The Federal Reserve Must Rethink How It Tightens Monetary Policy

By Thomas Palley

Cross-posted at the author’s website,

After more than 7 years of economic recovery, the Federal Reserve is positioning itself to tighten monetary policy by raising interest rates. In light of the wobbly reaction in financial markets, an important question that must be asked is whether raising interest rates is the right tool.

It could well be that the world’s leading central bank is going about the process of tightening in the wrong way. Owing to the dollar’s preeminent standing, that could have severe global repercussions.

Just as the Fed has had to rethink how it combats recessions, so too it must rethink how it transitions from an easy monetary policy stance to a tighter stance.

A quick review

In December 2015, the U.S. Federal Reserve increased interest rates for the first time in almost a decade. This move came with the expectation of gradually raising its interest rate to a new normal of 3%. Initially, normalization aimed to lighten pressure on the monetary policy pedal, and only later would it turn to hitting the monetary policy brake.

The normalization process was contingent on the data showing continued improvement, but the U.S. economy slowed in the first half of 2016, putting it on hold. However, since May, the data have again been robust regarding job creation and wage growth. Furthermore, there are signs of asset and house price exuberance in the U.S. economy that can be destabilizing and also inflict large future losses on working families.

These recent developments have prompted the Federal Reserve to consider restarting the process.

Raising interest rates is the wrong way to begin normalization

The problem is not that the Federal Reserve wants to restart the normalization process, but rather that it wants to do so by raising its policy interest rate. That risks spilling the infamous monetary policy “punch bowl”.

Raising interest rates is a dangerous step in today’s integrated global economy. The Fed must calculate especially carefully given that other economies (the UK, Japan, and the European Union) are on the ropes and lowering rates.

Raising U.S. rates in such an environment threatens to cause an inflow of hot money into the United States that will appreciate the dollar’s exchange rate and further fuel US financial markets.

That, in turn, will negatively impact manufacturing via lower exports and increased imports. It will also lower investment spending by injuring manufacturing. And it would further distort financial asset prices, setting them up for a possible disorderly correction.

There is an alternative normalization path

There is an alternative normalization policy path that avoids these problems.

1. The Federal Reserve should shelve plans to raise its policy interest rate. Later, if the normalization process goes well, it can put rate hikes back on the policy table.

2. The Federal Reserve should immediately stop reinvesting the income from its private sector bond holdings and should start running-off those holdings.

Having the private sector repay debt held by the Federal Reserve would drain liquidity from financial markets, thereby tamping down financial speculation and also putting incipient upward pressure on long-term interest rates, which is what policymakers desire.

3. If the Federal Reserve is concerned about house price inflation, it should impose a temporary reserve requirement on new mortgages.

That would make new mortgages more expensive, given that banks would pass on the cost of the reserve requirement to borrowers, thereby cooling house price inflation.

Most importantly, this well-targeted measure would not affect interest rates in the rest of the U.S. economy, thereby avoiding causing hot money inflows and collateral damage on manufacturing and investment.

4. If the Federal Reserve is concerned about a stock market bubble and related impacts on consumption spending, it should raise margin requirements.

Margin borrowing for stock purchases is at near-record levels. Even a symbolic increase would put speculators on notice and discourage borrowing. Such a move would also rehabilitate an important anti-speculation policy tool that has been allowed to fall into disuse.

Rethinking monetary policy in normal times

Chairwoman Yellen’s recent Jackson Hole conference speech was titled “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future”. She argued that the policy tools developed in the economic crisis to promote recovery need to be retained for possible future deployment. Those tools include interest on excess reserves (IOER), large scale asset purchases, and explicit forward guidance.

Whereas the Federal Reserve has radically rethought how to combat recessions, its policy framework for normal times is less changed and remains focused on interest rates. For instance, both IOER and forward guidance concern interest rate policy.

This lack of change means the Federal Reserve risks spilling the punch bowl. The above alternative program shows how that can be avoided.

Instead of immediately raising interest rates, the Federal Reserve should use the current transition as an opportunity to introduce quantitative policy tools such as margin requirements and adjustable discretionary reserve requirements on problematic asset classes. Doing so can allow it to drain the punch bowl without spilling the punch.

Unfortunately, the Fed is far behind the curve. It has directed all of its efforts to preparing the market for higher interest rates, when it should have first been preparing the market for these type of targeted measures. However, better late than never.

The Wrong Side of a Long, Long History of Resource Extraction

By Elizabeth A. Stanton, PhD

Cross-posted at the author’s blog,


Thanks to abundant coverage by social media, the nation watched this week as activists protesting the construction of a pipeline to transport oil through the Dakotas, Iowa and Illinois put their own safety at risk to protect a Native American cultural site. A Pinkterton-esque goon squad used pepper spray and attack dogs to clear the site for unscheduled excavation, resulting in injuries, hospitalizations, and an outraged public.

Energy Transfer Crude Oil Company—the developer of the Dakota Access or Bakken Oil Pipeline—asserts a public need for the 1,172-mile pipeline and promises jobs, tax revenues, and a boost to the economies of the affected states. Advocates arguing against this pipeline’s construction have found these claims to be unfounded. Energy Transfer bases its statement that the Dakota Access Pipeline is necessary on the business opportunity to get more Bakken oil to market sooner, and not on any public need that would be served by a greater flow of oil from the Dakotas to Illinois. The company’s claim that farmers need the pipeline to open up space to ship grain on trains that currently transport oil was soundly debunked by expert witnesses and even by Iowa’s Utility Board in issuing its approval of the project. There is no reason to believe either that Midwest grain shipments will be curtailed in the future or that building the pipeline would reduce any rail shipping constraints should they arise.

And while the private benefits of building the Dakota Access Pipeline are clear, any benefit to the public is harder to discern. Energy Transfer’s case for a public benefit in new jobs and tax revenue is difficult to credit after reading local economists’ critiques of the company’s underlying analysis. After studying Energy Transfer’s cost-benefit analysis of Dakota Access as well as post hoc assessments of recent, similar projects, Dave Swenson of Iowa State University found that the company had presented inflated jobs and economic benefit projections. More generally, Swenson found that pipeline projects are large but “labor-stingy” and most of their economic stimulus leaks out of the region in which they are built.

Energy Transfer’s assessment also fails to look at the cost to local environments and human communities. The planned route for the Dakota Access Pipeline was re-located away from the more densely populated Bismarck area because of health and safety concerns while dangers to the rural communities impacted by its new route have been ignored. Toxic water pollution and the permanent loss of cultural heritage sites have important effects on public well-being. Any complete accounting of the costs and benefits of pipeline construction must be broad enough to include these external, or non-market, costs.

I’d like to be able to say that the time has passed when a narrow pecuniary interest in resource extraction trumps the public good, but the permits issued by state agencies and the U.S. Army Corps of Engineers would prove me wrong. The Standing Rock Sioux protesters and their allies seem to be not only on the right side of history but also on the right side of prudent decision making for the public good. The Dakota Access Pipeline has not been shown to be necessary, and Energy Transfer has failed to offer a transparent accounting of all project costs and benefits, both monetary and non-monetary. A full halt on construction is essential while legal remedies are taken and an impartial, comprehensive assessment of impacts is made.

Elizabeth A. Stanton, PhD, is an independent consultant with more than 15 years of professional experience as an environmental economist, and has authored more than 80 reports, policy studies, white papers, journal articles, and book chapters on topics related to energy, the economy, and the environment.