The Federal Reserve has backed itself into a corner. Friday’s GDP statistic for the fourth quarter of 2015 was stronger than expected, but still a tepid 1.4%. Every other time the Fed began raising rates since World War II, there was a booming economy—typically with GDP humming along at 4% to 5%. Not so, now.
This conundrum stems from the fact that the Fed is ignoring one of its Congressional mandates: moderate long-term interest rates.
While GDP is closely monitored by the Fed, it is required by law to maximize employment and keep prices stable. This is the so-called “dual mandate,” which Congress enacted in 1977 and reaffirmed in 2000.
The Fed has discretion to interpret these mandates as it sees fit. That is where its price inflation target of 2% comes from and why it wants to see headline unemployment at or below 5% (although this is a moving target).
The Fed's third mandate
But the Fed actually has three mandates. According to the Federal Reserve Act, Section 2a, its goals are “maximum employment, stable prices, and moderate long-term interest rates.”
Weeks after becoming the Fed chairman in 2006, Ben Bernanke explained why the Fed conflates two of those mandates. He said it had “become the consensus view that the mandated goals of price stability and maximum employment are almost entirely complementary.”
Bernanke quoted early 20th-century economist Irving Fisher* for justification. Fisher was the first to point out that “interest rates will tend to move in tandem with changes in expected inflation.” In other words, if lenders expect prices to head higher, they will require a higher interest rate on loans.
The problem of decoupling
The problem is that the historical link decoupled when Bernanke ushered in the era of persistently-low interest rates in response to the financial crisis.
Since the 1950s, the yield on long-term U.S. Treasury Notes (green) has averaged about 6%. Currently, it’s 1.9%, making it difficult for the Fed to consider that “moderate.”
Meanwhile, price inflation, as measured by core Consumer Price Inflation (blue), is rising. Currently, it is 2.3%, which is already above the Fed’s 2.0% target.
At her last press conference, Fed Chair Janet Yellen said she was comfortable allowing price inflation to “overshoot” the Fed’s target. Nevertheless, the historical correlation between price inflation and long-term interest rates clearly became unhinged as Bernanke announced successive rounds of quantitative easing.
The Fed was too late
By ignoring this breakdown, the Fed waited too long to raise rates, a view shared by many economists and institutional money managers. In September 2016, bond fund magnate, Bill Gross, criticized any rate hike as “too little too late.” He argued that market turmoil would leave the Fed bereft of options.
Now, the Fed is in the unenviable position of having to choose between (1) raising rates into a slow-growing economy or (2) losing all credibility by reversing course with its rate hike promises. But the Fed is already preparing the public for option 2.
Softening the blow of negative rates
On March 18, Bernanke attempted to soften the public to the idea of negative rates, blogging “The idea of negative interest rates strikes many people as odd. Economists are less put off by it, perhaps because they are used to dealing with ‘real’ (or inflation-adjusted) interest rates, which are often negative.”
In other words, the public’s visceral reaction to another monetary experiment is incorrect, and it should trust the experts who have yet to extricate themselves from the prior experiment of quantitative easing. While Europe and Japan have taken the plunge into negative rate territory, it's far too soon to declare success there. The best they can claim is that it has not been a disaster.
Yellen openly admitted that negative short-term rates are on the table, but also said that such a measure would face legal uncertainty under the Federal Reserve Act. Given that negative short-term rates would further depress long-term rates, it's clear the Fed already has its answer: negative rates are illegal.
It's time that the Fed started obeying the letter of the law.
* Irving Fisher also famously said just prior to the Wall Street Crash of 1929 that the stock market had reached “a permanently high plateau.”