entry was posted on September 04th, 2015 and is filed under China, Liquidity trap, Monetary Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



