Fed Policy and the Market

As the (red line in the) below chart shows, the US Federal Reserve is embarking on a new policy to lift interest rates gradually back to normal levels. Today's post suggests that even if the Fed keeps to its goal of raising the Federal Funds rate gradually in the coming year, the Fed might not get what it is hoping for.

To convince you that this is no slam dunk (to raise market interest rates), it takes a little excursion into interest rates and then a closer look at the below graph.

Let's start with interest rates. There are many interest rates out there, and the Fed has no direct control over them. You can think about an interest rate in two ways -- as a saver or as a borrower. When you put your life savings into your money market account, you soon learn that with today's low interest rates you get enough return to buy yourself maybe 15 minutes on a Bloomington parking meter. If you instead lend the money to the government by buying a long-term government bond, you might get an interest rate of about 2.8%. That means if you buy a bond for $100, you will get back the sum of $2.80 each year you own the bond. That return amounts to a coffee of the day at Peet's. No refills.

You might instead want to borrow money. Most of us borrow for a car or a home or a month's supply of JD. In that case, you would pay the interest rate on a car loan or mortgage rate or whatever rate your friendly credit company charges.

Whether a saver or a borrower, you experience interest rates, and the fact is that interest rates are not set by the Fed or the government or even Santa. Interest rates, prices of stocks and peanuts, respond to market forces. If in today's market everyone wants to borrow and no one wants to lend, this tends to raise interest rates. If tomorrow most people are interested in lending and there are few borrowers around, then interest rates fall. We say interest rates are mostly market driven.

A quick look at the blue line (interest rate on a government bond with a 10 year maturity) in the graph below shows you that interest rates have a pretty exciting life. And this graph only shows you 1999 to present. A graph going back to the 1960s would make your head swim. Remember those 20% interest rates in the 1970s?

Okay, so rates are determined by market forces. Where does the Fed come in? Like most government entities, the Fed likes to try to make the world better. The way the Fed does this is to try to raise interest rates when the economy is acting like a runaway train car. Or when the economy gets slow and creepy, the Fed tries to stoke it with lower interest rates.

I keep saying "tries" because the Fed does not tell banks and other financial institutions how much to charge on auto loans or mortgages. But the Fed can try to influence these rates through its control over something called the Federal Funds Rate (FFR). The Fed sets goals for the FFR and can reach those goals by intervening in something called the FF market where bankers loan each other money on a  daily basis. It's too long a story for the blog today but just take it for granted that the Fed can take actions which either decrease or increase the FFR.

The FFR is the red line below. A quick review: the Fed altered policy several times since 1999, first raising the FFR, then reducing it only to raise it again. It bottomed out at the end of 2008 and was kept near zero until recently. November 2015 marks a turning point in which the Fed started raising the FFR. We are told that since the economy is now humming along at about 70 miles per hour, they need to raise rates to cool things off a bit. Plans are to increase the FFR several times into 2018.

Why raise rates? Presumably because a near-zero percent interest is not normal and it tends to penalize savers. Some think it might make savers want to take on too much risk by buying bitcoins or 8-track players. Whatever the reason, the goal today is to raise the FFR. The goal is to have the rise in the FFR spillover and influence all those other market rates. The chart below is instructive in that regard. We can look at the relationship between the FFR and the interest rate on government bonds with a 10-year maturity (I chose this one market rate because there are just too many too choose from and this one has the reputation of being a good indicator of what is happening to most rates.)

Notice in the chart that increases in the FFR do not always result in higher interest rates.

• After 1999, the FFR increased to almost 7% while the 10-year rate started to rise but then fell.
• After 2004, the FFR went from 1% to over 5% yet the 10-year rate bobbed up and down like a tuna in a shark tank and ended up only a smidge higher than it has been in the recent past.
• After 2016, the FFR gently increased while the 10-year rate's downward trend was only interrupted in 2017. But notice that the 10-year rate today remains below its peak value in 2014 and is well below other previous peaks.

Since you are still a bit slow from your New Years' partying, I will refrain from taking this much further. But the obvious question to ask at this point is why the 10 year rate has been so fickle. It is supposed to do what the FFR tells it to do. The bottom line is that market rates are impacted by many things -- psychological and other -- and only one of those many things is the level of the FFR. The chart shows how important markets are to interest rates and why it is possible that Fed policy may not succeed in its goal to protect the US economy from immodest growth. Worth speculating about at George and Wendy's is the long-term downward trend observed in the graph. The 10-year rate has been on a downward slope for about 17 years. I wonder what it will take in the way of Fed policy to reverse that.

Lesson 8 Macroeonomic Policy: Out Of Bullets?

Yesterday: General Sir – the enemy keeps coming should we keep firing at them? Yes, Private keep firing. But Sir, I am running low on ammo and most of the enemy intruders are the weak ones carrying no weapons. Private – I said keep firing. You never know when one those weaklings might hit you on the head with a broom stick.

Today: General Sir, I am now out of ammo and a whole new army is coming at me. What should I do? General? Are you there General? What should I do General? Click. Buzz.

When the market fell last week, it became more and more obvious that our policy makers are out of bullets. Which brings up the topic of what we mean by Macroeconomic Policy. So this is another lesson on macro for all you folks who tell me that you only understand one out of seven words in my posts. It is also an opportunity to crow about what  I have been calling jeopardy for years.

My parents never tired of warning me about jeopardy – meaning that today’s decisions can put you in a vulnerable place. My mother would shout, Larry quit playing Party Doll on your Victrola over and over and over. Do your math homework. If you don’t do your math homework you will someday be a horrible guitar player with no source of financial stability.

So I learned the concept of jeopardy at a young age. And that explains why I have been writing for at least five years about how the US Government and the Fed have put the nation at jeopardy. And this also explains why we are now in a very risky economic state because we may be facing tough times ahead and our policy makers are out of policy bullets.

Liberal or conservative, there is room to believe in the efficacy of national macroeconomic policy. But let’s start at the beginning using some questions.

What is macro policy? Macro policy is aimed at making national policy variables approach desired ends. It is not about specific industries or specific companies or specific regions. National policy ends are economic growth, low inflation and unemployment, and so on.

What are the options for macro policy? In most macro courses we teach that there are these four policy areas: Monetary Policy, Demand-side Fiscal Policy, Supply-side Fiscal Policy, and International Trade Policy.

Monetary Policy consists of the Fed managing interest rates and money. Demand-side Fiscal Policy involves the government (Congress and President) implementing policies designed to impact spending in the economy. Supply-side Fiscal Policy is about the government legislating policies that improve incentives to produce goods and services – more efficiently and in greater volumes. International trade policies are not popular in the US but generally involve countries trying to improve their competitiveness so they can sell more goods abroad. These policies include exchange rate manipulation as well as policies like Free Trade Agreements that would make US goods more desired by the rest of the world.

So are we out of policy bullets? If not out of bullets we are getting close to zero balance.

Fed policy is easy to start with. As you know the Fed has spewed a lot of money into the system and lowered interest rates to zero. None of that inspired a strong recovery. The Fed admits to economic weakness every time they explain the economy is too anemic to return to normal policies. So if a future shock weakens the US economy the Fed has little left that it can do. Any new monetary policy that would lead to negative interest rates or new rounds of quantitative easing would signal weakness and would worry world investors. You saw a little bit of that in the stock market last week.

How about Demand-side Fiscal Policy? The story is similar. The US government reacted to the past world economic crisis with huge increases in spending accompanied by policies to reduce tax rates. This was meant to prevent the economy from tanking. 

This activity took us into new territory when it comes to national debt. Without throwing around big numbers let’s just say that the relative size of our nation’s debt more than doubled and so far the debt burden is planned to get even higher in the future. When times improve we are supposed to reduce debt. But that never happened. Now as we approach a possible new economic contraction the government has no room to increase spending and/or reduce taxes. Do we want the national debt to double again? If we do try to use Demand-side Fiscal policy, then this will be taken as a sign of extreme alarm by world investors. We do not want that. I won’t even bring up Greece here. But I think you get my drift. Greece is clearly out of bullets. They don’t even have a slingshot.

How about International Trade Policy? I think we are out of bullets there since problems abroad mean that other countries are not buying much from the rest of the world and definitely are not buying from us. The value of the dollar is rising – not falling. Free trade agreements won’t do much to solve a crisis since the fundamentals mean that foreigners will not be buying more goods from us. They can barely buy goods from themselves.

What a pessimistic picture. Or is it? I left out one type of macro policy – Supply-side Fiscal Policy. Talk about tainted meat! Supply-side policy is an interesting alternative but it is saddled with cuss words like Reaganomics, Trojan Horse, Trickle-Down, and more. Liberals light up and glow when they use these terms. Sort of like when you got mad at your friend in third grade and called him a poopy-head. 

But SSFP -- let's call it that since it is less provocative -- is simple and straight-forward economics. Like bitters -- SSFP is not perfect for every situation but bitters is a necessary ingredient to make an awesome JD Old Fashioned. SSFP does wonders when suppliers of goods and services are reluctant to produce. SSFP attacks disincentives to produce. SSFP looks at things that unnecessarily add to business costs. SSFP is NOT about getting consumers to buy more. But it ends up increasing demand if it promotes firms to compete better and harder. 

SSFP tools are many. The best tool for today comes from examining what is constraining businesses right now. Why aren't firms hiring more workers? Why are firms reluctant to purchase new capital equipment and software? Why are some firms moving their assets abroad? Answer those questions and then use SSFP to remove the impediments. I won't prioritize the answers but clearly there are many areas of policy we can examine including minimum wage increases, environmental regulation, Dodd-Frank banking regulation, Obama-Care impacts on employment, and corporate taxation. 

My liberal friends will scream that we need all those taxes and regulations. Don't interpret me as saying we need to get rid of them. But just acknowledge that if we are truly out of policy bullets, then some small backtracking on these priorities could be very useful in getting this train wreck of any economy back on its rails. As J. Cash would sing -- Look Yonder Coming -- Coming down that railroad track.  It's the SSFP Special bringing my baby back! Humming is permitted.