Robert Reich and the big bad Fed

Robert Reich is in my facebook feed telling me that the Fed raising its benchmark interest rate in Sep by 0.25% would be a catastrophe for ordinary working people, and I should sign a petition for them to keep things on hold. Regardless of the likely sensitivity of the FOMC to such a petition (you’d have thought approximately zero!) – is he right to fear a rate rise? His argument is simple enough. To quote directly:

“The percentage of the American population that’s working is more than three percentage points lower than it was before the Great Recession, suggesting we’re 3 to 4 million jobs below where we should be if the economy were healthy. This isn’t because of aging boomers. Even the employment rate of prime-age workers (ages 25-54) is down nearly the same percentage. That’s because millions of working-age people have given up looking for jobs because they can’t find any. But they’re no longer counted as being employed so the Fed doesn’t see them.”

Essentially – he argues that the economy is far below full employment. Because of this, rates should not go up – as there is no danger of inflation with so much spare capacity.

In its own terms, there’s nothing wrong with this argument – this is how economics is supposed to work. The real economy, factories and offices and people, produce goods and services – and if the amount of money is just right, all of those factories and offices will be full of people (full employment) because there’s enough purchasing power to keep them there. Put more money into the system from here, and all you’ll do is raise prices. Take any out, and some factories or offices will lie unused. So far so obvious right – but of course that paragraph contains a slight of hand. We’re supposed to be establishing the basic mechanism via which interest rates control output and inflation – but all we talked about was ‘purchasing power’, ie the money supply. Of course, the normal thinking in economics is that interest rates affect the amount of money in the economy because they are the price of credit. Reduce the price (reduce the rate), and more loans will be taken out, thereby increasing the amount of purchasing power and providing the dollars, pounds or euros neccesary to keep capital and labour (factories and people) employed.

These highly stylised stories about how the economy works are, of course, backed up and fleshed out by a heft body of academic literature. But when I say backed up, I mean stuff like this – that paper’s not supposed to be an exhaustive account, just the result of a quick google search, and representative of the kind of evidence that is presented for the conventional account of how monetary policy works. Now, I’m not saying its wrong, partly because I’m not qualified but mainly because the idea that such things can easily be demonstrated to be wrong or right is a bit nuts. We’re talking about relationships between quite abstract statistical constructs (unemployment, inflation etc), with big measurement errors, constantly changing relationships to the real world etc. Not only that, but the proposed mechanism of interest rates controlling the amount of purchasing power, is pretty spurious when you think about it. Why should lower rates lead to more loans being made? Most people are happy to take out loans if the can get them – hubris takes care of that – most people’s experience of dealing with banks is that they ration credit, ie, they only lend at the prevailing rate to people they are sure will repay. 

When in doubt, in questions of strong claims about relationships between abstract things, I always like to just stick them on charts and see. So let’s do that. Below I plot the percentage change in the money supply (as represented by M2) in the US, against the interest rate (as represented by 3m LIBOR):

M2 vs Libor

Now I stress, I am putting this chart here not to try and dispel mainstream economic theory – rather to show that the relationships it relies on play out pretty messily in real life. There are periods on this chart where if you squint, you can see lower rates coinciding with higher growth in the money supply. 2000-2002 looks pretty good here. But there are also periods where lower rates coincide with lower growth in the money supply – 1990-1992 for example. Now there are a lot more moving parts than a simple linear relationship. I’m labouring the point here but this isn’t supposed to vindicate or disprove mainstream economic theory – rather to show it’s not at all obvious what happens when interest rates go up or down.

That’s one grounds for skepticism, and there’s another very important one. The target rate for fed funds is the policy variable that the fed is proposing to fiddle with – but people don’t take mortgages or get business loans at the fed funds rate. They have to pay prevailing market rates of interest. Any market interest rate is made up of four things:

– Expected base rate
– Inflation expectations
– Term premium
– Credit Spread

Unless you’re borrowing money overnight, the rate you pay will be a function of what the market believes will be the Fed’s average policy rate over the period you borrow, plus all that other stuff. The market, in its wisdom, has believed that the Fed is just about to hike rates for at least the last year, such that borrowers have already been paying rates that reflected a tighter path of monetary policy for some time – below I chart the 2y swap rate (which approximately reflects the average expected expected interest for the next 2y):

2y Rate

Since Jan 2013, borrowers have faced a 40bp (0.4%) increase in the price of 2y money. The market has been pricing a fed tightening cycle for over a year, and if the Fed were to raise rates now, aside from the traders betting against  a September hike (of which from personal experience there are not many), it’s hard to see how many people would be impacted. Simply having the market’s expected path of rates materialise is hardly the stuff of nightmares for real economic actors.

To conclude, this kind of alarmism over a September rate hike seems misplaced to me. The transmission mechanism of short term interest rates to the real economy is pretty uncertain, highly contingent, and in any case the market has anticipated a fed tightening cycle for over a year. I write this quick post not to enthusiastically cheer for a sep liftoff, but to point out that the alarmists have a lot of work to do to convince anyone to get excited about a 0.25% increase in the Fed funds rate! Robert Reich writes compellingly and originally on the capture of american policy making by corporate interests, and the perils of inequality, and I look forward to reading more of that, and less of this.


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