Are Central Banks Losing Control or Credibility?

June 15, 2016Monetary Policyby EW News Desk Team

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More fund managers are preparing for a steep decline in stocks as the Federal Reserve announces whether it will raise interest rates.  The Federal Open Market Committee press release, due Wednesday afternoon, is a much-awaited announcement on whether this is the meeting where the Federal Reserve will change monetary policy.

After months of pricing in a low chance of a rate hike, markets reacted sharply last month after several Fed executives gave public speeches and interviews asserting the strength of the American economy and the need to rein in inflation.

More recently, an extremely weak labor market data has caused markets to reverse course, although the Federal Reserve has not given a clear signal that it will back off on a plan to raise interest rates throughout 2016. Economists and investment bank analysts have asserted that the recent labor market will force the FOMC to pause its rate hike plans, but the lack of a clear signal from Fed chief Janet Yellen has caused increasing confusion and ire in financial circles.

Billionaire Jeffrey Gundlach, who manages the hedge fund DoubleLine Capital, told Reuters in an interview that “central banks are losing control” and that the Fed has turned into a “zombie.” Arguing that the Fed’s recent public announcements have caused more confusion than confidence, Gundlach told investors that bond policies in Europe, Japan, and America are not helping to drive growth, and that recent experiences in negative interest rate policies will create greater volatility in the short term.

“This summer is going to be a rocky ride,” he said.

Gundlach is not an outlier, according to a new Bank of America Merrill Lynch survey of fund managers. The monthly survey showed that institutional investors sold stocks and bonds and moved into cash at a radical pace, causing cash levels in funds to reach their highest point since November 2001, which was shortly after the dot com collapse and the tragedy of September 11 had caused intense economic uncertainty.

Academic commentators are also becoming increasingly critical of Fed moves. Writing for the Washington Post, Harvard economist and former presidential economic advisor, Larry Summers, criticized the Fed for its “ill adapted” and “misguided” strategy.

According to Summers, the Fed is focusing too much on inflation, which remains far too low to spur growth. Instead, Summers believes the Fed should focus more on increasing real wages for Americans by allowing inflation rates to rise above the central bank’s 2% target. Summers also recommends the Fed reset their target inflation rate because of “new categories of innovative and often free products” which has caused inflation to organically weaken from prior trends.

Summers also said higher inflation is necessary to spur more wage growth, noting that several indicators of a weak labor market often presage recessions and should indicate the need for a more accommodating monetary policy.