A Benevolent Central Bank

It has become clear that Fed Chairman Jerome Powell will do whatever it takes to keep the expansion going.  In early January, the stock markets rallied after Mr. Powell softened his rhetoric and promised “patience” in setting the federal funds target range.  Initially, the Fed was to be on “autopilot” and proceed with two rate hikes this year.  That promise was called off because of slowing global growth and the fear that higher rates would cause a sharp fall in asset prices. 

Now the chairman has excited markets by announcing at the Chicago Fed conference that “we will act as appropriate to sustain the expansion”—meaning that a rate cut could be in the cards possibly as early as July.  That sentiment was expressed earlier by St. Louis Fed President James Bullard

Currently, the effective fed funds rate is above the 10-year Treasury rate of 2.07 percent—and the yield curve is inverted, normally a sign of impending recession.  To restore a positive slope to the yield curve, the Fed would have to pencil in two 25 basis point cuts in its policy rate target range, which now stands at 2.25 to 2.50 percent.

But what if the decline in long-term rates reflects a growing uncertainty about the impact of trade wars on productivity and growth, which is driving investors worldwide to hold U.S. government bonds as a safe haven?  When the demand for U.S. bonds increases, their prices rise and yields fall.  By lowering the fed funds target, the U.S. central bank would divert attention from the trade conflict and the uncertainty it generates.

The Fed would simply restore the yield curve to its normal positive slope, and pretend that its “lower-for-longer” interest rate policy can create a permanent wealth effect.  The Fed also seems ready to return to large-scale asset purchases (quantitative easing) if short-run nominal rates approach zero.

It is true that core inflation, as measured by the price index for personal consumption expenditures, is low. But asset price inflation is not low. It has been fanned by the Fed’s policy of holding real rates close to zero or even negative.  Should the key policy of the central bank be to encourage risk taking by suppressing interest rates?  There is nothing in the Federal Reserve Act that says so.

Moreover, as Vincent Reinhart, chief economist at Mellon Investments Corp., writes in the current issue of the Cato Journal: “How can we expect traders and investors to react reliably to shocks in the future if their past is one in which they have been protected by a benevolent central bank?”

If the Fed followed a credible monetary rule, such as keeping nominal GDP on a level growth path and making up for misses, total spending would be a better guide to the stance of monetary policy than interest rates.  Interest rates are key intertemporal relative prices that should be allowed to adjust freely according to market forces—not be set by a small group of “experts” at the Fed. 

The Fed is rapidly losing its independence by catering to financial markets and seemingly to the White House.  If the Fed were subject to a nominal GDP rule, say a 5 percent growth target, financial market volatility would lessen.  Last December the Fed made a mistake by raising its policy rate target range and stock prices tanked.  That volatility could have been avoided if nominal GDP had been the target, because total spending was growing at about 5 percent.

By doing whatever it takes to keep the expansion going, the Fed risks further inflating asset prices while fleecing seniors who depend on interest income from their savings.  The Fed’s backstopping of stock markets and big government, by pegging   interest rates at low levels, will also further politicize monetary policy and encourage protectionist trade policy.

If the Fed could actually stimulate real economic growth by financial repression (i.e., by engineering negative real interest rates), then Congress would have little to do except to make sure the monetary printing presses were operating at maximum capacity.

The real problem today is not that there is too little inflation but that there is too much discretion in both monetary and fiscal policy.  Moving to a rules-based monetary regime, reducing the size and scope of government, allowing markets not the Fed to allocate credit, and addressing structural issues would help set the basis for long-run economic growth and prosperity.  Turning over all policy levers to the Fed is not a viable solution.