The Fed's Duplicitous Goals

Duplicitous is my big word for the day. According to Wikipedia, "Someone who is duplicitous is almost like two people, saying one thing but then doing something very different, even contradictory." You might called them two-faced.

When the Fed said recently that they are worried about inflation getting too low, I think they are being duplicitous. The Fed doesn't give a rat's patoot about low inflation. The Fed cares about one thing and one thing only -- growth slowdowns and recessions. That's it. Yet they persist in this nonsense about inflation being too low.

Why would the Fed want to be duplicitous? Let's back up. The Fed is the institution in this country responsible for monetary policy. Monetary policy is generally thought of as one of the most important components of a country's macroeconomic policy. The government uses its fiscal policy to achieve macroeconomic goals. The Fed uses monetary policy. Ok? Big gulp of JD.

Every institution has goals. The Boys & Girls Club wants to provide a safe place where kids can go after school to learn sports and games. Your local neighborhood bar creates a nice place for you to go after work so you can have a drink and unwind with your friends.

The Fed has macroeconomic goals so it can provide a non-inflationary growing economy. The Fed has been historically clear that it has two goals -- assist economic growth and keep inflation low. Notice -- keep inflation low, not high. That sounds nice, but like a juggler with only one arm, it is very challenging if not impossible to "kill two birds with just one stone". And that's the rub with Fed policy -- it only has one tool or instrument of monetary policy.

If the economy is growing too slowly or is contracting, the Fed tries to juice it up with lower interest rates. If the economy is growing too fast and inflation rises, it tries to slow things down with higher interest rates. Interest rate control is the one-hand or the single instrument of the Fed. That's all it has. One hand for juggling the economy.

Notice that the whole story focuses on economic growth -- keeping it from growing too slow or from growing too fast. Inflation comes into the story but only because it is the other side of the coin. The Fed doesn't care a whit about inflation. It cares about growth.

When the illustrious leaders of the Fed tell us inflation is too low during a time period when output is actually strong, it makes no sense. It is a trick to divert your eyes from what they are really doing. What they are really doing is playing national savior. The problem is not that economic growth is low -- the problem is that they think they can look into their crystal ball and know that without their intervention, economic growth might slow in the future.

It sounds nice, right? They have managed the economy so well today that they are now ready to manage the future too. Unfortunately, they don't know the future any more than they know when the next earthquake will hit Seattle. Surely one is coming but I doubt anyone knows when.

It is these errors in timing that usually cause the most havoc. Diddle around all day and then get on the I5 at 5 pm, and you will understand what I mean. The Fed is famous for worrying so much about future economic growth slowing that they try to keep interest rates low much longer than they really should. Virtually every period of dangerously high inflation in the US in the last 50 years came because the Fed fed the economy's furnace with money too long. Then they play the frying pan/fire game. Fight weak growth one day. Cause inflation. Fight inflation the next. Cause a recession.

What is the duplicitous point here? The point is that the Fed does not have a mandate or a policy goal to prevent inflation from falling. In fact, I doubt that they really believe that inflation will fall so low as to become a problem. What they do believe is that the rate of economic growth might fall in the future. But they don't want to admit that. It seems more responsible to be fighting low inflation today than to be attacking a predicted future slowdown. That doesn't seem more responsible to me, but then I don't work at the Fed.

I wish they would either be more honest or just quit doing that stupid stuff. Lower interest rates after a decade of low interest rates is not going to be the solution to any of our problems, much less the next recession.

The Fed, Market Interest Rates, and the Coming Recession

The Fed is in a quandry these days. They were having a perfectly nice day raising interest rates as it seemed the economy was strong enough to tolerate higher rates. In early 2016, the Federal Funds Rate (FFR) was near zero so what harm could it do to move that rate a smidgen? The red line in the graph below shows the FFR and you can see how the Fed raised it through 2018. It reached a little above 2.25%, not particularly high by national standards. So why not keep raising the rate to maybe 3% or 4%?

Note: The FFR is usually considered an instrument of the monetary policy controlled by the Fed. But the FFR is connected through markets to the interest rates on lots of other assets so when the FFR goes up, it usually drags up many of those other rates. In that way, the Fed influences a broad spectrum of interest rates. Among those assets are Treasury bonds with a maturity of 10 years. The interest rate or yield on the 10-year Treasury is often taken as a gauge of all market interest rates. When the FFR is higher than the 10-year Treasury rate, we call this unusual situation an inversion. End of note.

The graph below explains the hesitancy to raise rates further. Consider the far left side of the graph. Notice the FFR hit the range of 6.5%. Notice also that the FFR rose well above a key market interest rate -- the return on a 10-year government bond. Finally, notice that a recession, as indicated by the grey shaded area, following this inversion of rates.

Move ahead to the time period after 2006 and you see another similar rise in the FFR and an inversion of the FFR rate above the 10-year yield. Bam!, another recession. In this case the FFR maxed out at a little over 5%, and that was quite an increase from the 1% rate that prevailed before the policy to raise the FFR.

Just looking back over the last 20 years or so, we come away with the idea that large increases in the FFR that result in the FFR being higher than the 10-year Treasury rate can lead to recessions. Now we see what looks like the same phenomenon happening again. We see the FFR rising after 2016. We also see we haven't had a recession for quite a while. And we see the 10-year rate starting to fall. There is no real inversion yet but if you extrapolate the lines, you might see one soon. If you looked up these rates on Friday June 14, the FFR range was 2.25% to 2.5% and the 10-year yield was 2.0%. That looks like an inversion to me.

So where is the recession? The answer is that the recession is hiding somewhere near my last glass of JD. Where did I put that thing? Or maybe the inversion-thing is not as reliable as the graph indicates?After all, recessions have always been pretty hard to predict. Maybe there is more to it?

Can the graph help? For one thing, at 2.25%, the FFR is not nearly as high as the 5-6% levels that preceded the last two recessions. For another thing, with the market rate at 2.1%, that is much lower than the 10-year Treasury rates prior to the last two recessions. And rates today have shown no real discernible rise. Rates have bobbled around since 2012, and the market rate today is no higher than a lot of dates since 2012 and certainly not much higher than the rest of the months since 2012. If you compare today's market rates to those before 2012, today's rates look modest.

Just looking at the FFR and a key market interest rate, therefore, does not necessarily proclaim the coming of the next recession. Of course, recessions have never been easy to understand or predict. A housing crisis had a lot to do with the last one and in the past, all sorts of things from oil price shocks  to anchovies dying have precipitated recessions. Today has no shortage of risky trends that could set off the next one. Whether Fed policy can or could set off the next one is no sure thing. Maybe they should just stick with their plan to raise rates to normal levels?

Saving in the USA

Lassie, the Lone Ranger, and Superman save damsels and others in distress. I have two dear friends who similarly are trying to save me from an inevitable date with JD and the devil. But that kind of saving is not what I am writing about today.

My favorite part of teaching macro is when we discuss trade deficits. A very unobvious point is how the imbalance between national saving and investment causes trade imbalances – deficient saving leading to trade deficits. President Trump is correct to try to stop unfair trade but what he may be missing is that we are our own worst enemy. Our distinct lack of saving in this country is the culprit behind our trade deficits.

Of course a lack of saving disturbs our internal domestic economy too when saving is insufficient to meet the demands of borrowers. We call this crowding out when saving insufficiency leads to constrained business investment and lower spending in the economy. If foreigners decide to save here, that helps, but then we get the problem above as foreign savers have to buy dollars to save here and that causes the value of the dollar to rise and leads to a larger trade deficit. If only Lassie, the Lone Ranger, and Superman could help us learn how to save money! What a wonderful world it would be.

The Bureau of Economic Analysis has lot of macro numbers, so I went there to find saving data. What I found is organized in some tables below.

My point today is that we have a major problem with saving in the USA. The top table is the main table as it presents net saving. Underscore the word net. Net savings are calculated when you subtract the uses of saving from the gross amount saved. (You will find uses of saving in the second table and gross saving in the third one.)

Gross savings is what happens when households, businesses, and governments don’t spend all their income. Think of them putting this excess in the bank. Uses of saving gets at the idea that households, firms, and governments want to borrow some of that money they put into banks. Tuna might have a good year and sock away some dough. Peter needs a new Tesla. Lady Diane won’t let him empty his piggy bank so he goes to the bank to borrow some money.

The top table shows you net saving – gross saving minus uses of saving. A nation likes to have a big positive number for net saving. The first column shows you contributions to net saving from households, firms, and governments in 2000.

When the gross amount of savings just equals the uses of saving, we have a nice balance. What I referred to above is the problems created in countries when the sources are always too low relative to the uses of saving.

Notice that net saving equaled $616 billion in 2000. Net saving as a share of Gross Domestic Product (GDP) was about 5.9% in that year. Most of that amount was contributed by households, but domestic businesses and the Federal Government each made positive contributions in 2000. State and local governments were the only scofflaws that year with net saving equal to -$41 billion.  

Let’s see what happened in the past 18 years. In 2018, net savings was less than in 2000 at $599.2 billion. Net saving shrunk to 2.9% of GDP.  That is, in terms of GDP it was half of its former self. It recovered from being -2.5% in 2009, but that was an unusual and tough year.

Look at the 2018 column of the top table. Notice what changed. Households and business firms were contributing much more to positive net savings compared to 2000. The government is the main reason we changed. The federal government went from plus $156 billion to minus $986 billion. What?! Hand me the JD barrel please. 

Is it really possible that the Federal government could have a $1.1 trillion swing in net saving? If you want to lump in state and local governments, then add another $200 billion to the swing – for a total swing of $1.3 trillion from 2000 to 2018.

Politicians in all your favorite parties are whistling in the wind as they get you riled up about how unfair China is and whether Trump didn’t pet his dog enough last week. Don’t fall for that crap. Your favorite pols are a bunch of spending fools who know we aren’t smart enough to catch them at their nefarious schemes. This is a scheme, and both parties are guilty. Why do we let them get away with all this? Huge government deficits! Huge trade deficits! When will it end?

Table. Source www.bea.gov

	2000	2009	2018	Change
Net Saving
Domestic Business	142.9	560.6	789.9	647
Households & Institutions	358.3	666.5	1037	678.7
Federal Govt	155.5	-1248.9	-985.9	-1141.4
S&L Govt	-40.6	-341.3	-241.8	-201.2
Total	616.1	-363.1	599.2	-16.9
Uses of Saving
Domestic Business	1004.6	1531.2	2139.6	1135
Households & Institutions	227	397.5	573	346
Federal Govt	163.1	233.6	283	119.9
S&L Govt	116.6	209.1	278.3	161.7
Total	1511.3	2371.4	3273.9	1762.6
Gross Saving
Domestic Business	1147.5	2091.8	2929.5	1782
Households & Institutions	585.3	1064	1610	1024.7
Federal Govt	318.6	-1015.3	-702.9	-1021.5
S&L Govt	76	-132.2	36.5	-39.5
Total	2127.4	2008.3	3873.1	1745.7

Don't Raise Interest Rates?

Everyone seems to agree these days that the Fed should not raise interest rates. Today Chairman Powell said he might lower them. The Fed backed off their plan to raise rates to normal levels and President Trump wholeheartedly agrees. Paul Krugman, the famous macroeconomist and darling of Keynesians everywhere and the media chimed in last week in one of his columns.

I have been pretty consistent in this blog that interest rates ought to be raised. Today's post looks at some data to explain why it makes no sense to keep interest rates low forever. And really, do we think interest rates are the best tool to overcome the negatives of a trade war?

The mantra for low rates comes from those who  simultaneously love low rates and hate high rates. They love the low rates so they can borrow gobs of money and add to their ever-growing collection of cool cars and stunning shoes. Clearly these people do not like to save money. They hate higher rates for I guess the same reason.

Sophisticates like to point out that interest rates ought to have something to do with expected inflation. If inflation is expected to be low then interest rates ought to be low too.  These highly sophisticated individuals seem to discount everything else that is going on in the world. All that matters is expected inflation and interest rates. How nice it would be if the world was always so simple and easy! One could always boil everything down to two things!

To elaborate this world of only two things I asked Fred to draw a graph with two indicators -- the interest rate  on 10 year US government bonds and the inflation rate (one-year  percentage change each month of the consumer price index) from the early 1960s until now. The percentage change in the CPI is an indicator of past inflation but it's impossible to look inside people's heads for their future expectations and I am content to measure expectations with past performance.

What does the below chart say? Notice that the blue line (interest rate) is often well above the red one (Inflationary expectations).There were many months when interest rates were much higher than inflation. This was especially true during the 1960s and then again in the 1980s and 1990s. Somehow we lived through all those years without crisis. It is true that there were recessions scattered during those years.

You might point out that there were recessions in those years but if high interest rates above inflation are so disastrous, why weren't there more recessions! And if you look at the chart closely you will notice that those recessions came after very large increases in inflation. Notice at the end of the chart how low the inflation rates are. Inflation is barely noticeable recently.  Should the Fed really be so worried that a gradual increase in interest rates is going to cause a recession when inflation is so low?

It is true that interest rats have risen since 2015 but notice that the rise came from basically zero interest rates. Compare today's rates to any point you choose before 2015 and you have to conclude they are very low. How can one say they are too high? Do they look especially high relative to inflation? I don't think so.

The upshot is that the Fed has plenty of room to gradually raise interest rates without any real calamity. Of course if a trade war or Brexit or any one of a number of risk factors surface, we might be headed for a recession. But the Fed keeping rates so low today will do virtually nothing to save our economy from those shocks.

The Fed could be a real leader here. Educate people that normal interest rates are important for our country. Explain why keeping rates too low for too long is damaging. It ain't so hard. But I guess when central bankers turn into politicians, simple things sometimes can get hard.