How America Could Turn Into Another Japan

By Chandrashekar (Chandra) Tamirisa, (On Twitter) @c_tamirisa

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The financial markets are seeking clarity from the US Federal Reserve and from China before volatility can end. While China is implementing structural reforms to transform from a low-end manufacturing, export-based economy to a services and domestic consumption-based economy, the United States, after the Great Recession, is trying to recover to a self-sustainable GDP growth rate that is not dependent on central bank largesse.

Slow growth around the world (with the exception of India and parts of Africa) and oil supply glut, have depressed global energy, food and other commodity prices and inflation, the opposite situation of 2007-2008 when energy, food and other commodity prices and inflation were heading ever higher before the housing crisis hit the US. Since then, the world has been awash in liquidity because of expansionary monetary policy by all major central banks. That liquidity is seeking real investment oportunities which, if materialize, would raise aggregate demand and, thus, GDP.

The extraordinary US monetary easing in response to the 2007-2008 crisis has come under severe criticism from some quarters for creating a currency war and for the possibility of sparking inflation.

Economic recovery in the US since 2009 has strengthened the dollar relative to other currencies but inflation is still low because of low energy prices and cheaper imports due to the stronger dollar. Despite the US recovery thus far there is continued slack in the US labor market and in the economy which is putting downward pressure on wages and prices.

US economic recovery could withstand the end of QE 3 largely because domestic investment went up with capital being repatriated to the United States from abroad, primarily from the emerging markets, in anticipation of a stronger US economy as most of the rest of the world slowed down. It must be remembered here that QE increased excess reserves at the Fed to USD 2.5 trillion: this cash has not circulated in the economy which, in part, could have resulted in the mediocre US growth rates while also precluding any asset price inflation. There is an expectation on the part of the critics of US monetary policy that the Fed embarking on the gradual path of raising interest rates can similarly be withstood by the economy.

There is a case to be made here that Fed policy of paying interest on excess reserves (IOER) should end for that money to circulate productively in the economy. Also, the Fed must stop reinvesting the cash from the maturing bonds and housing assets and begin the process of very gradually shrinking its balance sheet. Ending IOER will “expand” money supply while shrinking the Fed’s balance sheet will tighten financial conditions: two opposing effects which will keep the economy in balance.

The globally low inflation conditions, low wage growth and the stronger dollar could further disinflate the US economy and eventually lead to deflation by preventing the US economy from eliminating the slack if the Fed embarks now on the path of gradually normalizing interest rates in the US. There is the risk that the US economy could slow as a result of rising interest rates, putting the country in a situation similar to Japan of the past two decades from which escape could be difficult. In fact, the global economy is currently at risk of deflation. Further, it is unclear if the Fed’s inflation forecast through 2018 takes into account Fed’s forecast for the federal funds rate: will inflation continue to rise from now through 2018 to the Fed’s target of 2 percent even as interests rates are rising during the same period?

It is, therefore, advised here that the US economy examine ways to increase domestic real investment to grow the economy faster at the current zero federal funds rate and let inflation (wages and prices) rise more before getting on the path of normalizing interest rates.

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About Chandrashekar (Chandra) Tamirisa

http://www.thecommonera.com/Common_Era/Me.html
This entry was posted in Economics, Japan, Monetary Policy, North America and Caribbean, Transformations LLC. Bookmark the permalink.

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