Fumbling Around in the Dark

Fumbling around in the dark is a scary thing. You awaken at 2am in a very dark hotel room to find that you are relieving yourself in the closet. Or maybe you are trying to find the glass with one ounce of JD left in it, and you accidently knock your wife’s mobile phone into the toilet. Regardless, fumbling around in the dark can be pretty destructive.

Such fumbling is simple to explain. You are used to having light to guide your eyesight. Take away the light or the eyesight and you find yourself in a treacherous environment. Decision making becomes a totally new thing. You can do it but it necessitates new rules. It might require that you memorize the layout of your hotel room. It might mean groping with hands or buying a cane. How you operate depends very much on the expected time period of the darkness. A temporary situation would be dealt with differently than a permanent one.

It seems to me that the Fed is operating in the dark today. With Congressional economic policy in the potty, we rely on the Fed to guide the economy. Unfortunately, the lights went out in 2008 and the Fed has been groping around for ways to assist the economy ever since. In the beginning, most of us thought that the darkness would be temporary. Now I am not so sure. 

By darkness I mean that we have been dealing with economic problems and performance that are new. Our economic indicators are misbehaving. GDP contracted far more than during our experience of the last 75 years. US inflation bordered on the negative during those years. The Fed was correct to assume its role of lender of last resort. Economic darkness called for rare policies right after 2007.

But the great recession ended in 2009 and, according to my JD calendar, it has been eight years since we started an economic recovery. And yet in those eight years the Fed saw the same thing – economic weakness. And thus the Fed keeps its interest rate target at less than 1% and it leaves trillions of dollars in bank excess reserves. Why is the Fed so afraid to return to a normal monetary policy? Note I haven’t asked why they didn’t raise interest rates to 3-4%. I simply asked, why didn’t they start to return us to a more normal policy?

The latest answer is that they have already attained a normal policy. That is, the economists at the Fed looked into the darkness and drew a conclusion. Normal has changed! In particular, they resurrected a concept called the neutral or natural rate of interest. Aha – the neutral rate of interest has declined and therefore the current rate of less than 1% looks a lot more normal. 

What is the neutral rate and why is the Fed so confident that it dropped like a rock? Tuna – the neutral rate is not the neutered rate. To the rest if you – the neutral rate is an interest rate at which monetary policy is just right. As in Goldilocks, the Fed wants a monetary policy that is neither too cold nor too hot – they want it just right. If for example, the current policy interest rate (the Fed’s main policy target is an interest rate called the Federal Funds Rate) is 0.6% and the neutral rate is 4%, then we would conclude that the Fed’s policy rate is too low. It would also imply that the Fed is stoking the fires of the economy too much. But if the policy rate and the neutral rate are both around 1%, then Goldilocks kissed the charming prince and she and the frog live happily ever after.

As you can imagine, the Fed is relieved that it found economists who would explain why the neutral rate is low – and why it might stay that way until Nolan applies for Social Security. Not to contradict economists who work for the Fed, I will say that if they are wrong about this, then the Fed will continue providing stimulus to the economy long after it should have stopped, and the consequences could and probably will be a Fed-engineered bout of stagflation.

Could they be wrong about the size of the neutral rate? I think so. To conclude that the neutral rate is low, the Fed focuses on recent data that shows among other things a slowly growing economy. Such data includes declining labor force participation, a slowdown in productivity, and a discovery of new planets that might have doppelgangers for Barbara Streisand and Sara Palin. But can we believe all this?

I recall a very widely held concept called Secular Stagnation advanced by leading economists that explained why, after World War II, the US economy would slip back into the Great Depression. It never happened. Similarly, economists today look at data from a spoiled batch of milk. Whatever caused the great recession of 2008-09 and whatever unprecedented policies followed that decline appear to remain with us today. But just as turning off a light switch causes confusion for a while, the impacts of the last eight years will dissipate and then disappear. In the meantime our usual data are going to be very suspect, and thus our conclusions from such data will be equally suspect.

This darkness meant that the Fed had an excellent excuse to use emergency policies in the beginning of the recession. But it does not mean it should make up excuses to continue that policy forever. While the Fed is supposed to support full employment with stable prices, nowhere does it say they should engage in a binary policy of spigots open followed abruptly by closed spigots. The Fed does not know the value of the neutral rate. Erring on the side of a low rate to support its current aggressive policy means risking a future burst of inflation and an eventual Fed-induced recession. To mix metaphors – it is time to take the foot off the accelerator. 

Fed Gone Wacky?

Bloomberg.com had an article last week with a photo of a smiling Janet Yellen which said that the Fed was elated that the inflation rate was rising in the US. On the same day was an article “The Fed Embraces a More Diverse Future” that had several quotes from Fed officials decrying disparate effects of unemployment on minorities. Minneapolis Fed President Neel Kashkari promised to “spend a day in the life of a struggling black family in order to better understand that experience.” The article concluded  

“While the Fed may have no direct ability to do anything about this relationship, it may be less willing to call an overall unemployment rate of 4.5 to 5 percent full employment if it coincides with a black unemployment rate of 8.5 to 9 percent.”

I wanted to know more about the explicit goals of the Fed. I found the below words at a Federal Reserve website https://www.federalreserve.gov/faqs/money_12848.htm

The Congress established the statutory objectives for monetary policy--maximum employment, stable prices, and moderate long-term interest rates--in the Federal Reserve Act. In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.

Wow. Double Wow. The Fed’s explicit job is to control inflation and employment. Yet today’s Fed officials are happy to see more inflation and are not content when they reach their goal of full employment.

Interesting is how cavalier the Fed is departing from its statutory mission. I can see it now. Hey coach I think I would be more popular if I played guard on our football team. But son, you are a quarterback. Come on coach, the linemen are cool guys and I always wanted to hang with the cool guys.

The Fed has no mission and has no ability to affect the composition of unemployment. If they drive the unemployment rate below the usual definition of full employment – they can provide some jobs for those at the lower end of the labor pool. But history shows that such jobs do not last very long. Driving unemployment so low will cause the economy to run fast enough to absorb more workers. But like any engine that runs faster than normal for a while – it will generate frictions that eventually bring it back to normal – if not requiring a new engine! History suggests also that the aftermath of such reckless driving is often the dreaded scourge stagflation wherein both inflation and unemployment rise together. At some point the Fed then has to tighten and cause a recession and even more unemployment. Thus gains are not only temporary but they end up worsening the entire economy.

As for the seemingly perverse joy over a September rise in the inflation rate, this just underscores my point. Yellen has recently been quoted as saying it would be okay for the economy to run hot for a while. I like my coffee hot but she is delusional if she thinks a hot economy is a good thing. Higher inflation and a hot economy won't accomplish anything except to raise and then dash the expectations and lives of those least able to deal with such changes. 

Unfortunately our current Fed has fallen for the liberal line that one should focus on the short-run. Despite relying on nothing more than dreams and drugs, our Fed wants to make people feel happy that it is doing something. But like many do-gooders, the Fed has neither the tools nor the mission. Just because Congress is broken it does not mean the Fed can pull a rabbit out of a hat. Unequal incomes may be a problem but like the QB who wants to be an offensive lineman, the Fed is neither qualified nor licensed to solve this problem. Mrs Yellen -- please just stick to your job description.  

Fed Policy, Red Bull, and Buddha

Will the Fed raise interest rates? Will I gain one pound after eating the giant pork chop at Le Petit Cochon? Answer: Who cares? Apparently the market seems to care more about interest rates than my waistline. So let’s work on that question today.

Thanks to my friends at the St Louis Fed I was able to download a chart from their lovely FRED service. This graph charts an interest rate – the 10 Year Treasury Constant Maturity Rate (or let’s call it Ted). Ted tells you what you could earn on a riskless asset with a 10 year maturity. It also seems to be at the heart of something called the interest rate yield curve. I see some of you are dosing. So let’s try one more time – this graph of Ted shows you an interest rate that represents interest rates on all sorts of assets. Ted is like the popular guy you know. If Ted goes to the Player’s Pub then everyone goes there. If Ted goes to the IU Opera, then the crowd goes to see the Flying Dutchman (highly recommended for people suffering sleep deprivation).

The Fed does not directly control Ted. But smart people watch Ted to gauge how the Fed’s actions will affect all sorts of interest rates. I love the below graph of Ted. I could write about it until the cows come in even though I don’t even have one cow.

The graph shows Ted from well before 1970 to now. It shows how Ted behaved over a long period of time and over lots of short periods of time. It shows Ted before, during, and after recessions.

Ted got really heavy as a youngster and peaked out at around 15% in 1982. Then he went on a diet and has been losing ever since. Sure he falls off the Dick’s Burgers wagon now and then but he keeps getting svelter and svelter.

As a result of looking at this graph of Ted for at least 100 hours you can come away wondering if there is something called a normal interest rate for our times. Despite what the Fed might do or not do in the coming weeks, one story is the long-term trend since 1982 towards lower rates. Perhaps rates will go even lower for yet another phase of this trend?

Or you might say that the downward trend has to end sometime. Negative interest rates are possible but it seems strange to think of negative interest rates as the new normal. It would be like going into a Whole Foods and being told that they will pay you $10 to take home a dozen natural cage free no hormone no antibiotics Omega-3 Nest laid, vegetarian diet certified human raised and handled extra-large eggs.

So let’s ignore the trend. The other thing you might note is that Ted generally rises before recessions. These recession-inducing interest rate increases might have been a natural result of a rapidly growing economy or the direct result of an intended (or not intended) Fed policy. If you have on your reading glasses you can see the shaded vertical bars representing recessions and look at how many of those bars were preceded by a rising Ted. Aha – the culprit has been found and so the recession cure is right before our very eyes. Do not let the Fed push Ted up and we won’t get another recession!

Not so fast Nathan. If you squint and look even harder you can find a number of time periods in which Ted rose but did not lead to a recession. So now we have it – rising Ted causes recessions at times and does not cause recessions at other times.

This brings us back to our current dilemma. We are all waiting for the Fed’s decision as to whether they will raise interest rates another smidge in June or July or whenever. The second Rufus gets a whiff of a rumor of such an interest rate increase, Rufus calls in the dogs and the markets go crazy. But seriously, what is wrong with these markets? 

Looking at the chart, have you noticed how low interest rates are? Are we really serious that another 15-25 basis point increase is going to throw us into a tizzy? Whatever that policy might do to Fred in coming months its value will still remain on such a low portion of the graph that you can hardly see the increase.  Imagine how people felt when the Fed engineered the 15% rate in the early 1980s? Now that increase was noticeable!

Graphs and data do not prove anything. But they sure have a way of putting things into perspective. Janet Yellen, her colleagues, and a lot of financial people need to put down their Red Bulls, take a deep breath, and say Om next to a babbling brook. Get on with normalizing monetary policy and try a little quiet meditation. 

2% Inflation and the Fed

The Fed seems to have a thing about 2% milk. Or was that 2% inflation? It has become a passion with them. It’s like your mom when you were a kid. Honey, if you are good we will take you to Legoland. What is good Mom? To start with clean up your room. And then you should get straight Bs. Straight Bs? Why do I need straight Bs to be good – good enough to go to Legoland?

Mom knew that I would never get straight Bs. I could hardly sit in my school desk for five minutes let alone concentrate long enough to get a B on anything. The Fed has been singing this 2% inflation song for quite a while – and all during that time the chance of inflation reaching 2% was about the same as my getting straight Bs.

Why is the Fed so disingenuous? Mostly to take our collective eye off the ball. There used to be a time when the proper role of the Fed was to provide just the right amount of liquidity to the economy and restrain inflation. But then the Keynesians messed things up and suggested that since the government is totally inept, the only organization besides Donald Trump left to control the economy is the Fed. So instead of humbly trying to  dampen inflation and inflation expectations the Fed has turned into this multi-headed hydra doing everything from dunking basketballs to fine tuning the unemployment rate.

Janet has no troubling dunking so she and her fine fellows at the Fed (notice all the Fs) have spent the last 8 years or so telling us bedtime stories about monetary policy and the unemployment rate. Janet will not rest until every last legal and illegal fast-food server has a full time job with rapidly growing wages. She is still a long way from reaching that goal so she is even more dedicated. But here’s the rub. Aged economists like myself keep reminding her that at some point after she has poured enough money onto the smoldering economy she will have created enough economic and financial imbalances to sink a manatee.

Janet wants to please even old guys like me so she gives what we might call “lip service” to the idea of inflation. Janet wants unemployment much lower (and wages much higher) and will say just about anything so she can say she slayed the employment dragon. One thing she can say is – look dudes. I poured enough money on the economy to drown China and look – no inflation. Well – there is some inflation so she had to come up with a number for the perfect amount of inflation and that number is 2%. She keeps pointing out that inflation is less than 2% and she acts as if that is a bad thing. Is it a bad thing when your money buys more? Instead of saying she wants the unemployment rate lower – she chides us with this silly statement that inflation is less than 2% and that is a bad thing! Worse – she says – we must keep stimulating the economy until we can get inflation up to 2%. 

Up to 2%!!! Am I yelling? I spent my whole 169 year career thinking the Fed is supposed to REDUCE inflation. Where did we get this raise inflation crap??? It is just like those straight Bs. Mom didn’t want to take me to Legoland. Janet does not want to raise inflation to 2%. What Janet really wants is a gold star for employment achievement.

You say – but Larry – the Fed just raised the interest rate. Are you never happy? Did you never get to Legoland? Yes, I did get to Legoland and it was wonderful. As the Fed announced its miniscule increase in the interest rate it spent more words reassuring us that the future increases will be so gradual that no one will even notice. But even that tiny little interest rate increase isn't guaranteed. If ANYTHING comes up this year that has even the tiniest possibility of slowing growth in the US economy you can be sure that the Fed will end their attempt to restore a bit of normalcy to monetary and financial conditions.

2% inflation is a gimmick and it means nothing. What matters is the Fed’s progressive agenda and that it is riveted on the unemployment rate and economic growth. Mark my words. If the inflation rate rises close to or above 2% while the employment situation is not sufficiently solved – the Fed will explain why 2% was never a rigid target. The Fed will then explain why 3% makes more sense. Hey guys, is 4% really so bad? 

Why am I so mean about the Fed? The answer is that they don't read the handwriting on the wall. First, remaining issues with employment have nothing to do with monetary policy and everything to do with long-term structural issues. Loose money and low interest rates are doing little for growth and everything to increase imbalances. Second, we already see the worrisome bubbles developing that arise from near-zero interest rates. Third, if inflation does begin to rise despite little progress on employment, the Fed will likely ignore the inflation and will end up creating a very unstable stagflationary environment. Those of you who experienced all that in the 1970s know why that is not a desirable end. 

The Fed should stop this charade about wanting a higher inflation rate and just tell the truth. They are not going to stop this abnormal monetary policy until every last one of us has a full time job and wages are growing faster than kudzu. Domestic and global imbalances be damned. 

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.