Our over-reliance on monetary policy is the problem
I am going to argue here that monetary policy is both less effective than fiscal policy, and that over-reliance on it unnecessarily politicizes monetary policy by putting unelected officials in too prominent an economic role.
I would argue that monetary policy should never be the primary macro policy driver in any economy. Yet, when you look around the world it is in almost every advanced economy. It is certainly that way in the eurozone, where interest rates are negative and the largest economy runs fiscal policy via a debt brake and a “black zero” no-deficit rule. And it’s mostly that way in the United States, where every word a Fed official utters is parsed to discern what it means for the future of the economy.
That’s no way to run an economy.
The Fed’s Overtightening
Even so, yesterday’s post was all about the Fed. And it was all about the Fed’s ability to create policy errors that caused recession. And so, that link between Fed action and recession makes it seem like the Fed is omnipotent. It’s not though.
I wrote something in the middle of my piece on the Fed’s overtightening yesterday that I think is important in this context. And I want to use it as a jumping off point for this post on the over-reliance on monetary policy.
Now, when I say ‘overtightening’, I am talking about investor confidence and financial conditions, not the real economy. I think of the real economy as largely independent of the financial economy except through the impact that investor confidence and access to credit can have. And so, I see monetary policy affecting the real economy primarily through the financial conditions and interest rate conduit, creating winners and losers as interest rates change and investors gain or lose confidence in the prudence of incremental capital investments.
There are a few things wrapped up in that paragraph. So let me take them one by one to show you why I see monetary policy having too big a role in business cycles.
The financial economy is not the real economy
You often hear people chastise others who are overly focused on financial markets by saying, “the stock market isn’t the economy.” And by that, what they’re saying is that what happens in asset markets simply isn’t a proxy for what’s happening in ordinary people’s lives. Just because asset prices go up or down doesn’t mean it puts more or less money in peoples’ pockets.
The financial economy is separate from the ‘real’ economy. It’s interrelated, yes. But they are not the same.
So when you hear that the Fed raised rates 25 basis points or lowered rates 25 basis points, you wouldn’t be totally off base if you shrugged your shoulders and asked “who cares?” All the Fed did was raise the rate for overnight lending of reserves. And that only affects how much banks have to pay to borrow reserves. It doesn’t directly influence anything else – not Treasury rates, not mortgage rates, not credit card rates – and certainly not salary growth rates or unemployment – which are the things most people care about.
For the Fed to have any impact, there has to be a “transmission mechanism”. That’s the jargon. And the way this ‘transmission mechanism’ works is actually very much in dispute. When the Fed raises rates, it’s supposed to feed through to interest rates in the rest of the economy and then into the economy as a whole, with a lag. But it doesn’t always work that way. Back in 2005, Fed Chair Alan Greenspan was famously perplexed that the Fed was jacking up rates every meeting without meaningful impact on Treasury yields. Let me quote him at length to show you the problem:
Long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields.
The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year U.S. Treasury notes even if the more-distant forward rates remain unchanged. Historically, though, even these distant forward rates have tended to rise in association with monetary policy tightening.
In the current episode, however, the more-distant forward rates declined at the same time that short-term rates were rising. Indeed, the tenth-year tranche, which yielded 6-1/2 percent last June, is now at about 5-1/4 percent. During the same period, comparable real forward rates derived from quotes on Treasury inflation-indexed debt fell significantly as well, suggesting that only a portion of the decline in nominal forward rates in distant tranches is attributable to a drop in long-term inflation expectations…The broadly unanticipated behavior of world bond markets remains a conundrum.
The very next year, Greenspan’s successor Ben Bernanke hypothesized Greenspan’s ‘conundrum’ was the result of a ‘savings glut’.
Given the global nature of the decline in yields, an explanation less centered on the United States might be required. About a year ago, I offered the thesis that a “global saving glut”–an excess, at historically normal real interest rates, of desired global saving over desired global investment–was contributing to the decline in interest rates... So long as these factors persist, global equilibrium interest rates (and, consequently, the neutral policy rate) will be lower than they otherwise would be.
And he used that as a reason to disregard an inverted yield curve – commonly seen as a harbinger of recession. Of course, recession began in short order — and the mother of all financial crises too, making it clear that using the savings glut hypothesis to ignore recession warnings wasn’t a very good idea.
Low rates don’t spur investment
It is even more problematic than that though. Part of the thinking behind lowering interest rates is that lower rates will spur investment. Lower rates are supposed to induce businesses to go out there and buy stuff and to hire people. But the research doesn’t show that’s necessarily what happens.
For example, economic researchers at my alma mater Dartmouth wrote this in 2013 as the abstract for an economic study:
We study the factors that drive aggregate corporate investment from 1952–2010. Quarterly investment responds strongly to prior profits and stock returns but, contrary to standard predictions, is largely unrelated to changes in interest rates, market volatility, or the default spread on corporate bonds. At the same time, high investment is associated with low profit growth going forward and low quarterly stock returns when investment data are publicly released, suggesting that high investment signals aggregate overinvestment. Our analysis also shows that the investment decline following the financial crisis of 2008 represents a fairly typical response to changes in profits and GDP at the end of 2008 rather than an unusual reaction to problems in the credit markets.
I bolded the important bit.
Even the Fed’s own research shows the problem. This abstract is from a 2014 Fed piece, appropriately titled “The insensitivity of investment to interest rates: Evidence from a survey of CFOs“. Again, look at the bits I highlight below:
A fundamental tenet of investment theory and the traditional theory of monetary policy transmission is that investment expenditures by businesses are negatively affected by interest rates. Yet, a large body of empirical research offer mixed evidence, at best, for a substantial interest-rate effect on investment. In this paper, we examine the sensitivity of investment plans to interest rates using a set of special questions asked of CFOs in the Global Business Outlook Survey conducted in the third quarter of 2012. Among the more than 500 responses to the special questions, we find that most firms claim to be quite insensitive to decreases in interest rates, and only mildly more responsive to interest rate increases. Most CFOs cited ample cash or the low level of interest rates, as explanations for their own insensitivity. We also find that sensitivity to interest rate changes tends to be lower among firms that do not report being concerned about working capital management as well as those that do not expect to borrow over the coming year. Perhaps more surprisingly, we find that investment is also less interest sensitive among firms expecting greater revenue growth. These findings seem to be corroborated by a cursory meta-analysis of average hurdle rates drawn from firm-level surveys at different times over the past 30 years, which exhibit no apparent relation to market interest rates.
Conclusion: low rates do not necessarily spur greater capital investment. So when the Fed lowers rates to boost the economy, really all its definitely doing is helping borrowers at the expense of lenders by reducing both interest income and interest expense. In some situations, that may be stimulative. But, in others it may not be.
Lower for longer may be poison
One last thing here: even if cutting interest rates is stimulative, how do we know keeping them low is also stimulative? Maybe it’s the change in interest rates that matters, not the level.
I would argue that low interest rates may have a greater impact on investor behavior than on business investment. They cause investors to ‘reach for yield’ to hit funding targets and investment rates of return hurdles. And they stimulate animal spirits by making speculative money-losing investments with the promise of future profit look more attractive. The FT’s Robin Wigglesworth notes that:
Two decades ago, well over half of the global bond market boasted yields of at least 5 per cent… Today, a mere 3 per cent of the global bond market yields more than 5 per cent — the lowest share on record.
How are you supposed to hit your pension company’s 7% return bogey? You can’t — unless you take on a lot more risk by buying lower quality bonds or ones with longer maturities or both. Try buying a 100-year Argentina bond, for example.
And let’s not forget savers’ behavior too. It’s not at all clear that taking Grandma’s savings account yield down to 0.25% is going to ‘stimulate’ the economy. It might just make Grandma poorer and cause her to spend less, making the lower for longer concept anti-stimulative. After all, the private sector is a net-receiver of interest.
The point is this: if we don’t even know what the transmission mechanism for monetary policy is and how it works, how are we supposed to believe monetary policy is effective?
Global growth slowdown and panic
So, me, I don’t believe monetary policy actually is that effective. The problem is that it’s the only game in town. And in a world of slowing global growth, a Fed that is running higher interest rates than almost every other developed economy central bank is a Fed that is tightening financial conditions to the point of recession — globally.
What’s happened is that, while the Fed was raising rates, global growth slowed. And then a trade war has slowed growth even more. Right now, the global manufacturing sector is in a recession, even in the United States. Germany, Italy, the UK, Singapore and many other countries have just shown quarterly economic contractions. Some of these economies are likely in a recession. And that’s caused a lot of people to fear recession in the US as well, particularly with the trade war escalating into a currency war. This is what inverted yield curves are telling us.
So, at the margin, a Fed that doesn’t cut rates is a Fed that is tightening financial conditions to the point where they are the problem. And remember, since monetary policy doesn’t have any direct impact on the real economy, they are also not the solution. But because they are tightening financial conditions around the world, they are certainly the problem.
Given how much global growth has slowed, the last thing we need is an inverted yield curve or a financial panic.
If governments really wanted to stimulate, they would use fiscal policy because that puts money in people’s pockets. And fiscal policy is orchestrated by elected officials whose conduct we have some say over through elections. That’s not the case with monetary policy.
With fiscal policy, the question is always about priorities. For example, when Donald Trump signed the tax reform bill into law back in December 2017, the tax cut gains were slanted toward corporations and the wealthy. And while you might justify some of that on the basis that the wealthy pay the majority of taxes and many people in the US pay zero taxes, the reality is that tax cuts for rich go to the people with the lowest marginal propensity to spend. You’re not going to get a lot of bang for your buck.
As Marshall Auerback wrote me:
We don’t even have to invoke the moral arguments on inequality any longer (even though they are very strong). It should be blatantly obvious to anybody with a pulse these days that to continue to distribute the bulk of GDP’s gains to an increasingly small number of people (with the highest savings propensities to boot) is invariably going to cause one’s economy to grow less efficiently.
What’s more is that the repatriation of overseas cash and tax breaks for corporations was premised on the concept that we would see a surge of capital investment. Supply side economics. The ‘surge’ never happened.
Here’s how I’d sum up.
I think monetary policy is ineffective. We don’t even know how it works. Sure, rate policy can help at critical junctures in the business cycle by lowering interest payments when debtors are under stress. But, we’ve hit the limits of what central banks can do. As a result, we’ve resorted to quantitative easing, negative interest rates, and yield curve control. And for what? It’s crazy.
The solution is staring us in the face: help put money in the pockets of the people who are facing the most severe financial stress in our economies. Those are the people who need the money the most and are most likely to spend that money too. Until we do that, the stress on our economic and financial system will continue to grow… and political unrest will continue to grow with it.
I am going on holiday now. Maybe the beach will put in a positive frame of mind.