What good is the Fed?
Federal Open Market Committee. Public Domain. Source: Federal Reserve
The conventional wisdom is that the Fed controls the economy in the short run by controlling short-term interest rates. But folks didn’t always think this way. In the ‘60s and ‘70s Keynesian economists thought that interest rates only had a tiny effect on spending, and therefore a minimal impact on the economy.
Then came Paul Volker. He made ending inflation the goal of Fed policy, and he did this by raising interest rates through the monetary aggregates. The Fed Funds rate was 12% when Volker announced his new policy, and peaked at over 20% in 1981. The policy worked. Inflation declined from its April 1980 peak of 14.5% to about 2.5% in July 1983.
It’s hard to overstate how this revolutionized economists’ thinking. The fact that Volker’s policy change was followed by back-to-back recessions and dramatically lower inflation led policy makers to dramatically change their view of the Fed, monetary policy, and the economy. The Fed Chair suddenly became the second most powerful person in the country.
But it’s still unclear how this works. In the ‘90s, Ben Bernanke published a famous paper (cited over 4500 times in peer-reviewed journals) that showed how supposedly “interest sensitive” components of the economy don’t seem affect aggregate spending or investment very much. We “know” that interest rates have an impact on the economy. But we don’t know why. It’s probably not through the banks: most corporate finance takes place outside the banking system. It’s not through consumers: mortgage rates have been at rock-bottom levels for a decade now, and consumer spending has been tame.
In fact, the variable that seems to have the greatest impact on the economy most recently is the stock market. As stock prices rise and fall, investment spending has risen and fallen.
Source: St. Louis Fed
Is this why Janet Yellen has become our stock-guru-in-chief, offering her opinion about stretched market valuations and different sectors? Is this why Alan Greenspan was reluctant to prick the stock market bubble, complaining about irrational exuberance instead? Is the Fed afraid that the market crashes after the dot-com and housing booms led to the collapse of private investment, and two recessions?
This is awkward. We don’t want our central bank to decide whether the stock market is too high or too low. Fed officials have no greater expertise than anyone else in second-guessing the wisdom of the market – or lack thereof. There’s no special “Magic 8-Ball” in the Eccles Building to tell them what’s going on in the economy. And it’s a sign of desperation when government officials try to impact asset prices to change how people behave. I’m old enough to remember Nixon’s wage-price freeze and Phase I, II, III, and IV, and how ineffectual those policies were in stemming inflation.
Fed policy seems to work in the short run, but we still don’t know how or why. A little humility seems appropriate. Alas, humble is not how I would describe most government officials today. Stay tuned!
Douglas R. Tengdin, CFA