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China slowdown? Lessons from Japan


August 28, 2015 Comments (0) Views: 2281 Homepage

The Fed’s ‘other’ rate dilemma

When it comes to the legality of the various unconventional monetary policy measures that have been employed in recent years, it’s the European Central Bank that has got most of the attention. Look more closely, though, and it’s the US Federal Reserve that you might want to be more concerned about, and particularly if the latest China-related market hiccup causes it to delay its first policy tightening any further.

“It is my judgement that the law has, from time to time, been conveniently ignored,” said an irate Senator at hearings on the operating performance of the US Federal Reserve. It wasn’t a recent accusation, I’ll grant you. Actually, the Senator in question was Hubert Humphrey, and the date was 1976. Two years later, the result of his and others’ deliberations was the Full Employment and Balanced Growth Act, more commonly known as the Humphrey-Hawkins Act. Among the changes it brought about, one was to the Federal Reserve’s monetary policy mandate in the form of Section 2A of the Federal Reserve Act, which subsequently (and still, to this day) reads as follows:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

It’s an innocuous enough looking sentence, on first inspection. ‘Maximum employment, stable price’: it’s the famous dual-mandate. But what about the bit on ‘moderate long-term interest rates’. Be honest: did you even realise it was there? And now you know it is there, what do you think about the idea of long-term interest rates as having been ‘moderate’ in recent years? They haven’t, have they? Actually, they’ve been extraordinarily low, and particularly in comparison to the size of the fiscal deficit and the US national debt. Indeed, if I’m not mistaken, the precise goal of more than one of the unconventional monetary policy measures enacted in recent years was to ensure that long-term interest rates were anything but ‘moderate’.

Isn’t that a problem?

And it’s not the only potential problem. What about the stipulation to “maintain long run growth of the monetary and credit aggregates”? Have you seen much mention of the monetary and credit aggregates in recent years? You haven’t. In fact, in its latest Monetary Policy Report, you won’t find a single mention of the terms ‘M1’ or ‘M3’, only two of ‘M2’, and not a single forecast of a monetary or credit aggregate in sight. Not only did the Fed stop publishing targets for the monetary aggregates back in the year 2000, but it stopped calculating and publishing one of the key monetary aggregates altogether in early-2006. Remember M1, M2 and M3? Well, as of 2006, there was no more M3, which was a pity – it turned out – because it was signalling that monetary policy was significantly too easy at the time. And in a 2009 Fed staff presentation on inflation, the only mention of the money supply was in a slide entitled “we had to say something or Milton Friedman would have been very angry”. Actually, Mr. Fed staff economist, you were supposed to be analysing the money supply not because of Milton Friedman, but because it’s the Law.

By the way, and with apologies if you think I’m nit-picking, but that stipulation about “stable prices” isn’t what the Fed’s self-imposed 2% inflation target equates to at all.

But back to that problem of “moderate long term interest rates”. He’s been rather quiet of late on the subject of economics, but former Fed Chairman Ben Bernanke was quite the blogger for at least a couple of weeks back in April. Wouldn’t you know it, but three of his first four posts were on the subject “why are interest rates so low”. It’s just a guess, of course, but I doubt that Ben Bernanke was just idly blogging away on whatever he happened to read about in that morning’s Wall Street Journal. If you ask me, he was blogging furiously about low interest rates because somebody had whispered in his ear that it was something of a legal weak-spot in the policies undertaken during his Chairmanship of the Fed.

Of course, the Federal Reserve doesn’t have to listen to me when it comes to US monetary policy. But it does have to listen to the Federal Advisory Council, a body mandated under Section 12 of the Federal Reserve Act to meet with the Board of Governors four times per year with respect to banking and monetary policy-related issues (the CEOs of Wells Fargo, Morgan Stanley & Comerica are among its current members). Here are a couple of excerpts from the latest Committee meeting, in May:

“Council members believe that the normalization of monetary policy does not need to wait for both sides of the Federal Reserve’s dual mandate to be fully satisfied”;

“The current zero bound rate level was initiated as an emergency response to the crisis of the recession. We are no longer in a crisis environment, and a crisis level of rates is no longer warranted”;

“Asset prices are being heavily influenced by the low interest rate environment and might tend to stray from fundamental value if policy remains too easy for too long”;

“The impact of long-term near-zero interest rates has potentially played out its effectiveness”.

Come September, my suspicion is still that the Fed will raise interest rates. It’s not that I don’t worry about China, or further trouble in the Euro-land. But I do wonder about Fed getting itself into difficulties with Congress if it continues its policy of zero interest rates despite the fact that its price and employment objectives have both been virtually met. And when I say I worry about the Fed getting into ‘difficulties’ with Congress, I really mean that I worry about it getting into ‘even more difficulties’, because it already has its hands rather full with respect to community banking, the leaking of highly confidential information, audit rights, and a new Taylor rule of some sort.

And I don’t know if you’ve noticed, but there’s a rather important election season directly ahead.

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