The writer is a philanthropist, investor and economist
The stock market has been jolted from its record highs in recent weeks, as investors who rely on low interest rates to “justify” steep valuations have been confronted with the prospect of tighter monetary policy.
This might be a prelude to more turmoil. The US Federal Reserve appears to be walking a tightrope, with the potential for a policy error at each side.
On one side, US consumer price inflation reached an annual rate of 7.1 per cent in December, and the central bank appears behind the curve to contain it as it continues to expand its balance sheet, keeping its benchmark fed funds rate near zero. On the other side, the inflation spike has emerged at the same time as supply disruptions, a gradual narrowing of pandemic-related fiscal deficits and indications of weaker business activity. This leaves the Fed at risk of tightening policy into a slowing economy.
Yet these risks may be minor compared with the policy error the Fed has already made, by abandoning a systematic policy framework for more than a decade, in favour of a purely discretionary one.
“Systematic,” in this context, means a framework where policy tools such as the level of the fed funds rate maintain a reasonably stable and predictable relationship with observable economic data such as inflation, employment, and the “output gap” between real gross domestic product and its estimated full-employment potential.
Systematic policy allows individuals and financial markets to anticipate the general stance of monetary policy based on observable data. In contrast, purely discretionary policy is like inconsistent parenting; having set no boundaries, any failure to appease is met with wails of surprise, crisis and tantrum.
In 1993, Stanford economist John Taylor proposed a systematic framework for assessing what the fed funds rate should be based on the level of inflation and the output gap. The Taylor Rule and related guidelines mirror the actual fed funds rate reasonably well from 1950 until 2003.
The similarity weakens after 2003, and particularly after 2009 owing to shifts in the Fed’s monetary policy. Yet the deviation of the actual fed funds rate from systematic guidelines has little beneficial impact on subsequent economic outcomes. This does not imply that monetary policy is irrelevant. Rather, the benefit of monetary policy mirrors the extent to which it systematically responds to non-monetary variables.
To describe a small change in the fed funds rate as a grave policy error vastly overestimates the correlation between monetary policy and economic outcomes. Information about the stance of monetary policy offers surprisingly little improvement or meaningful impact on forecasts for GDP growth, employment growth and inflation. Likewise, the relationship between unemployment and general price inflation better resembles a scatter of birdshot than a well-defined “curve” or a manageable policy framework.
Ultimately, the Fed’s central policy error may have little to do with the speed at which it tapers its asset purchases, or the timing of the next few rate increases. Instead, the critical policy error may prove to be the consequences of discretionary policy on the financial markets. The Fed has encouraged a decade of yield-seeking speculation, as investors try to avoid being among the holders of $6tn in zero-interest hot potatoes.
By relentlessly depriving investors of risk-free return, the Fed has spawned an all-asset speculative bubble that may now leave investors with little but return-free risk. Valuations still stand near record extremes.
It is true that low interest rates encourage elevated stock market valuations. But it is less appreciated that once valuations are elevated, low interest rates do nothing to mitigate the poor long-term market returns that typically follow.
In 1873, the economist and journalist Walter Bagehot wrote of savers’ aversion to low rates: “John Bull can stand many things, but he cannot stand interest rates of 2 per cent”. Forgetting this, in 2003, the Fed sent investors on a yield-seeking quest for alternatives to short-term interest rates of 1 per cent. Investors found that alternative in mortgage securities, with ultimately devastating consequences.
The Fed has now encouraged an even broader and more extended speculative episode. It can be prolonged only by making its consequences worse. The way forward is to embark on a well-announced return to systematic policy, never forgetting to ask whether the weak effects of monetary discretion on real economic outcomes are worth the risk of malinvestment and speculative distortion.