Tomorrow the Fed will announce its decision on whether to increase interest rates for the first time since 2006, and the markets seem to be thinking we’ve got at least another meeting until it happens. Markets are up in the last couple of days and even long-beaten gold is catching a bid, sensing that interest rates won’t rise. In one of my last posts I opined that the Fed wouldn’t increase rates, but I can’t disagree with one of my favorite economic commentators, Jim Grant, who above argues that Ms. Yellen is simply tired of the question. He may be right…if the Fed gives a pretty clear signal its one for now, and–if more come in the future–they will be very measured and delayed. Nevertheless, the problem is twofold.
First, the Fed has no good options. They should have increased interest rates quite a long time ago, and now it is clearly more risky to increase interest rates than say a year ago. Yet the continued failure to begin rate normalization allows the uncertainty that keeps our economy down to remain. The Fed was rightly criticized for telegraphing their tightening in 2013 and then backing down when the stock and bond markets buckled in the so-called “taper tantrum.” The Fed desperately wants to send a signal that they are not under Wall Street’s thumb (hence Jim Grant’s point in the video above that Janet Yellen wants this issue off the table), but they likewise don’t want to be blamed for driving a precarious recovery into the ditch. Expectations of increased U.S. interest rates have driven the dollar sharply higher over the last year, leading to financial flows heading back to the U.S. from emerging markets such as Brazil, China, Turkey, etc. in pursuit of higher yields. These financial flows are the natural result of profit maximizing financiers trying to profit from the Fed’s artificial manipulation of interest rates and therefore currency values. Yet those changing financial flows are a driving factor in world-wide market stress. So they really are between a rock and a hard place, much of it their own making.
Second, I’ve just watched the Republican debate and no one has yet mentioned the Fed unless I missed it. Why is it in a free economy we think the Fed should be in control of its most important price? Mr. Grant correctly notes that the result of the Fed’s zero interest rate policy (ZIRP): we have significantly mis-priced risk in financial assets. The Law of Demand applies here as everywhere, when the price of something goes down, the quantity demanded rises. In this case we have lowered the price of risk and it leads to increasing risky assets. Ultimately riskier assets may yield more or less, but it leads to ultimately more volatility. As Rand Paul argued in the WSJ today (gated),
Consider an analogy. When the U.S. Forest Service took a zero-tolerance approach to forest fires 100 years ago, what ultimately happened was a massive wildfire at Yellowstone National Park in 1988 that wiped out more than 30 times the acreage of any previously recorded fire. Paradoxically, by refusing to allow small fires to run their natural course, the forest managers made the entire park vulnerable to a giant inferno.
What is true of forests holds for the economy: When governments create a lie, whether it’s a fabricated ecology of no fires or a fabricated economy of no failures, the truth reveals itself even more violently than otherwise. Attempts to stop any dips in the stock market with monetary stimulus postpone the necessary adjustments to how and where resources and workers are deployed. Interest rates are a vital signal in the market; they must be allowed to do their job—that is, they must be allowed to be free.
But perhaps the most important question is what good has the ZIRP done? Clearly its made it easier it easier for big government–the interest costs of our debt are far lower than they should be, putting us significantly at risk when interest rates normalize. Our interest rates will one day be punishing, but not today–today money is essentially free to our government. When the price of government goes down, the quantity demanded rises. Wall Street also loves low interest rates. When interest rates fall, the future cash flows from every financial asset become more valuable–every asset’s price rises with lower interest rates. So the stock markets have done well. But has a ZIRP made main street better? If so, by what measure? The Fed can only echo Mr. Obama’s claim, the counterfactual that cannot be proven, that it would have been worse. Perhaps, but perhaps not.
The Bible says nothing about monetary policy, but I can’t help but draw the analogy from 1 Sam 8, when the Israelites demanded a king. God warned them through Samuel that when they refused to trust Him, but seek a king to fight for them, they’d regret it. Why do we think we need a “king” for monetary policy? Do we not yet regret the Fed? How many bubbles bursting will it take?
Edit Update 18 Sep: Markets drop on Fed Uncertainty. Maybe in Fed We don’t trust?
“The signaling by the Fed yesterday doesn’t see confidence to pull the trigger to raise from zero to 25 basis points, I think is negative sentiment that’s hitting the market,” said Art Hogan, chief market strategist at Wunderlich Securities. “I think they’ve done more harm than good,” he said.