Cause and Effect and Interest Rates

As humans, we struggle with cause and effect, and it is understandable that President Trump does too.

I yelled at a student one day as I was driving on campus and almost hit him crossing in front of me. Clearly, he almost caused an accident. He chased me down and yelled at me for driving too fast. He told me that I almost caused the accident. Hmmm. Was he the cause and I the effect? Or was it just the opposite? With no police officer or bystanders around to adjudicate, I guess I will never know.

Monetary policy is even murkier as it relates to cause and effect. You may have heard that the Fed has decided to normalize interest rates in the USA. After keeping rates near zero for many years, the Fed has been using its levers to raise something called the Federal Funds Rate (FFR). It is believed that when the FFR rises, it pushes or pulls lots of other rates up. Thus, one might believe that when the Fed raises the FFR, it causes increases in interest rates on cars, houses, business loans, and so on.

It is also true that any of those interest rates can rise without any actions of the Fed. That is because interest rates are market variables. If people decide they want more chili dogs and fewer cheeseburgers, this can drive the price of hot dogs up and cheeseburgers down. We call that a market phenomenon. Similar forces are at play with respect to loans and interest rates. If the economy strengthens, more people want to use loans to buy houses and cars. Companies often want to borrow more so they can expand their businesses to meet the demands of a stronger economy. A rising economy, therefore, tends to raises interest rates on all sorts of loans.

With respect to cause and effect, we have learned two things. Thing 1 – the Fed can impact interest rates. Thing 2 – the economy can affect interest rates.

There is a Thing 3 worth mentioning. You alert folks might have noticed that the government has decided that it should borrow more because it spends more than it takes in taxes. I wrote about that recently. As of this year the government needs to borrow around $800 billion just to cover its deficit in 2018. That annual amount is heading toward $1 trillion per year. The government will be floating a bunch of treasury bonds to borrow all that money.

I could go on with other things affecting interest rates in the USA – putting pressure on them to rise. But most of us can’t balance three things in our increasingly senile brains, so let’s stop there. The point is that the Fed is only one of the three. Even if the Fed stopped its current policy of interest rate normalcy, these other factors would keep driving interest rates upward.

So what should we do? In one sense of cause and effect, rising interest rates are bad because they make buying cars, houses, and other things more expensive. But notice with Thing 2 that one cause of rising interest rates is a strong economy. Interest rates rising are the effect and not the cause. Clearly, we don’t want to have a policy to weaken the economy to bring interest rates down. So let them rise.

If interest rates are rising because of government debt, then that’s a different story. We can and should try to reduce interest rates in this case for two reasons. First, the cause is not a strong economy. Second, government deficits and debt are very worrisome risk factors on their own. Thus we can kill two birds with one stone. Reduce government debt, and this will reduce the risks of high government debt and reduce interest rates.

Forget the Fed. They are not the cause of much of anything as they try to restore normalcy. Let the economy grow at a reasonable rate, and let’s manage our government debt. If we do all that, we will likely forget interest rates and enjoy a better economy. 

Fed Policy and a Rubber Seesaw

You know what a seesaw is, right? It’s a lot of fun. It’s a long board with a fulcrum at the center. Tuna sits at one end and Peter sits at the other. When Tuna move downward, Peter moves upward. You can do that all day. Or until the board breaks.

Lots of things in economics are like seesaws. The price of JD goes down and demand for JD goes up. The value of the dollar goes down and the Scots buy more JD. The Fed reduces the interest rate and the economy expands. Lots of seesaws out there.

In the past, the Fed believed in a seesaw called the Phillips Curve. This Phillips Curve said that if the unemployment rate went down then inflation would go up. Since inflation and unemployment were so rigidly related, either one could be used to indicate a need for monetary policy. A reduction in the unemployment rate meant inflation was rising and the Fed could back off. That is, the Fed would give less stimulus to the economy.

But that was in the past. Now the Phillips Curve is no longer rigid. It’s like the Phillips Curve has a bend in the middle, and both ends are going down. Think of the Gateway Arch in St Louis. Imagine a seesaw with both ends on the ground. Weird. Tuna and Charlie would sit there and nothing would happen. How sad.

Dr. Yellen is very confused about all this. Inflation and unemployment are both down. The thing that is curious about her reaction to all this is that she ignores the unemployment rate being down as she favors the information she is gleaning from the inflation rate. The unemployment rate is so low many folks are being tempted to return to the labor force. That should be a sign that Fed stimulus is no longer needed. But Dr. Yellen doesn’t want to be guided by this. She would rather focus on the inflation rate’s downward status. If the inflation rate is down then, by gosh, she is going to keep stimulating the economy.

It seems crazy and backward to me. Unemployment is very personal. People are getting jobs. We should like that. But we also know that pushing unemployment too low can bring very undesirable results. Just like a racer who runs the first lap much too fast, she may not have enough gas left to finish well. Inflation is also very personal. Most of us prefer a lower water bill to a higher one. Ask your neighbor. Is she complaining about prices being too low?  I don't think so. So why would the Fed want to continue with a policy of making things more expensive for us? 

Answering that question requires a fresh paragraph. Why does the Fed want to make things more expensive? The answer is that the Fed associates a low or falling inflation rate with dismal expectations and a lack of buying power. So even if everyone had a job, the Fed would still worry that something is amiss in the economy. And Dr. Yellen would keep stimulating.

What could be wrong with that? There are a couple of problems. One I mentioned above. We often associate over-stimulus with bad future events such as recessions. The second reason is that lower inflation rates might be the result of things the Fed simply does not and should not control. Maybe that thing is global competition. Or maybe the low inflation rate is the result of innovation that lowers prices. Clearly the Fed has no business or tools to interfere with either of those things.

Dr. Yellen has her teeth clenched like a dog with a bone. And she is not going to stop clenching until she gets us back to the good old days when inflation was soaring. She might coax output and income growth above 3% for a while. But if we learned anything from the past, an economy that grows too fast too long gives us a recession and higher unemployment. It is quite possible and highly desirable for her to implement a less stimulating policy. She should get to that task immediately and quit using low inflation as an excuse. Demand too low out there? Ask Amazon.com. I don’t think our problem is insufficient demand. 

Lesson 17 Interest Rates

Everyone knows what an interest rate is. But today the interest rate is more talked about than Howard Stern’s new personality. The Fed has a new policy to increase interest rates, yet interest rates go in the opposite direction. Is this a Putin plot to control the US economy? Maybe, but it is also true that most of us don’t know squat about interest rates, so let me waddle into the fray and try to make us all experts. I also explain why I think US rates will rise, and the prediction is not mainly the result of Fed policy.

There are more interest rates out there than new expensive bourbons. Dang, even Washington State is making bourbon. That should really infuriate our Kentucky friends. Interest rate is a phrase that means if you let someone have some of your money for a while, they will give it back with a little bonus. Consider my savings account at the local credit union. I gave them several thousand dollars, and I got 18 cents back in interest this month. Not all financial assets are that crappy thankfully, but in today’s financial scene, we talk about interest rates being very low. You can earn interest on savings accounts, short-term government bonds, long-term government bonds, private bonds, and so on. 

In macro, we talk about things like national output, the price level, the wage level, and so on, even though we know there are many different goods and types of labor. So it is with interest rates: we often refer to “the interest rate” even though we know there are many of them out there. So my first order as macro blogger-in-chief today is to say that the 10-year US government bond is often used as a statistical indicator of the US interest rate. Today that rate is at about 2.3%. To put that rate into perspective, it achieved a high in the early 1980s at 15% and as recently as 2007, it peaked at more than 5%. So it is pretty clear that at 2.3% interest rates are very low today. If you buy a bond for $100 then you would expect to receive roughly $2.30 in interest over the course of a year. That will not buy you one espresso mocha at Peet’s.

So why is the interest rate so low today? Why is the Fed having trouble raising it? And what explains the future course of interest rates? Wow – lots of questions.

Let’s address the various things that impact interest rates. If you lend money to a company, they are going to use it to improve the company. So if prospects are good for companies, they are very apt to be borrowing. Suppose a company borrows money to expand the capacity of one of its manufacturing plant. If prospects suggest a 5% return on money they borrow, then they don’t mind paying 3% to borrow the money. So a major factor affecting interest rates is optimism about the future economy. The more optimistic firms are, the more they are willing to pay for funds. The more pessimistic they are, the less they are willing to pay to borrow.

A second factor is inflation expectations. Paying back a loan takes time. The lender receives these payments and that constitutes their return. If the prices for goods and services rise during the payback period, the lender receives dollars that are worth less in terms of goods and service. Thus, at the beginning of the loan, it behooves the lender to anticipate future inflation. Imagine if they think inflation will reach 100%. A 4% interest rate would be lame. Maybe 104% would be better and would protect them from the expected inflation. So we say that today’s interest rates have an inflation premium. The higher expected inflation is, the higher is the interest rate.

What else affects the interest rate? A third factor is risk. Risk relates to the expectation of the lender receiving no payments. That is, if the economy tanks sometime in the future, then the lender gets nada. The riskier the economic environment is, the more the macro risk rises and the more lenders want today in the way of an interest rate.

That’s a long list of factors affecting the interest rate – optimism about business prospects, inflation expectations, and risk. What else? The general idea of supply and demand as it impacts bonds points to other factors like returns in the stock market, real estate, insurance policies, and foreign assets. One has choices in holding assets. Instead of owning bonds which give you a rate of return, you could also choose to have stocks, real estate, savings accounts, and similar assets from other countries. Thus, anything that makes these other assets relatively more attractive will reduce the demand for bonds and raise the interest rate. For example, if interest rates begin to rise in Europe, investors might sell US bonds so as to buy more European bonds. This would lead to a rise in the interest rate in the US.

Finally there is the Fed. Usually the Fed tries to impact short-term interest rates but quantitative easing suggests they attempt to influence the entire term structure of rates from short to long-term.

I probably have forgotten something but you can see the list of things that could impact the US interest rate is pretty long.

Anyone who wants to think about the interest rate today or in the future has to grapple with all these factors. What do you think about these?

US business confidence?

Inflation expectations?

Macroeconomic risk?

Stock market gains?

Relative desirability of real estate, life insurance products, banking products?

Interest rates abroad?

Fed policy ?

Price of JD?

Here is my quick outlook. As the distance from the great recession widens, the world economy is going to continue to slowly improve. Along with these improvements will come more optimistic assessments of US economic growth.

Worries over long-term changes in labor force participation and productivity will remain but will be lessened. As these worries recede aggregate demand will get even stronger and the result will be higher employment, wages, and inflation.

While I am not predicting a resumption of very high economic growth, I am projecting a more positive response than is now envisioned. With the Fed slightly more worried about inflation, their policies combined with the more sanguine macroeconomic outlook will produce a clear cycle of rising interest rates. Since the US will likely be leading this global parade, our higher interest rate will spill over to higher rates abroad and will create international impacts that will raise US rates even more. 

I hesitated about going further but no economist makes a prediction without covering his butt. Nations are prone to making horrible policy choices. It will take some doing but a general recognition that new policies will be inherently bad for economic growth could lock us into interest rate purgatory for a long time. The US, China, the EU, and several other places need to keep their collective foot on the growth pedal. Stupid stuff will keep it all low --  interest rates, economic growth, investment spending, productivity growth, and labor participation. Focus on the growth ball, guys. Plain and simple. Interest rates will go up and we will enjoy it. 

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. 

Truth, Lies, and Misrepresentations

We are learning a lot lately about how people purposely lie and mislead on social media. Especially sad is how people fabricate news stories to the delight of friends who they know will spread the lies multiple times. The term urban legend has been around a long time. I understand it to mean a fictional account that has been circulated enough so that many people believe it to be true.

It worries people that soon we won’t know the difference between fact and fiction. Information will exist but its validity will be suspect. Whether it is evidence about global warming or about the color of the skin of a murderer, most of us will just shake our heads and wonder if the latest story has any truth to it. Information will (already has) become entertainment and persuasion.

We have been dealing with fact and fancy for a long time. In physics, we learn that the very fact of observing a phenomenon can bend its result. Does a tree that falls in the woods make a sound if we are not there to hear it? These ideas titillate the mind. Complicated phenomena (like poverty, economic growth) must be observed and interpreted, and there is room for two different observers to come away with two very different observations and conclusions.

Thus it is reasonable to think of truth as being subjective. And therefore it is possible that you might think one person is lying despite his or her very ardent attempts to be truthful. But when it comes to most things, this element of subjectivity is pretty minor. Many things are very clear. What goes up usually comes down. One final JD has predictable effects. A person high on crack may commit horrible crimes. Too much pollution makes for illness and discomfort. It it other more complicated phenomena that cause the consternation about truth or fiction.

I want to split a hair about these complicated issues. Yes, there is more than one interpretation. There is more than one intelligent view of the truth. But that does not give one license to intentionally lie and mislead. I am often critical of economists who intentionally distort issues by leaving out critical facts that they know to be true. They probably do not admit to their families that they tell whoppers, but surely they appreciate the back slaps, promotions, and high-paid speech opportunities that come with wowing their followers.

Sadly, misrepresentations are hitting new levels. Let me list below some of the ones that have been spouted in the last week by very prominent people.

Federal Reserve interest rate increases will lead to the next recession.

Any attempt to reform Obamacare will be tantamount to pushing grandma over the cliff.

Because Boomers are retiring, it is impossible to have strong employment growth in the US.

Consumer finance deregulation will lead to predatory lending and hurt loan customers.

Tax rate reductions that are part of tax reform will worsen poverty.

Deregulation of the financial sector will lead to excessive leveraging and lead to another financial disaster.

Any attempt to regulate abortions will cause irreparable harm to women’s health.

Infrastructure proposals with strong private sector participation/ownership will lead to rampant corruption.

No, I am not going to take each of these and bore you with a complete analysis. But be honest. The people who are now saying these things (and more) are misrepresenting truth. The people who say these things get wealth, power, and popularity by misleading you or providing ideological fodder for your predilections.

Could any of the above statements be true? Of course they could. But they might also never happen because they are each based on excluding things we know to be true. We know that regulations introduced in the last eight years were not all perfect. We know they have had severe unintended effects. We know that today we have major economic and social policy challenges. 

Policies and regulations can easily be represented by a meter or a dial. In some years the needle moves to the left. In other years it moves back to the right. Arguing about these shifts and changes is normal. Screaming bloody murder when the next team gets power is normal too. But making up stories is not and should not be tolerated. 

Let’s decide a position for the needle in the coming years based on honest and open discussion of the fullest possible set of facts. It might not amount to absolute truth but it will get us a lot further than a bunch of sad distortions. 

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.  

Lesson 15 Money and Monetary Policy

Janet Yellen is the head of the Fed. She and her colleagues at the Fed determine the nation’s money supply. Much has been said about her management of money and lately she is being labelled a lackey of the President and Mrs. Clinton. I doubt she is lackey but I would say that she is guilty of drinking the same Kool-Aid as her liberal progressive buddies in government.

We grew up with Kool-Aid and I don’t mean to disparage that lovely and colorful drink with enough sugar in it to start a diabetic colony.  What I mean is that Yellen, Obama, Clinton and many others share a similar philosophy in general and in particular with respect to the magical qualities of money.

And that’s what makes this post today so much fun. Money itself is about as exciting as your Uncle Ed who rocks himself to sleep at 1 pm in the living room while you watch his cigar ash fall on his partly open bathrobe. Money is paper. Or money is electronic entries that get transferred from one account to another. 

This is not exciting stuff. You buy something – whip out a bill or a debit card – and the deed is done. Nothing to write home about there. It’s like your best friend Peter. You wear plaids and so does he. You wear stripes and so does he.

Although money itself lacks any real excitement, governments can turn it into Charlie Sheen on crack. There was a day when the world did not have money. We called that barter. A farmer would trade three carriage loads of corn for two dresses. That worked okay but corn farmers could not always find dressmakers and so pretty soon money evolved. If everyone carried money it made transactions much simpler.

Money went through a number of stages. Money needed to be around. At first it was commodities – stuff that most people already had and knew the value of – like corn or wheat. Then they were replaced by commodities that seemed to be more durable and held value better – like silver and gold. Silver and gold are pretty but those commodities are heavy or bulky and not easy to safeguard or carry to Sam’s Club. The next stage created paper money  wherein the paper money had to be backed by gold. Paper was essentially valueless but it represented an amount of gold.

Are you history-lovers still awake? Finally came the stage where money could be pulled out of a hat. Not really a hat but essentially the same thing. Central banks create money at will. They need nothing but a magic wand and an Internet connection. Money is “backed” by faith that the central bank will always create the right amount. Not too much and not too little. Like Goldilocks, we like just the right amount of money. The Fed pretends to give us what we want.

And here is where ideology comes in. The conservative school of thought sees the world as being very complicated and uncertain. The right amount of money is no easy thing to attain. Jim suddenly needs money to fix his roof. Dan swears money off when he decides to live in the forest. Imagine figuring out the right amount of money for a whole country day by day. Humbly, conservatives prefer a passive approach. Transactions usually grow by about 5% per year. So let the money supply grow by 5%. End of story. Go fishing.

But liberals always think they know more and apparently they are nervous people who don’t like fishing. They erect giant data collecting machines and try to measure the demand for money on a minute by minute basis. They take great delight and credit by measuring and the ups and downs of money and then trying to match those demand changes with more or less money. Think Whac-a-Mole. Liberals admit that sometimes they get it wrong. They admit that sometimes they even cause recessions when they get it wrong. But alas they are progressives and they are pretty sure that sometime in the future their models will be more correct and the world will be saved. Think Don Quixote.

If the above is not enough to make you reach for the JD pitcher there is more. Even though the infamous JM Keynes said that controlling money was like pushing on a string other modern liberal economists decided to give monetary policy a bigger role in society. Matching money supplied to transactions needs was way too boring for these moderns. So they decided they would match money to employment, prices, exchange rates, and hooker sales. If employment was too low then pump a bunch of money. If prices are too high take it back out. If exchange rates rise then blame China. If hooker sales go up or down call Charlie Sheen.

Talk about a way to guarantee that your name will get into the Bloomington Herald Times on a regular basis. The Fed now has so many balls in the air that it would take a multi-headed hydra to try to catch them all. But undaunted they collect data every day and they have serious discussions and then they go home to their mansions and foreign sports cars.

Yellen and her buddies at the Fed and in the government are not necessarily colluding. They simply have this faith that they know how to manage a 21^st century global economy. That they have been doing it badly never concerns them. They never question this faith that more active policy is better. They are modern and smart. They will learn from their mistakes and finally get it right. They will save us.

Their disease is incurable because failure begets more activism and then more failure. Nowhere in their playbook is taking a deep breath. Nowhere in their training is the idea that too much variance and activism creates uncertainty. Nowhere in their discussions is that it takes time to disentangle short-term noise from long-term trends. Nowhere in their arsenal is the knowledge that some problems are non-monetary in nature and require non-monetary solutions. 

Lackey? I don't think so. Misguided and dangerous? I think so. 

Happy Trails or Fearthquake 2?

This is dangerous. It is Saturday and the time I usually begin the drafting of Tuesday’s blog post. The financial markets will open and close on Monday before I post my usual dribble. Common sense would argue to let the experts stick their necks out and say stupid things that turn out to be wrong. I could instead write about Donald’s ties or Hillary’s latest pantsuit. But no, I decided to join the fray. Don’t ever say that economists don’t live life on the edge. Please note the dripping sarcasm.

Anyway if you have a television or a cell phone, you know that financial markets did a crazy dance on Friday. The main market indexes closed 2% down and US interest rates rose. I am guessing that in some places gravity pulled things up and sinners read Bibles. It was quite a day.

Those of us who were alive and over the age of seven in 2008 remember a similar decline in the markets. In that case one decline led to another and it wasn’t long before billionaires were removing zeroes from their wealth numbers. So if people are a little crazy this week it is because they have personally seen the fearthquake’s ability to turn everything upsidedown. See last week’s post if you don’t know the word fearthquake.

Many of us are beginning the football season unsure of what to bring to the tailgate. Should we bring expensive bourbon or PBR? Was Friday a false signal? Was Friday an exaggeration? Or was Friday the beginning of hell?

I am guessing that Friday was an exaggeration. Mom, that truck is going to hit us. No it isn’t. Yes it is. No it isn’t. Well, it isn’t really a truck. It’s a toy truck.

In my stupid example the truck is a metaphor for rising interest rates. On Friday we saw what happens when more and more people became surer that a truck is going to hit them. Fed officials said this. The ECB said that. Japan said so and so. All that information helped people become more sure that interest rates are going to rise and stocks plummeted.

I don’t question any of that. But what we collectively are not sure of right now is how big the truck is. A truck is coming but how devastating will be the resulting collision?

One view is held by the naïve mathematicians. Naïve means a strong belief in mean-reverting behavior. Suppose you averaged 180 pounds for most of your life and you get ill and lose 20 pounds. A mean-reverting forecast would have you gaining 20 pounds and going back to your normal weight. If an interest rate had an average of 5% and is now 2%, then a similar approach would believe the interest rate is headed back to 5%.

Mean reverting forecasts make a lot of sense. But notice they are based on an “everything else is the same” assumption. You dropped weight because of illness. When the illness departs you gain back the weight… if everything else is the same – your eating is the same, your exercise is the same, and you still have most of your teeth.

But mean-reverting behavior makes less sense if much has changed. With respect to interest rates, has anything changed? It depends on who you talk to or read. My Republican friends would tell me that Obama has destroyed the US economy. As such capital is worth less, the economy will grow slower, and the trust in bonds has diminished. Furthermore demand, like the final third of a cheap cigar, is harder to draw and is leading to permanently lower inflation. My Democrat friends would point to the negative impacts of income redistribution, globalization, and deplorable Republicans in harming economic growth, demand, and inflation.

If these lovely people are correct, then the usual pressures that would produce a return to a 5% interest rate (from the example above) are missing in action.  That means that the changed economic reality of today and tomorrow does not imply a return to any specific higher interest rate. Surely rates will rise but will they rise by 1%, 2%, 3% or more?

These are some of the questions discussed at our Saturday tailgates. Surely our favorite teams will win by many touchdowns and the deviled eggs will be delightful and make the JD go down ever so nicely. But don’t expect that these questions will be resolved on Monday (yesterday) or today. Get your seat belt on for another good ride. Or maybe they will be resolved and today will return to unicorns and methane-free cows. 

I am guessing that the bucking will go for a while but when the dust is settled we will be back on our slow-growth economy with nervous stock prices and interest rates. Interest rates will rise but ever-so-slowly. 

I’ll end this with the lovely words that Roy used to sing to Dale,

Some trails are happy ones,
Others are blue.

It's the way you ride the trail that counts,
Here's a happy one for you.

Happy trails to you,
Until we meet again.
Happy trails to you,
Keep smiling until then.

Who cares about the clouds when we're together?
Just sing a song, and bring the sunny weather.

Happy trails to you,
Until we meet again.

The Fed, Fitbit and Fearthquakes

Can you weigh yourself too often? Most of us are concerned about our weight. Being too heavy or fat is not what we strive for and in many cases we ought to be concerned for health reasons. As such, measuring one’s weight or girth is not a bad idea. The question then is how best to measure.

The measure I prefer is how my clothes feel. I cannot fool my Levis. When I gain weight they scream at me. Another approach is to buy a nice scale and stand on it now and then. I approximate that once a year when my blankety-blank doctor insists on knowing how much I weigh at my annual physical. To add insult to injury he makes me wear my shoes on the scale. Others think it sensible to detect trends and to weigh oneself at least once a month. My Fitbit friends are at the extreme. They measure every second.

And that’s where I part company. And that’s where I also get to today’s topic, the Fed. The Fed thinks it needs to read the pulse of the nation every minute. As if these frequent measurements will help them manage the US economy better. Think of your weight again. Body weight is partly mystery. You and I have both gone on radical diets that lasted at least 12 hours. And guess what? The stupid scale said we gained weight. And even if weight was a little more understandable and we did lose 0.5 pounds in 12 hours or 12 days – what then would that tell us? Way to go dude. Go eat a big buffalo burger.

Good monetary policy ought to be like a good diet. It works because you apply a new sensible regime over a long period of time. Or maybe it is more like a steamroller. If the road gets bumpy then flatten it out. Don’t take a hammer and flatten each and every bump as it arrives.  Ms. Yellen’s Fitbit contains an intermittent flow of hundreds of pieces of relevant but often conflicting information on a daily basis. It has her mesmerized. As recently as last week she was still not convinced that the US economy was growing fast enough. Let’s take in a little more data today. Maybe tomorrow she will be convinced. Or maybe not.

Meanwhile what is the problem? Why can’t we just lumber along? We aren’t growing very fast but we are growing faster than most other countries. Shouldn’t we be happy and proud about that? And inflation is not a problem. Give Ms Yellen a break. This line of argument shows how successful she, her buddies at the Fed, folks in government, and the press have been about hiding the elephant in the shop. It amazes me that except for an article here and there in some business tabloids, everyone is silent about something called imbalances.

Imbalances is not a great word. It doesn’t shout “save me” in the same way that recession or rich persons or automatic rifle does. Maybe I should make up a new word. Let’s call it a Fearthquake. F has nothing to do with methane this week. F means financial. Earthquake means well earthquake. They had an earthquake in Italy recently. We know earthquakes are terrifying events. A Fearthquake is just as bad. We had a Fearthquake in 2007. We are still suffering from the aftershocks.

That Fearthquake and the looming next one come from imbalances. In the case of 2007, the imbalances were in the housing and equity markets. Maybe that is why we are so reluctant to name this evil. Many of us were enjoying price appreciate in our homes and stocks. No one wanted to rain on that parade. But the Fed learned nothing from that episode. It is totally obvious that keeping interest rates low to negative for almost a decade is causing the economy to walk slowly and with a limp. Saving makes no sense in this economy. 

One wonders why productivity is so slow. Has there ever been an economy in the world that had strong perpetual growth in productivity and output with such little saving? And risk tolerance. I am not a finance expert but corner one if you get a chance. Because of low interest rates households are moving into bonds instead of money; into risky bonds instead of low risk bonds; into equities instead of bonds, and so on. And firms are doing the same things. Government believes they can borrow more and more – and a rising national debt will have no negative consequences. They back student loans as if these loans will ever be paid back. Please tell me Ms Yellen why you don't talk about any of these imbalances and the coming Fearthquake?

Call it imbalances or a Fearthquake. Ms Yellen needs to trash her economic Fitbit and put on her jeans. Maybe they will convince her that something bad is coming. It might not be too late for a return to sane monetary policy. 

Better Than a Stick in the Eye

“Better than a stick in the eye” means an outcome is not very good but it is better than getting something much worse. No one wants to get a stick in the eye. Logic dictates that we try to do better than the stick but right now it appears that we’d rather have the stick. 

No I have not emptied another bottle of JD. I am thinking about economic policy and the coming presidential election. Now that Hillary Clinton seems even more likely to be the Democratic candidate the barbs are flying between her and Donald Trump. He is dangerous and incoherent; she is immoral and corrupt. Your mother wears combat boots. Your father is dumber than Papa Q. Bear (of the Berenstain Bears).  

I am hoping that somewhere down the line these two candidates will actually talk about policy but I am also hoping that the JD genie delivers a case to my front door. The question is not why these two people prefer to shout at each other. The question is why we voters put up with it.

Why are we so entertained or enamored by rude, colorful language in the people who say they want to be President of the USA? Will they continue this when in office? Will Hillary decry that her pecs are bigger than Putin’s? Will the Donald say his hands are larger than Dolly Parton’s?

The last time I looked US economic growth was lackluster, capital spending is literally falling, and the Fed decided to put off returning to a normal policy regime because the economy appears too fragile to withstand a 0.15 increase in the federal funds rate. You would think that these candidates would be seriously debating what to do about falling labor productivity, workers leaving the labor force, soaring national debt, and Jason’s new addiction to smoking meats.

Doing all that hard work would be better than a stick in the eye yet we prefer the stick. Why? I guess because we have gotten to the point where answering the real questions is either boring or just too hard. What to do about productivity? Wow, talk about a sleeper. Go down Main Street of your town and ask 50 people what they would do about declining US productivity. Then ask those same people to name 7 types of weed or all the members of the SF Warriors including the names of the managers. I think you see what I mean.

But I think there are enough of us who really care enough to want some real debate. I am going to get in trouble with just about everyone I know for saying the following but I think it is true.

·      Monetary policy might be much too expansionary right now but that policy will always be used by politicians to stimulate a weak economy. Can't we find something in between?

·       Fiscal policy is leading to unsustainable national debts but again, deficit spending is ingrained in national thinking for a weak economy. Is there no middle ground? 

·       Legal abortion is here to stay. We might argue about making it a little easier or harder to get. But it is not going away.

·       China might not abide by all agreed trade rules but it cannot be ignored.

·       Immigrants – legal are not – who have been in this country for decades might deserve a sympathetic ear even as we realize that a country has to protect its borders.

.

I could go on and on but you get the drift. We have serious policy issues and they are not going to be resolved by sticking things in our adversary’s eyes.   We have had enough of that already. For two years the Democrats held a majority and used it. Ever since Republicans have tried to counter everything Democrats did. There is much shouting and accusing and little in the way of governing. If we keep that up for another 8 years, what is going  to happen with all our issues?

Some Democrats say that when they are restored to power they are going to ram all their stuff down our throats. Some Republicans say the same. Finally back in power we Republicans are going to undo everything Obama did.

Really? Is that what governing is supposed to be all about? I don’t think so. I think there are enough of us who think that way so we need to be heard. We can begin by stuffing a bunch of $100 bills in a pillow case and mailing them to me. Okay nevermind that one. But for a start we should stop supporting candidates who won’t debate real issues. We should stop supporting candidates who continue to call each other names. Having real debates about issues is not a lot of fun but it is definitely better than a stick in the eye. 

Perhaps we should threaten a voter's strike. If our current crop of candidates knows that they are going to lose votes from moderates, perhaps they will moderate. Let them fight for moderates by explaining what they are going to do to solve our current economic mess. If they won't and they continue to feed the polar frenzy, then we should make it very clear that we won't vote for the jerks.  Don't they have something to gain by retaining and attracting moderates?  What happens if the moderates organize a revolt?  

Do you have a better idea? Naw. You Ds fear Trump so much that you'll stick with candidates who appear more reasonable yet haven't said one sensible thing about solving our economic problems. You Rs will let Trump say anything because you think Hillary will name the wrong people to the Supreme Court or will be pushed to support liberal causes. And while you do all that people drop out of the labor force, banks and firms sit on their resources, and productivity gets lower than a limbo stick in Nassau. If we don't demand sensible policies then the polar extremes will continue to destroy this country. Whew, I need a large ice cube and a cold glass. 

Cash: It's Just as Good as Money by Guest Blogger Buck Klemkosky

What Yogi Berra said is only partially true. In fact cash and money are not the same thing. There is a lot more money in the world and the U.S. than cash. Currency is another name for cash and in the U.S. it includes coins minted by the U.S. Treasury and bank notes ($1 to $100 bills) printed by the Federal Reserve Bank. The U.S. has $47.6b of coins in people’s pockets or piggy banks and $1,369.2b of FRB notes floating around. Not all are circulating in the U.S. as the dollar can be used in almost any country in the world. No one knows exactly how many dollars are outside the U.S. but government estimates are up to one-half. They have been talking about a cashless society for years but the amount of U.S. coins and notes increases 5-6% annually.

Currency (coins plus FRB notes) in circulation in the U.S. is $1,416.8b. Money includes all that currency but in addition includes bank demand (checking) deposits, shares at credit unions and money market funds and outstanding traveler’s checks. That equation describes M1, a narrow version of the money supply which totals $3,050.2b today. M1 plus savings deposits and time deposits less than $100,000 equals M2, which totals $12,466.7b. M2 is a broader measure of the money supply which the Fed monitors closely in setting monetary policy. 

Currency in circulation is less than half of M1 and 11.4% of M2. So cash may be as good as money but it’s not the same as money which is more widely used and more important in economic transactions.

Cash may be just as good as money for small economic transactions but obviously very burdensome for large transactions. Analysis of the denominations of currency outstanding tells an interesting story. In the U.S., $100 notes outstanding total $1,080.b, 78% of all notes. In Europe, there are $322b of €500 notes ($550) outstanding, 30% of total euro notes; Switzerland has $39b of SF1000 ($990) notes, 92% of all Swiss notes and Japan has $67b of ¥10,000 ($88.50) notes, 92% of all yen notes outstanding. Luxembourg, a country notorious as a tax haven, has euro notes outstanding equal to 200% of its economic output.

The obvious question is why there are so many large denomination bills outstanding in these countries? Most Americans don’t carry a lot of $100 bills and many Europeans don’t know the 500-euro note exists; most are in Russia and other countries outside the Eurozone. Swiss retailers usually will not accept the SF1000 bill for payment. 

Subtracting the amount of U.S. currency abroad still leaves over $2000 for each of the 330 million U.S. citizens and over $5000 per household. The obvious answer is that many of the high-denomination notes play little role in the functioning of the legitimate economy. It is the currency of choice for illegal purposes such as drug trafficking, money laundering, fraud, tax evasion, corruption and terrorist activities. It has been estimated by the IRS that $350b-$400b annually is not reported as income because of cash transactions in the underground economy. A 2011 study found as much as 18% of all taxable income goes unreported costing the government nearly $500b in revenue. There are legitimate reasons for having cash transactions but the probability of abuse increases.

Many are in favor of abolishing all high-denomination bank notes to make it more difficult to carry on illicit activities. Canada scrapped a C$1000 note in 2000 and Singapore a S$10,000 note in 2015. In 1969, the Fed and U.S. Treasury stopped issuance of $500, $1000, $5000 and $10,000 bills although they remain legal tender. At the end of 2015, $300m of these bills are still outstanding, most as collector’s items. While the U.S. Treasury says they have no plans to change the denominations in use today, the European Central Bank will consider abolishing the €500 note later this year. Achieving international consensus to eliminate other high-denomination bank notes will not be easy but it will be on the G20 agenda later this year for consideration.

Another reason some are making the case to eliminate cash as another “outdated relic” is monetary policy and the advent of negative interest rates. Banks in the Eurozone, Sweden, Denmark, Switzerland and Japan already have to pay to deposit funds at their respective central banks. If negative rates should ever filter down to bank depositors, it would incentivize everyone to convert deposits to currency. Large corporations and institutions with billions of dollars in deposits can’t easily convert them to physical cash; it would have to be stored in warehouses and vaults, incurring storage and security costs. Some large banks already impose a fee on large corporate deposits. Individuals could more easily convert deposits to cash and put it under the mattress, but at the risk of theft. Conversion of deposits to cash and hoarding of cash would diminish the effectiveness of monetary policy. The ability of a central bank to implement negative-interest-rate policies would be made less effective by cash hoarding. For example, the amount of SF1000 bills has increased by 17% since the Swiss Central Bank imposed negative interest rates on bank reserves in December 2014. Even though bank depositors don’t yet pay negative interest rates, this shows the sensitivity of big-bill cash hoarding to the possibility.

While there hasn’t been much progress toward a cashless society in the U.S., some countries such as Sweden and South Korea have seen the use of currency diminish. South Korea, for example, is a checkless society although bank notes are available. Every major building there has an ATM machine which allows one to pay bills via wire transfer to any other bank with no fee. The technology certainly exists to have a cashless society in the U.S. and elsewhere using mobile phones, online banking and more sophisticated ATM machines. Digital transactions would be cheaper, faster and provide more transparency. Those engaging in illicit activities would not like it or if worried about “big brother” overseeing their activities. There would have to be a central bank system to provide trust and stability unlike Bitcoin and several other private digital currencies. But don’t expect currencies to fall by the wayside any time soon; currencies have been around for 4,000 years and probably will be for many more decades. People like the security of having physical cash at their disposal as Yogi undoubtedly did.

Global Interest Rates Turn More Negative by Guest Blogger Buck Klemkosky

For centuries, the bedrock assumption of finance was that borrowers paid interest and lenders and investors received interest, and that nominal interest rates would always be positive. That assumption has been turned upside down in recent years as lenders are now paying interest to borrowers; this prevails mostly in the commercial banking industry on banks’ deposits, called reserves, at the central bank. These reserves can either be required to back customer deposits at the bank or excess, those not needed to back customer deposits. Central banks are now charging commercial banks in 23 countries for their reserves on deposit or on their excess reserves.

Ever since the Great Recession (2008-2009), central banks have had to do the heavy lifting getting economic growth back on track and reducing deflationary pressures. First came the near-zero interest rate policies (NZIRPs), then quantitative easing (QE) and now the negative interest rate policies (NIRPs). The NZIRPs were implemented to boost aggregate demand by consumers and corporate investment by lowering borrowing costs. Another intent was to create a wealth effect by increasing bond, stock and housing prices, making consumers less risk-averse and more willing to spend or invest. QE programs involved massive amounts of bond purchases by central banks with the intent of lowering long-term interest rates on mortgages, auto loans and corporate bonds. The NIRPs work on the supply side by making loans more readily available to borrowers. Central banks impose an interest rate on bank reserves to motivate banks to lend excess reserves to borrowers to help invigorate lethargic economic growth. And there are unprecedented amounts of excess reserves on deposit at central banks.

The central bank of Sweden was the first to have an NIRP in 2009 but dropped it and raised interest rates as the economy improved. The ECB started its NIRP in June 2014 at -0.3%, joining Sweden (-0.5%), Denmark (-0.65%) and Switzerland (-0.75%). In January Japan joined the 22 European countries, 19 in the Eurozone, by implementing an NIRP with a -0.1% charge on some bank reserves as well as maintaining a massive QE program. In March, the ECB made a further cut in its negative rate to -0.4% and increased its QE program to €80b monthly, including the purchase of investment-grade corporate bonds denominated in euros. They also cut the short-term borrowing rate by banks to zero. Interestingly, the ECB imposed a negative rate on itself by offering to pay banks 0.4% to borrow money on a longer-term basis up to 4 years, as long as the banks lend the borrowed money.

These NIRPs have carried over to the bond markets as $7t of bonds, mostly government, have negative yields. This represents 25% of all government bonds outstanding in developed countries. In Japan and Switzerland, government bond yields are negative out to 10 years maturity, 8 years in Germany and the Netherlands, 7 years in Belgium and France, 5 years in Sweden and Denmark, 4 years in Italy and 2 years in Spain. A year ago there was less than $1t of government bonds with negative yields. There are also billions of dollars of corporate bonds with negative yields mostly in Europe and Japan. Some corporate bonds have been issued with a negative yield, Nestlé in Switzerland and more recently a bank in Germany. Today two-thirds of the $26t of government and corporate bonds in the Bank of America Merrill Lynch bond index have yields that are less than 1% or negative.

What are the potential problems with NIRPs? There are a multitude. Low and negative interest rates are challenging for banks that borrow (take deposits) short term and lend or invest long term. Thus far banks have been reluctant to impose negative rates on deposits but have had to lower rates on loans, sometimes negative, to stay competitive. Their net interest margin is being squeezed. Life insurance companies are also impacted as they have guaranteed rates on annuities and other insurance products. Money market funds have struggled with NZIRPs and NIRPs just exacerbated their margins or lack thereof: eleven of the largest money market funds in Japan have turned away new deposits and may return existing funds to depositors. NIRPs present problems to defined benefit pension plans that have assumed returns on investments well in excess of bond yields. More NIRPs may have dire consequences for many financial institutions. And NIRPs are a repression on savers who are receiving near-zero interest rates and perhaps negative in the future.

In addition to financial institutions and savers, NIRPs potentially increase risks to financial system stability by creating bubbles in financial assets like stocks and bonds and real assets like housing. It may also create problems for investors chasing yields in riskier assets and longer maturity assets. Many believe the primary objective of NIRPs is to weaken currencies and make a country’s exports more competitive. This is a zero-sum game if all countries try to devalue and risks the potential of currency wars and trade protectionism. Finally, NIRPs may signal that prior monetary policies such as NZIRPs and QE have failed and people will lose confidence in central banks and then they have a credibility problem.

One unintentional consequence of NIRPs has been cash hoarding and a surge in safe sales in Europe and especially Japan. The cash hoarders are ordinary citizens responding rationally to NIRPs which work only if savers spend or invest their money. Money is unproductive if stuffed under a mattress or in safes and safe deposit boxes. Cash hoarders prefer large denominations as do those carrying out illicit activities such as drug trafficking, money laundering, tax evasion, corruption and terrorist activities. The high denomination notes like the $100 bill, the €500 note, the SFR1000 note and the ¥10,000 note make up the largest portion of the respective paper currencies. 

Demand for these has accelerated in Europe and Japan; circulation of the SFR1000 notes ($1010) grew 17% in 2015 after Switzerland imposed a NIRP in January 2015.

Cash hoarding is an impediment to NIRPs and because of that some economists want to retire high-denomination notes and others to eliminate all paper currency and go digital. Theoretically negative interest rates can go lower but are constrained by cash hoarding, shadow banks and other factors.

NZIRPs, QE and NIRPs all had the same objective of stimulating stagnant economies. The question is have they worked? Japan has had an NZIRP and QE for some time but their NIRP is just two months old. The initial reaction to it was not as expected. The yen did not weaken, but strengthened relative to the dollar by 8%, savings increased and borrowing declined as citizens began to hoard cash. An NIRP has not helped Europe which is still experiencing anemic growth and deflationary pressures. There have not been a lot of positives so far with the NIRPs, except perhaps for lower borrowing costs, especially for governments, but that also could have unintentional consequences. The lack of robust economic growth in the countries that have implemented these policies may be due to other economic headwinds, and these economies may have been in worse shape if the policies had not been adopted. 

Christine Lagarde, managing director of the International Monetary Fund, states “if we had not had those negative rates, we would be in a much worse place today with lower growth and lower inflation.” Former Fed Chairman Ben Bernanke stated in his blog that negative interest rates “appear to have both modest benefits and manageable costs” and that “market anxiety over below-zero borrowing costs seems to me to be overdone.”

Even though the Fed raised short-term rates in December, some, including Congress, are questioning whether the U.S. could experience negative interest rates in the future. Janet Yellen, Fed chairperson, stated in congressional testimony in February that negative rates were discussed in 2010 but not implemented at that time. She also stated that she was not aware of anything that would prevent the Fed from implementing a NIRP but it would need further investigation of legal hurdles. The Fed already includes a negative interest scenario in bank stress tests and short-term U.S. Treasury bills have occasionally had negative yields.

If these monetary policies lose their efficacy or potency, what might be the last salvo of monetary policy? One possibility is what the late Milton Friedman referred to as a “helicopter dumping policy” (HDP). This would entail the central banks directly financing government spending or tax cuts, or directly sending checks to tax payers. This would be a more dramatic monetary policy than the three prior ones and would certainly be the “big bazooka” in stimulative monetary policy.  It is hard to imagine HDPs ever being implemented, but a decade ago the same could have been said about NZIRPs, QE or NIRPs.

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.