The Fed’s Gamble on Surplus Labor

LONDON – In recent weeks, the US Federal Reserve has buoyed markets by adopting a more gradual approach to policy normalization. Fed Chair Janet Yellen’s most recent public remarks, in late March, were more dovish than anticipated. And, at its last meeting, the Fed suggested that it would pursue two, rather than four, quarter-point interest-rate hikes in 2016. In response, investors have sold the US dollar and bid up equity prices and US Treasuries, and commodities and emerging-market assets have surged.

At first glance, these developments are curious. For one thing, the Fed’s decision appears to be at odds with signs that US inflation is accelerating. If, as some have suggested, the Fed is responding to fears about global growth, it would not make sense that risk assets – above all commodities and emerging markets – are rallying. But there is a logical thread that explains these apparent inconsistencies, one that centers on a potentially high-stakes Fed gamble.

Before we get to that wager, it is worth considering other proposed explanations for the market rally. The first centers on monetary easing by the European Central Bank and the Bank of Japan. But negative interest rates and flat yield curves harm banks’ earnings; links between extraordinary monetary policies and growth or inflation remain tenuous; and surely monetary policy is subject to diminishing returns by now.

Another view focuses on OPEC countries’ oil-supply restraint, claiming that it is helping to support oil prices and thus high-cost producers in North America. But this logic rests more on correlation than causation. OPEC has not decided to cut production, and only a handful of its members have agreed to freeze output. A genuine reduction in global excess supply awaits a decline in output, as existing wells, deprived of capital investment, run dry.