After an extended and tedious period of navel-gazing worthy of Hamlet, the Fed on Wednesday announced a ¼ percent increase in the Federal Funds rate. Given the vast pool of liquidity residing in the banking system, the central bank can accomplish its goal only by paying banks 0.5% interest on their excess reserves—a boon to bank shareholders. The Fed will execute reverse repo operations to mop up excess liquidity, so as to get short term rates to their target.
The market sighed in relief…finally! However, not much changed. The Fed’s supposed “tightening” is small relative to its decision to keep reinvesting the US$4 trillion in US Treasury and mortgage securities that it bought between 2008 and 2014. The decision is both too little and comes too late; tightening should have begun in 2012 (according to the Taylor Rule), when the economic recovery was stronger and asset inflation hadn’t yet gotten out of hand. Of course, this is a Fed that is beholden to investors, who want to have their cake and eat it too. Now all will suffer the resulting indigestion.
Last week’s Wall Street Journal featured a piece called, “The Mystery of Missing Inflation Weighs on Fed Rate Move.” The message of the piece is that the Fed has been confounded by the failure of inflation to rise toward its 2% target despite a massive program of money creation. As I wrote in our October quarterly letter to clients:
The fact that monetary policy has been ineffective in meeting its stated goals should not be surprising. Although the fortunate trends of recent decades fostered a widespread belief in the Fed’s omniscience, the central bank’s forecasts—like those of most economists—have rarely been accurate. Moreover, as John Hussman demonstrated, there has been only a weak link, at best, between monetary policy and subsequent growth and inflation outcomes. To be sure, central banks earned praise by rectifying their disastrous policy mistakes of the 1970s, putting in place policy rules and targets to reestablish their anti-inflation credibility. But their supposed success in fostering non-inflationary growth during the golden era of globalization was mostly an illusion—rather like the rooster taking credit for the dawn.
The ineffectiveness of monetary policy reflects two realities that central banks have been reluctant to accept. First, that liquidity moves rapidly across borders, toward the most appealing target. Easy money in the US arguably did more to stoke the boom in China and other emerging economies, than it did to help US workers. Second, in a globalized economy, inflation trends are largely outside of policymakers’ control. Despite widely divergent monetary policies over time and across countries, inflation has tended to rise and fall on a secular, global basis.
Fed policy in recent years has not merely been ineffective—it’s been counterproductive. Easy money has sowed the seeds of deflation by (1) sustaining unproductive excess capacity through low interest rates, and (2) encouraging excessive indebtedness which, at the extreme, limits households’, corporations’, and governments' ability to spend. The Fed made the mistake of believing its policies mainly influenced the demand side of the economy, rather than the supply side. Moreover, in considering the drivers of demand, it focused on the intertemporal consumption effect of low interest rates, rather than the income effect. The former may have been dominant 20 years ago, when people were younger and had more scope to borrow. Now, with low rates having driven down returns on all assets, people feel the need to save more in order to cover their retirement needs.
In sum, Fed policies have inflated the assets of wealthy people who don't need more wealth, and encouraged borrowing by those who can't afford to borrow. Exacerbating inequality and dividing the nation. Nice work.