The Federal Reserve acknowledged slow worldwide economic growth and volatile financial markets at last month's meeting of the Federal Open Market Committee. This is really not news but a continuation, albeit somewhat more pronounced, of what has been the case for over a year. Analysts' assessments late last year about a strengthening economy are now looking incorrect, as the current trend raises deepening questions about whether the recovery will continue. The recovery has benefited mainly the wealthy while producing slow jobs growth and meager income for middle- and lower-income Americans.
There will always be considerable handwringing and second-guessing with each Fed move or lack thereof. That said the Fed should not delay putting in place a long-term plan that diminishes its outsized influence and allows the financial markets to work without undue interference from the central bank.
Much of the Fed's problem is tied directly to its obsession with achieving an elusive goal of 2% inflation. That goal is unlikely to be achieved any time soon because the world's economy is exceptionally sluggish with excess capacity nearly everywhere.
Ironically, low inflation has actually been a good thing for the U.S. economy. Wages are up only about 2.2% over the past five years, about half of what normally occurs in an economic recovery. If the Fed were successful in achieving its 2% inflation target, it would offset nearly all wage gains, which would severely weaken consumer spending, the one bright spot in our economy.
Business investment is the area that has been weak in this recovery, due primarily to job creators' lack of confidence that current monetary and fiscal policies will lead to stronger economic growth. Higher inflation does not cause or create greater economic growth. To the contrary, it is greater economic growth that leads to higher inflation. The Fed should be focused on increased employment and faster economic growth – period.
It is past time for the Fed to begin normalizing monetary policy and stop interfering in the markets. Economists estimate that the equilibrium federal funds rate (i.e., the interest rate at which monetary policy would likely be neither restrictive nor accommodating) is about 3-4% today. The Fed should increase rates slowly, as long as the economy and employment continue to increase, regardless of a low inflation rate, bringing federal funds to 2% by the middle of next year. A 2% federal funds rate would still be accommodating but would put the Fed in position to quickly increase the federal funds rate to the equilibrium rate of 3% to 4% should inflation get out of control – or to lower the federal funds rate below 2% if the economy is growing too slowly.
Raising rates in this fashion will have a collateral benefit for consumers, who have been earning close to zero percent interest on their savings accounts for years. The current situation has been particularly harsh on the consumers in retirement who do not participate in the stock market and live on fixed incomes.
The Fed should also stop buying long term bonds and mortgages and let the markets begin to function properly. The Fed's seven-year intervention in the markets has contributed to asset prices rising to "bubble-like" levels, including in the stock market, in prices for high-yield and long-term bonds, and even perhaps some values in commercial real estate, among other asset types. Some asset prices are already beginning to unravel, shattering confidence in the economy. We hope that the Fed refrains from bailing out the wealthy once again with monetary policies artificially supporting higher risk assets.
Prior to recent years, the Fed's balance sheet had never reached a trillion dollars; today it stands at more than $4 trillion, which is nearly 25% of the federal government's debt. The Fed needs to normalize monetary policy and stop buying bonds and mortgages, which will gradually reduce its balance sheet.
The incomes of a substantial and growing number of Americans are flat or declining, and still too many individuals who want to work cannot find a decent job. The U.S. has long been the most prosperous nation in the world, due largely to the unparalleled success of our free-market system. It is past time for the Fed to allow the markets to operate.
Richard M. Kovacevich is the retired chairman and CEO of Wells Fargo. William M. Isaac, former chairman of the Federal Deposit Insurance Corp., is a senior managing director and global head of financial institutions at FTI Consulting. The views expressed are their own.