Fed Tales

Those of you who can count will notice this is my third post in recent weeks about the Fed. Okay – I am a Fed-O-Holic and I have to observe a three drink limit.  So I promise not to write another one about the Fed for at least a week unless they deserve it.

I love to write about the Fed. I spent my career teaching, researching, and writing about monetary policy. I am still capable of emptying a perfectly good room when I start to pontificate about Fed policies. But that hardly stops me. Since I am old, that means that I have seen a lot of change and witnessed, if nothing else, the disconnection between Fed policy hopes and realities.

As smart modern people we believe that learning is natural and possible. We watch a two-year-old fall down repeatedly only to finally learn how to straddle even the tallest bar stool. It is only in the realm of federal institutions, however, that it seems learning is next to impossible. And the Fed is a federal institution. While it is technically independent from governmental institutions like Bob Dole and the Supreme Court, The Fed is obviously impacted by hopes and dreams and Nancy Pelosi.

I was motivated this week to write about the Fed because of the many articles being written these days about how the Fed is going to fine tune the coming increases in interest rates. That sounds hopeful doesn’t it? Imagine Janet Yellen and her colleagues standing behind a large high tech machine. Janet yells out – interest rates up 20 points this week. Aye Aye Capn says the FOMC and magically all the newspapers report a rise of exactly 20 basis points. Capn Yellen is hoisted onto Michelle Obama’s ample but sexy shoulders and they all march out of Washington singing Federal Reserve Drinking Songs. We raised the interest rate 20 points hurrah hurrah (to the tune of Johnnie Comes Marching Home Again).

Seriously. Can it be possible that we lived through millions of years of Federal Reserve policy and we still believe it when the Fed Chair tells us they are going to manage the upward (or downward) movement of the interest rate? It is not dissimilar to believing in the tooth fairy. Jimmy says – Mommy, is the Tooth Fairy going to bring me a new Harley Davidson if you put my bloody tooth under the pillow tonight? Of course, honey. The Tooth Fairy wants to know if you want saddle bags or not.

No I am not drinking JD (at the moment). Then why all the silliness about such a serious topic? The answer is that somehow because Fed policy is both technical and complicated we are prone to believing the largest fibs since Bill Clinton said he didn’t get busy with that person.

Why even worry about Fed fairy tales? Fairy Tales are wonderful. We love reading them to our kids. But somehow they don’t injure most of us. We grow up somehow understanding that we won’t all be saved by the Handsome Prince because we left our glass slippers at the counter at the 7/11. But Fed Tales are dangerous and subject us to very poor forecasts that can lead us into making very poor decisions. Yes, honey Ms Yellen is going to raise the rate by 20 points this year. No honey – rates will not rise by 21 points this year. Don’t worry your little ahead about that.

Let me make two points to support my lunacy. The first point has to do with what actually determines interest rates. Let’s call that point theoretical. Snore. The other one has to do with reality – looking at the data. Last week I presented inflation data. This week I look at interest rates.

Because some of you are already sleeping in your Lucky Charms, I will make the theory part less than the 1000 pages it deserves.  Any self-respecting economics textbook explains that interest rates are determined by the interplay of saving and investment. Whenever saving exceeds the needs for investment, market forces push interest rates downward. On another day when saving is insufficient for investment needs, rates rise to ration out the scare supply of funds. Point: interest rates are generally driven by private sector decisions.

With the US economy expanding and expected to expand even more it is natural that investment and interest rates will rise. Notice that the above story about simple supply and demand says nothing about the Fed. So let’s add them into the story. In times of a weak economy investment demand is low and rates fall. But sometimes they don’t fall enough to quickly resuscitate spending. Thus the Fed adds more money into the equation. This amounts to adding artificial temporary savings to the market and this action pushes market rates even lower.

When the economy starts to expand, investment and interest rates will rise with the economy. If the Fed is a worrywart they believe that the rising rates will prevent the economy from expanding and they pour in even more money thus keeping rates down. 

The Fed can keep doing this as the economy builds momentum but notice that their policy amounts to keeping a heavy hand on the lid of a rapidly bubbling pot. As the temperature rises what do you think will happen to the lid when the Fed lifts its hand? Yup – it will pop up. The longer the Fed holds its heavy hand on the lid – the higher the lid will eventually fly.

Interest rates rising is just like the lid rising. The longer Ms Yellen holds interest rates down the more thrust is building to push interest rates up. She thinks she can hold her hand on the lid a wee bit longer. She believes rates will then rise gradually.What if she is wrong? The below graph proves nothing but is illustrative. 

Below is a graph of the Federal Funds Rate. The FFR is the rate that the Fed directly controls through its policy instruments. Other rates, like government bond rates or mortgage rates seem to go up and down with the FFR. So when the Fed changes the FFR it often affects many or most rates.  The shaded areas are all the US recessions since 1970. 

I am sure the Fed never said anything like this -- yes we are starting to let the FFR rise and we hope it will begin slowly and then take off like a rocket until it causes a recession. But history does not lie. Except for the last recession (2008/2009) which was caused by a housing and financial crisis, virtually every recession followed a time period in which the FFR rose much more than just a little bit. Rates rose before 2000 or before the dot com crisis -- but that one is less clear than the previous recessions. Typically interest rates do not rise gradually. Ms Yellen is telling a tale that's as slippery as a bar of soap on a bathtub floor.