The Fed’s Thinking and Policy Explained in Two Sentences

Our friend JR sent us this quote from the new Fed chairman Janet Yellen on Fed policy:

You know, a lot of people say this (asset buying) is just helping rich people. But it’s not true. Our policy is aimed at holding down long-term interest rates, which supports the recovery by encouraging spending. And part of it comes through higher house and stock prices, which causes people with homes and stocks to spend more, which causes jobs to be created throughout the economy and income to go up throughout the economy.

We are struck with admiration – and we sincerely mean this. We had 18 1/2 years of Alan Greenspan and people are still trying to figure out what he said. Eight years of Ben Bernanke gave us a lot of academic theory applied in real-time to the economy without any understanding of the outcome. Then the new Fed chairman, in two sentences, explains in plain, clear English what the Fed has been doing all along. Let’s step through it.

The Fed has two and only two classes of tools to affect the economy, control over interest rates through monetary policy and control over market psychology through communication. We will focus on the former.

The Interest Rate Tool

In Living In a Hypothesis we used Figure 6 to show the effect of the Fed’s control of short-term interest rates to affect unemployment. In that case we used the number of unemployed persons to represent unemployment. The problem with this approach is it fails to account for population growth. So in Figure 1 below we use the unemployment rate as provided by FRED (the data tool of the St. Louis Fed) and plot it against the Effective Fed Funds Rate (EFFR).

Figure 1. The Effective Fed Funds Rate (red line) and the Civilian Unemployment Rate (green line).

FRED Graph

There are several things to observe in this graph. First, changes in the EFFR lead the unemployment rate by several months starting with the 1958 recession. This indeed shows that the tool was effective in guiding the economy. The next point to observe is that the distance between the peak in the EFFR and the peak in unemployment increases with each recession suggesting that the economy is becoming less responsive to the use of the tool. Finally note that the recovery in the EFFR after each recession starting with the 1980 recessions was less and less each time before it had to be used again. Also, it had to be lowered more each time. The recovery from the 2002 recession was insufficient to allow the tool to be used effectively again. Indeed, in 2009, the rate was reduced to zero (ZIRP) and remains there leaving the possibility that it will not be reversed sufficiently if at all to be useful for the next recession.

The Fed then tried to stimulate the economy by using Large Scale Asset Purchases (LSAP) or quantitative easing (QE) to lower rates on longer term fixed income instruments. Purchases under QE eventually extended as far out the yield curve as the 30-year long-bond depressing interest rates at all maturities. Purchases of mortgage-backed securities have likewise had some effect on keeping mortgage rates down to stimulate housing. It is generally recognized that QE is losing its effectiveness if it has not already done so.

The explanation for broken tools is clear to many people apparently except the Fed. Fed policy of using low interest rates extending back to the Greenspan era has created a massive credit bubble. Consumers have no room to take on additional credit, so making such credit available more cheaply will have little effect other than some refinancing.

Yellen said it in one sentence: Our policy is aimed at holding down long-term interest rates, which supports the recovery by encouraging spending. We took a couple more sentences than she but we wanted to explain why further monetary policy based on LSAP, while distorting markets in an extremely dangerous manner, will have little effect on economic activity and will  ultimately fail.

The Wealth Effect

The second part of Yellen’s summary of Fed thinking is the so-called ‘wealth effect’. If you feel wealthy you act it out by spending. In the early stages of low interest rates, housing became more affordable and more houses were built and sold adding significantly to economic growth and jobs while driving up prices. Owners refinanced mortgages at lower rates and withdrew equity, spending it (see MEW). Some of the money was invested in the stock market. Everything boomed … and eventually went boom (stocks in 2000, houses in 2007).

One fallacy of the wealth effect is that the wealth is implicit. Sure you have an extra $200,000 of value in your house. The problem is unless you withdraw equity by refinancing, you can’t spend the money. The same is true for stocks. You haven’t made any money until you sell the appreciated asset. A few people sold houses in high-priced markets and bought houses in markets priced much lower, pocketing the change. Most home owners are tied to jobs, friends, schools, and other activities that make moving impossible. The gain remains unrealized and if the market crashes – which both houses and stocks have done – the wealth vanishes. The wealth effect is real but it is also mostly illusory.

The wealth effect is built from markets in a Ponzi-style manner. When the music stops there is panic for the exits and values plummet. The wealth that the Fed has built is illusory in this way and most of it will vanish, likely around the time of the next recession which will deepen its severity.

So Janet Yellen appears to be refreshingly direct. It remains to be seen if she maintains the traditional Fed doctrine or if she can find a real-world understanding and bring it to Fed policy. She likely has no good way out. Thanks guys!

Powered by WordPress | Designed by: photography charlottesville va | Thanks to ppc software, penny auction and larry goins