The US Federal Reserve is being criticized for being behind the curve in terms of cutting interest rates. In the recent monetary policy decision, the Federal Reserve kept its policy rate unchanged, against strong expectations that it would cut it, especially given the drop in the employment rate. A recent Financial Times-published article ‘Federal Reserve under fire as slowing jobs market fans fears of recession’ indicated as follows: ‘The employment report released on Friday showed companies added 114,000 positions across the world’s largest economy last month, significantly lower than the 215,000 average gain over the past 12 months. …The data comes two days after the US central bank opted against lowering its benchmark interest rate, which has remained at a 23-year high of 5.25 per cent to 5.5 per cent since last July. In justifying the decision, chair Jay Powell said the Federal Open Market Committee wanted to see more evidence that inflation is headed back to its 2 per cent target before following through with any monetary policy pivot.’
Paul Krugman, an Economics Nobel laureate, in his New York Times article ‘The economy is looking pre-recessionary’, which was published on August 5, in which he was critical of the decision of the Federal Reserve not to bring down the policy rate. He indicated in the article ‘The United States probably (probably) hasn’t entered a recession yet. But the economy is definitely looking pre-recessionary. And policymakers – which right now basically means the Federal Reserve – need to move quickly to head off the risks of serious economic deterioration. It’s already clear that the Fed made a mistake by not cutting rates last week; indeed, it probably should have begun cutting months ago. …[The US Federal Reserve] should make a substantial cut – probably half a percentage point, rather than its usual quarter-point – at its next meeting, scheduled for mid-September.’
The policy rate decision in advanced countries, especially in the world’s biggest economy, the USA, not only impacts its own economy, but central banks around the world take a cue from it. This is mainly because of the competition for foreign portfolio investment (FPI), whereby central banks in general, and in addition to the inflation related requirements, also follow policy rate movements in advanced countries.
Unfortunately, this thinking is yet to sink in, may that be the central bank of developed countries, or developing countries in general, whereby over-board austerity policies has meant not only excessive economic growth sacrifice, but also risking going into recession. Instead, what is needed is not just primarily emphasizing monetary policy to control inflation, but also significantly using fiscal policy. Hence, there should be not over-emphasis on aggregate demand squeeze policies, but more focus on aggregate supply policy, especially in a world of fast-unfolding existential threats, and as a result prevalence of greater likelihood of deep, and frequent external shocks.
This, although a wrong policy choice, given the highly volatile nature of FPI, should not be targeted, especially when keeping the policy rate high means significant economic growth sacrifice. Instead, foreign direct investment (FDI) should be attracted through lower cost of capital, improving the economic institutional quality, and enhancing the quality of regulation for reaching better price discovery in markets.
On the other hand, high policy rate in developed countries, also impacts the debt repayment distress of developing countries; a number of which, including Pakistan, are under high debt distress. The ‘Task Force on Climate, Development, and the International Monetary Fund’ in its report ‘Achieving catalytic impact with the Resilience and Sustainability Trust [RST]’, which it released recently, pointed out with regard to rising cost of IMF loans as ‘Figure 1 shows how the SDR rate has escalated over the last two years, thereby amplifying RST borrowing costs.’ A higher policy rate also means a higher special drawing rights (SDR) interest rate, which as per the report above, from being very close to zero percent during the fourth quarter of 2022, jumped to four percent during the later part of 2023; the third quarter to be precise.
Moreover, lack of loosening of monetary policy, or in other words, pursuing an over-board monetary austerity policy has meant that it continues to be above four percent. Higher debt repayments, needless to say, squeeze an already difficult fiscal space with developing countries, which means spending less on increasing economic resilience, and welfare.
Instead of relying heavily on using interest rates to control inflation, what is needed is fixing the supply side, improving the economic institutional quality, and enhancing the performance of markets. For instance, renowned economist, Joseph Stiglitz, who is also an Economics Nobel laureate, pointed out in this regard, in his Project Syndicate published article ‘A balanced response to inflation’ as ‘…rapid structural change often call for a higher optimal inflation rate, owing to the downward nominal rigidities of wages and prices (meaning that what goes up rarely comes down). We are in such a period now, and we shouldn’t panic if inflation exceeds the central bank’s 2 percent target – a rate for which there is no economic justification. … What we need instead are targeted structural and fiscal policies aimed at unblocking supply bottlenecks and helping people confront today’s realities.’
Unfortunately, this thinking is yet to sink in, may that be the central bank of developed countries, or developing countries in general, whereby over-board austerity policies has meant not only excessive economic growth sacrifice, but also risking going into recession. Instead, what is needed is not just primarily emphasizing monetary policy to control inflation, but also significantly using fiscal policy. Hence, there should be not over-emphasis on aggregate demand squeeze policies, b more focus on aggregate supply policy, especially in a world of fast-unfolding existential threats, and as a result prevalence of greater likelihood of deep, and frequent external shocks.
