After spending the last year plugging all the Wall Street heavy hitters willing to pay $250,000 a meeting for the privilege of picking the ex-Fed Chairman’s brain, Ben Bernanke has resorted to sharing his views via blog in the hopes of a few page clicks. I shouldn’t make too much fun of Ben – I think he is a decent man that tried his best in a bad situation. The errors from irresponsible monetary policy were set in place long before he took over as Chairman. Given the massive debt levels, when the financial markets came unglued, Ben didn’t have much choice except to print. The reality is that no one wants to pay the price associated with decades of poor policy. At this point, there is no way forward except for an inflationary reset. The optimists that think we can grow our way out of this massive indebtedness need to check their numbers. The pessimists that advocate allowing the economy to undergo a cleansing deflationary credit crash need to re-examine our society’s willingness to endure short term pain in exchange for the hopes of long run gain. No, there is only one way out of this mess. Inflating away the debt is the most obvious and easy answer. Solving your economic problems with inflation has a long tradition, and to think that the answer will somehow be different this time is just naive. Ask yourself how many currencies have collapsed because of deflation. Then compare that to countries whose economy have been wrecked by inflation. Sure maybe it will be different this time, but that’s never the right way to bet…
Back to Ben’s new blog. There is considerable value in examining Ben’s views to help understand what is driving the thought process of the current Federal Reserve members. Although they are all individuals, Ben’s views won’t differ that much from Chairperson Yellen’s. At their heart, they are both academics with similar lines of thinking.
And the topic of his first blog post “Why are interest rates so low?” is a telling indication of his beliefs about the Federal Reserve’s responsibilities (or lack thereof) for the massive bubble we find ourselves mired in.
Why are interest rates so low? Will they remain low? What are the implications for the economy of low interest rates?
If you asked the person in the street, “Why are interest rates so low?”, he or she would likely answer that the Fed is keeping them low. That’s true only in a very narrow sense. The Fed does, of course, set the benchmark nominal short-term interest rate. The Fed’s policies are also the primary determinant of inflation and inflation expectations over the longer term, and inflation trends affect interest rates, as the figure above shows. But what matters most for the economy is the real, or inflation-adjusted, interest rate (the market, or nominal, interest rate minus the inflation rate). The real interest rate is most relevant for capital investment decisions, for example. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.
Ben is of course correct that the Federal Reserve has traditionally only controlled the short end of the yield curve. They have set the Fed Funds rate and allowed the market to establish rates for the rest of the curve. But in 2008 when the Fed found itself constrained by the zero bound for Fed Funds, they ventured into Quantitative Easing and started influencing longer term rates. Yet I think even with this new development, Ben would argue that the market was setting the real rate and that the Fed was just supplying the needed liquidity.
To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.
If the Fed wants to see full employment of capital and labor resources (which, of course, it does), then its task amounts to using its influence over market interest rates to push those rates toward levels consistent with the equilibrium rate, or—more realistically—its best estimate of the equilibrium rate, which is not directly observable. If the Fed were to try to keep market rates persistently too high, relative to the equilibrium rate, the economy would slow (perhaps falling into recession), because capital investments (and other long-lived purchases, like consumer durables) are unattractive when the cost of borrowing set by the Fed exceeds the potential return on those investments.
And herein lies the mistake that Federal Reserve committee has been making for the past couple of decades. They believe that rates have not been set too low because there has been no inflation.
Similarly, if the Fed were to push market rates too low, below the levels consistent with the equilibrium rate, the economy would eventually overheat, leading to inflation—also an unsustainable and undesirable situation. The bottom line is that the state of the economy, not the Fed, ultimately determines the real rate of return attainable by savers and investors. The Fed influences market rates but not in an unconstrained way; if it seeks a healthy economy, then it must try to push market rates toward levels consistent with the underlying equilibrium rate.
The Federal Reserve has consistently kept rates too low. Full stop. This has distorted the economy. There is no doubt in my mind. It hasn’t resulted in traditional inflation because of the secular headwinds of the powerful deflationary force of tens of millions of Chinese (and other developing nations) entering the world’s workforce. When combined with increased globalization and massive technological advancements, there has been tremendous deflationary pressure that has masked the irresponsibly accommodative monetary policy.
The Fed has kept rates below the “equilibrium rate” for much too long which has encouraged all participants to take out too much debt. When you price something too low, it increases the demand.
Ben believes that Federal Reserve policy has merely shadowed secular moves in interest rates. At the margin, they have tweaked policy trying to smooth out the business cycle, but they are not responsible for overall levels.
The state of the economy, not the Fed, is the ultimate determinant of the sustainable level of real returns.
He takes no responsibility for the Federal Reserve policy’s affecting the economy’s long term structure. Ben believes the rate that the Federal Reserve sets is merely reflection of the long term equilibrium with a slight tweaking to counter short term cyclical moves. He believes that the Fed is nothing more than a weatherman reporting the weather – not the one determining it.
I think that the Fed’s policies are directly responsible for the current mess. They have consistently set rates far too low, fooled by the belief that since inflation was in financial assets instead of traditional inflation measures, it was benign. By doing so they have boxed themselves into a corner where they have no choice but to continue with their overly accommodative monetary policy.
It is far too late to go back. The time for prudent monetary policy was decades ago. At this point there is no choice but to simply get about to the task of inflating away all this debt. It will be interesting to see how Ben and the other academics justify their coming policies. With Ben starting his blog, we will get a first hand view of what is going through their minds as we embark down this path.