The Fed Review This Month...

The discussion over the US’ Fed policy in December among economists and analysts is gearing-up as we approach the date and the consensus view is that it would increase tightening depending on the inflation target and the unemployment-rate. The actual inflation has remained on the upside but lower than the target, when the unemployment-rate has fallen close to 4.6 % and the economy has grown more than expected in the previous term which further bolsters the chance of a rate-hike this month. However, the recent jobless claims do also strengthen the rate-hike case. Therefore, the Fed is almost on its mark to increase the Fed’s Fund-rate to stop overheating and to increase traction in the future slowdown by increasing its ability to cut-rates in the future by increasing them at the moment, but as we know the natural-rates are on a downward trend, therefore we could not expect the Fed to increase sharply because that would affect the economic activity in a negative stride and would bring the slowdown in the economy. The natural rate theory says that interest-rate should not produce inflation or deflation so as to make the economy stable because inflation fosters inflationary expectation that is neither good for consumption because aggregate demand would go down, nor for investment because the value of capital-stock would go down. However, deflation would increase deflationary expectations, but since lower prices would also discourage supply people would rush to buy the inventories. The expectation that people would delay spending is not acceptable. In addition lower-prices would again lower interest-rate and interest-rate expectations which would increase supply in the future which further means price correction or lower prices. Lower borrowing cost is a larger part of the overall cost which is likely to increase supply and lower prices. The Fed is targeting inflation and has increased inflation expectations which have made the economy costly when there is already a long-term marginal-productivity and real-wages gap. Nonetheless, Janet Yellen has conveyed to the government to increase productivity by investing in education, skills and innovation. But, what would be the use of increasing productivity when there is already a big gap in real-wages and productivity since 1970s. Paul Krugman supports the stagnant-wages theory. Nonetheless, the Fed too might help increase real-wages by increasing deflation and deflation expectations by keeping the money-supply little tight… Or by increasing nominal wages by continuing with lose money-supply and increase inflation and inflation expectation which actually reduce demand. Milton Friedman in his optimal-monetary-policy envisaged deflation as the right strategy and maintained that nominal interest-rate should be sufficiently down. Therefore, the Fed might increase rates again after a complete year to keep the prices lower and lower inflation expectations in the future, but there might be a trade-off between inflation and unemployment, a little higher unemployment at which prices and wages support a higher or increasing real wages which also means lower prices is the right thing to desire for. Wages or real wages should increase to keep demand intact in the face of lower population and labour-force-participation rate. Revival in the lagging demand due to low real wages compared to the productivity might also help to increase domestic-demand and spending and economic-growth…. Nevertheless, in the next five years we could expect natural interest-rate not above 2% which is currently negative… By increasing nominal rates the Fed would also increase real-interest rate because inflation and inflation expectations would also go down… But, sharp tightening is not expected because that would also lower growth and growth expectations…