Does Monetary Policy Have a Future?I have chosen a provocative title, but it is fully justified. Fed officials are flying on autopilot, but the controls don’t work anymore, or at least not reliably. Fed watchers are largely clueless. The investment community and the economy may be collateral damage.
Let me begin by briefly reviewing the recent past. All through last year, Fed officials were signaling they would begin a program of rate increases. At first, there were going to be 8 increases of one quarter point. As the year progressed, the first increase faded into the future. Finally, in December 2015, the Fed finally hiked its new interest-rate targets by 25 basis points. In my opinion, the FOMC did so largely to keep its credibility.
At the time, I wrote that “the chief effect of Wednesday’s action and accompanying statement is to once again increase uncertainty in financial markets” (O’Driscoll 2015). I became convinced that, promises to the contrary notwithstanding, the Fed would not raise interest rates again before December 2016. Instead, policymakers would dither all year. I forecast the earliest rate hike would be in December 2016. Note, I did not predict the Fed would actually raise rates this December, just that they would not do so before. I think I have been vindicated.
The reasons for Fed inaction were both political and economic, and they reinforced each other. On the political front, most Fed watchers naively ignored that 2016 was a presidential election year. Yes, the FOMC has raised interest rates in election years. But I felt there would be significant pressure on the Fed no to do so this year, and, frankly, I felt the Fed has become more politicized over the years. So, political considerations argued against a rate hike.
I turn next to economic considerations. The conventional economic case for increasing short-term interest rates was really quite weak. Neither of the two Fed mandates provided much justification. Early on, some Fed officials forecast that inflation would rise as the economy neared full employment. Yet the inflation rate remained stubbornly below the two-percent target. Next, Fed officials suggested the economy was approaching full employment. With or without inflation, they argued, the FOMC needed to start raising interest rates.
In fact, this recovery has been weak by any standard measure. It is a long recovery, but a weak one. That is true whether measured by output growth or employment growth. The contention that we are at or near full employment ignored labor-market realities. The Civilian Labor Force Participation Rate has been in free fall since the Great Recession. It has only recently shown an uptick. For men, the picture is even more dismal. The participation rate is near an all-time low. It is a largely unnoticed crisis, which Nicholas Eberstadt (2016) has chronicled. He estimated that there is a “male jobs deficit” of 10 million. The economy is not close to any reasonable concept of full employment. There was no employment justification for raising short-term interest rates.
I have come to the conclusion that the stated reasons for raising rates are not the real reasons, at least not for some Fed officials. They are constrained to Humphrey-Hawkins criteria (inflation and unemployment). But there is concern over the compressed margins for banks and money-market mutual funds. For banks, spread between borrowing rates and lending rates are compressed. For money funds, yields on eligible assets are very low, and it is difficult to pay a positive return to shareholders after costs. Can you imagine Fed Chair Yellen or New York Fed President Dudley saying we need to raise interest rates to make banking more profitable?
There are also international considerations. By now, central bankers are beginning to see the folly of negative interest rates. For the ECB to get rates just back to zero, however, U.S. rates must move higher into positive territory. Then, too, there are the EU’s banking problems. The cost of bailing out European banks could be monumental. A little extra economic growth from a weaker Euro would help finance that cost. Can you imagine if Fed officials said we need to raise U.S. interest rates to bail out the Germans?
There are good reasons for raising rates. They have been too low for too long. Capital is being misallocated all over the place as a result. Instead of stimulating investment in the real economy, low interest rates have fueled stock buybacks, M&A, and financial engineering more generally. The financial sector has grown at the expense of real economic activity. Asset bubbles have been created. The Fed’s policy of buying MBSs (Mortgage-Backed Securities) has channeled credit into housing. If these considerations were paramount, however, interest rates should have been higher long ago.
Some might say that, if I am correct, the Fed is in an impossible position. The economy is too weak to raise interest rates, but asset bubbles necessitate higher rates. That would be true if current monetary policy were stimulating the economy. In fact, unconventional monetary policy has been contractionary. To repeat, the policy of very low interest rates has been contractionary, not expansionary. The Fed has been dampening economic growth.
As already noted, very low interest rates have compressed bank’s margins. One can see that in the relatively flat yield curve. The point is even more compelling if one factors in risk. Lending is a risky activity. A bank must expect to earn a positive risk-adjusted rate of return. Right now it can earn 50bp risk free on reserves on deposit at the Fed. Moreover, those reserves satisfy the mandated liquidity balances of Dodd-Frank. Speaking of Dodd-Frank, its restrictions on risk-taking greatly reinforce the effects of the Fed’s low interest rate policies. Bank lending is discouraged. That has had an especially large impact on small business lending. Small businesses are the job creators for the economy. That is another reason why employment growth has been weak.
In a forthcoming article in the Cato Journal, Professor Charles Calomiris of Columbia University has estimated that the value to a bank of acquiring a deposit is approaching zero. Banks are actually turning deposits away. That implies, of course, that the value of all those branch networks is approaching zero since they are basically deposit-gathering facilities. The traditional business of banking may not be a viable model under current monetary and regulatory policies (Calomiris 2017).
To recapitulate, higher interest rates might actually spur economic growth. And they would be good antidotes to asset bubbles. What, then, are the prospects for higher interest rates?
The Federal Reserve’s unconventional monetary policy has robbed it of the ability to influence interest rates as it has in the past. That is particularly true for raising interest rates. The necessary linkages in monetary policy have been broken, or at least damaged.
In the past (pre-2008), how did the Fed raise interest rates? It sold short-term government bonds, Treasury bills. That pushed up the interest rates on bills and put upward pressure on other short-term interest rates. Banks, attracted to higher returns, competed for federal funds to lend. That drove up the fed funds rate, which restrained lending. The fed funds market was a choke point.
All these linkages are gone.
The Fed has zero Treasury bills on its balance sheet, so it has no short-term assets to sell. The policy of large-scale asset purchases — QE — flooded banks with reserves. Banks do not need to borrow reserves; reserves are abundant. The fed funds market, greatly shrunk in size, now mainly consists of transactions between GSEs — chiefly Federal Home Loan Banks — and a few banks, mainly foreign.
So what did the Fed do in December 2015 to increase short-term interest rates? It increased the interest rate paid on reserves from 25bp to 50bp. And it posted a rate of 25bp for reverse repos at the New York Fed. It then set a target range of 25-50bp for the fed funds rate. Did it hit that fed funds target? Yes, about in the middle of the range. Did it matter? Not really, for the reasons just mentioned. The availability and pricing of fed funds no longer constrains most banks. Moreover, the goal was surely to raise market interest rates. The opposite occurred. I quote former Cleveland Fed president, Jerry Jordan, on point: “Yields of market-determined interest rates subsequently fell and remain below the levels that prevailed before the increase in administered rates” (Jordan 2016: 26).
The Fed is now largely engaged in a futile exercise to control the economy. The massive expansion of its balance sheet flooded banks with excess reserves. “Operation Twist” robbed it of short-term assets. Its influence over short-term, market interest rates is attenuated at best. Nor does it seem able to control the money supply, though that is a more complicated issue (Jordan 2016).
What financial markets have feared the most, they in reality dare not hope for. The Federal Reserve is not positioned to raise short-term, market interest rates. If the feared spike in inflation materializes, the Fed is not positioned to contain it. Markets are expecting or fearing the Fed will do things it can no longer do. The misalignment between market expectations and Fed capabilities is very dangerous, and I fear it will not end well. Not an out-of-control central bank, but a not-in-control central bank is the problem markets must confront. The Fed is not positioned to control inflation when and if that becomes a problem.