Tuesday, August 11, 2015

Humpty Dumpty Monetary Policy

Humpty Dumpty sat on a wall. Humpty Dumpty had a great fall. All of the king’s horses and all the king’s men couldn’t put Humpty Dumpty back together again. No wonder baby boomers are screwed up. What kind of story is that to tell a kid? I think it affected all those adults who work for Ms. Yellen on the Federal Reserve Open Market Committee. Or maybe it was JD? 

The FOMC met again and I am told the caviar was delicious. Once again they had pouty faces and wrung their hands and worried that they could not possibly begin a sane and sensible monetary policy with interest rates above zero. So it made me think of Donald Trump. No not really. It made me think of Humpty Dumpty. The Fed believes our economy is like Humpty. If the FOMC begins to raise the Federal Funds Rate above zero then the economy will fall off its wall and will be shattered beyond repair. Seriously. If they had announced a new target for the FFR at 0.5% would Humpty really fall off the wall and be shattered beyond recognition? Would the US economy rapidly disintegrate? Would people be unable to afford Uber rides and take home pizza? Would Whole Foods have to reduce prices to competitive levels?

So I wanted to delve a little deeper into this issue of why the economy might be so fragile that even a tiny return to monetary policy normalcy might be dangerous. Do we really have a Humpty Dumpty economy? Let’s take real GDP growth. It is true that it is averaging less than 2% of late. But most forecasters believe it has settled into a rate of growth of about 2-3%. Keep in mind that real GDP usually averages about 3% per year so 2-3% isn’t exactly a gutter ball.  The unemployment rate at 5.5% is actually better than the 5.7% average since the 1950s.

Larry Larry Larry. Look harder. My hand-wringing friends would point out to me that there are lots of scary spiders in the corners that speak to weakness. Investment in plant and equipment has been weak. Workers are dropping out of the labor force. Net exports are threatened by a strong dollar. China cannot find its way out of a China shop. And Hillary Clinton can barely buy groceries on the family income. But come on. There are ALWAYS signs of strength and weakness in any economy on any day of the week. And while many of these problems are worrisome – do they really mean we are in a Humpty Dumpty economy in which our Fed must keep interest rates at zero?

Is the Fed Funds rate out of line? I looked at that. The Fed Funds Rate is basically zero now or to be more exact somewhere around 0.12%. The FFR averaged 4.81% since the 1950s. That means that sometimes it was higher and sometimes lower than 4.8%. The FFR ranged from 0.94% to almost 18% from the mid-1950s to 2007. Note that it was never zero until after 2007. 

If we exclude the most recent extreme FFRs since 2008, there were only seven quarters since the early 1950s when the FFR was around 1%. These seven quarters were not bunched together as they occurred in 1954, 1958, 2003 and 2004. 

Clearly at zero percent today there is no precedent for such low and persistently low interest rates. Recession is not the reason to have zero interest rates for years upon years. We had 9 recessions between 1953 and 2001.  These recessions were as short as 6 months and as long as 16 months. The great recession of 2007 lasted 18 months. Of course it has been over since the middle of 2009. It has been over for 6 years. We should be closer to average policy. We should be closer to a FFR of 4.8%. Yet is zero.

Some of you experts want to point out that I should be using the real FFR . That is, I am comparing apples and oranges because the expected future inflation rate affects the level of the FFR. They would point out that our FFR is so low now because inflation is so low. So I deflated the FFR by the inflation rate (of personal consumer expenditures) and found that the average REAL FFR from 1954 to today was about 1.52%. Today’s zero FFR is a real FFR of -2%. By that measure we find that the real FFR is 3.52 percentage points below average.

Whether measured in nominal or real terms there is no question that today’s monetary policy interest rate is way out of line for anything close to normal times. This implies that the Fed thinks the economy is like Humpty Dumpty.  But is it? And is there any harm done by having non-normal policies during normal times? I think so. 

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