Stop dancing to the Fed's fiddle

For the first time in almost a decade the market shrugged off a significant move by the Fed when it increased its rate by 0.25%. Of course, the market had anticipated the increase for a year and so priced it in earlier. And euphoria over the president elect trumped Fed policy. This is a good time to reassess the logic of dancing to the Fed’s fiddle.

Mainstream economists used to dance to the tune of Keynes and fiscal policy until the disaster of stagflation in the 1970s. Fiscal policy, they cried, suffered from too many lags to be effective, as if the lags were the only reason it couldn’t be effective. There were no problems with lags during the 1930s under FDR and it still wasn’t effective.

Fickle as teenage groupies, mainstream economists switched their adoration to the Fed. The Fed could save us all when Uncle Sam failed. Adulation for the Fed climaxed with the financial media’s crowning of Fed chairman Alan Greenspan as the “Maestro” who could orchestrate the economy as he wished with a wave of his wand.

Then housing landed on the economy and caused the Great Recession (GR). Ben Bernanke waved his wand but the economy wouldn’t perform. It couldn’t get out from under the house. Eight years later, confidence in the Fed has evaporated and mainstream groupies are bailing out on the Fed and returning to their first love, fiscal policy.

George Selgin has a post at Alt-M in which he claims that the Fed isn’t responsible for our current low interest rates.. Larry White and Selgin know money and banking better than anyone I have read. The essence of the post is that the Fed suffered from erectile dysfunction in 2008:

As we've seen, rates originally crashed, not because monetary policy was too easy, but because it was too tight. The Fed erred, in other words, not by pushing rates down but by trying to prop them up in the months leading to Lehman’s collapse...it also implies that a central banks that strives to maintain an excessively high rate target will, by over-tightening, cause spending (or, if you prefer, aggregate demand) to decline.

So the Fed didn’t cause the GR, but it made it worse by trying to keep rates vertical. Then after the Fed lowered its rate, chasing the effective rate down, Bernanke struck a dissonant chord by paying interest on excess reserves (IOER). IOER soaked up the liquidity that lower rates spilled on the floor of the economy. Selgin thinks Bernanke invented IOER in order to keep short term rates from going negative, but it has hurt growth in the economy by keeping rates too high.

Selgin’s answer the question of why rates have remained so low for so long is that the natural rate of interest has fallen.

The alternative explanation — that natural rates have themselves fallen — is supported by a mass of empirical studies, showing that all of the principle determinants of “natural” nominal rates, including expected inflation and total factor productivity, have been trending downward since long before the Fed’s first large-scale asset purchases.... . The switch to unconventional policies resulted in a substantial increase in uncertainty concerning the future course of interest rates, which served in turn to keep rates low by further dampening an already dampened appetite for investment.”

To summarize, the Fed blew it in 2008 by trying to keep short term interest rates too high and that killed the economy. Dead economies don’t demand new loans, so interest rates reclined. Bernanke’s misguided attempts to keep rates from totally collapsing precipitated a fog that Robert Higgs called “regime uncertainty.” But Higgs blamed the massive rise in regulation under the current administration for the recent fog. Airplanes, orchestras and economies don’t work well in fog. The Fed raised rates last week, but as Selgin wrote,

..., it will be just another instance of the market dog wagging the FOMC tail.

There is an old saying among Austrian economists that the central bank may launch an unsustainable expansion but the real economy of goods and services ends it. Mainstream economists will never overcome their obsession with government, but hopefully investors are beginning to.

Mises, Hayek and Benjamin Anderson warned economists that the most serious mistake one can make in monetary theory is to disregard the quantity theory of money. The second is to accept it as working mechanically because it’s difficult to tell how people will respond to changes in interest rates or the money supply. There are many confounding factors.

The Fed plans to raise rates three more time next year, based on its forecasts of how fast the economy will grow. But this article from Mises.org "The Fed who Cried Growth," the Fed has a foggy record in forecasting. Those investors who are still dancing to the Fed’s tunes will have sold their bonds for losses as the prices of bonds have fallen. If the Fed is wrong, as it usually is, interest rates will reverse course next year and decline, meaning bond prices will rise and give those who buy bonds now a boost in returns from the appreciation of their principle.