The Fed Hangs Fire on Interest Rate Rise

Janet Yellen, the Chairman of the Federal Reserve Board of Governors
Wikimedia Commons/U.S. Federal Reserve

As widely expected, the Federal Reserve Open Market Committee (FOMC) hung fire on raising the Fed Funds interest rate yesterday. The Fed Funds rate is the interest charged by the Fed to member commercial banks overnight for borrowing funds from the Federal Reserve. Inevitably it becomes the short-term interest rate charged to banks’ best, most credit-worthy customers.

Reasons for the Fed Hang Fire

The Keynesians controlling the FOMC have been impressed by the faltering of the economy, much as the rest of us have been. What terrifies them is the recent first quarter fall in GDP growth to 0.8%, together with the recent dismal

announcement of an increase of only 38 thousand new jobs in May, the fewest in six years. Economists had been expecting around 160,000 new jobs according to data provider FactSet. In addition, to make the pain even worse, the preliminary estimate for new jobs in April was revised downward to 123,000. Not widely publicized but probably equally influential on the FOMC is the decline of the Federal Reserve’s Labor Market Conditions Index (LMCI). The monthly change in the LMCI has been proven to be an almost perfect coincident economic indicator.

The monthly change in the LMCI has fallen to -4.8 index points, the lowest it has been since the Great Recession, which is a profoundly recessionary signal.

Yet, after roughly seven years the Federal Reserve strategy to stimulate the economy through zero real short-term and long-term interest rates has also been a profound failure. What is a good Keynesian to do! The Keynesian faith says low interest rates are always stimulative, and increasing interest rates will always retard growth. The contrary evidence of the past seven years should hint to the Keynesians that it is not just low economic demand that has held back more robust growth.

This is why Janet Yellen’s remarks yesterday, at the press conference where she explained the FOMC’s reasoning for the hang fire, are so fascinating. A video of the press conference in its entirety is shown below. Perhaps the FOMC has begun

to get the hint. What particularly seems to have surprised the Fed has been the lack of business investment outside of the energy sector. However, as could be expected of anyone who has had their faith challenged, the FOMC is resistant to changing their approach. While not decreasing interest rates, Yellen announced they will not be increasing them precipitously either. They intend to increase short-term interest rates very slowly and very cautiously. The FOMC’s expectation is that the fed funds rate will be below one percent by year’s end, and will not rise to around 2.5 percent until sometime in 2018. They do not expect the interest rate to rise to a more normal three percent until sometime in the unforeseen future,

Also, toward the end of her prepared remarks, Yellen said the Fed would continue to “reinvest” the proceeds from matured assets on their balance sheet. That is, as soon as long-term mortgage backed securities and treasury bonds mature, the Fed will purchase a like-amount of new long-term assets from member banks to keep the level of long-term assets they own constant. This will have the effect of holding down long-term interest rates at around their present levels.

In response to a question from Steve Liesman of CNBC about why accommodative monetary policy has been so ineffective in stimulating GDP growth, Yellen could only respond by noting that Keynesian econometric models predict that the “neutral fed funds rate”, the largest rate consistent with a growing economy, is very close to zero. She also mentioned uncertainty about lingering effects of the Great Recession, and particularly about the low growth in productivity.

The low growth of productivity ties back with Yellin’s earlier mention about the FOMC’s surprise about the lack of business investment. Productivity growth is most highly correlated to business investment driving improvements in technology. Yet to obtain the capital for investments there must be increased savings, and savings are directly depressed by low interest rates. Ironically, the very means of low interest rates Keynesians are using to stimulate growth are actually holding growth back by depressing savings, investments, and productivity growth.

Factors Depressing Growth Outside the Federal Reserve

But it is not just Federal Reserve monetary policy holding back investments and growth. Some of the factors depressing investments are completely beyond Fed control, but are imposed on the economy by the executive and legislative branches of government. Currently, corporations are one year into an earnings recession with corporate revenues falling at an accelerating rate. With revenues falling, it should not be a surprise that businesses are decreasing their investments, and are hiring ever fewer people. I noted in the post The U.S. Economy and Stock Markets, June 2016 that there was a curious cyclical behavior of the total business inventories to sales ratio. Beginning every year from 2010 to the present, there has been an initial spike in the inventories to sales ratio, probably related to the Christmas season, followed very quickly with a large drop in the ratio.

Apparently, towards the end of every year, company officers would become optimistic about increased sales for the coming year, thinking the economy would finally escape its doldrums, and increase their production, only to be disappointed by economic reality. They would then have to cut back their production until sales pruned their inventories. As you can see from the graph above, the amplitude of these year-beginning spikes has been growing year by year.  If a company’s productive capacity causes such large inventory spikes, why should they invest to get more capacity?

The automatic response of a dyed-in-the-wool Keynesian would be that obviously there was too little demand for the productive capacity available, and therefore there should be some Keynesian stimulus coming from the government to help occupy current productive capacity. Yet, there are two additional causes of low demand relative to productive capacity other than market failure that Keynesians are loath to admit.

• The government imposes costs on companies that drives up prices of their products to an extent that consumers will not buy much. Such costly government policies include high taxes, as discussed in the posts Economic Effects of Current Tax Policy; The Ideal Tax Regime -1; The Rahn Curve, Hauser’s Law, the Laffer Curve and Flat Taxes; and Big Corporations Abandoning the U.S. at an Increasing Rate. Additionally, government increases corporate costs through costly regulations, as I discuss in The Burden of Government Regulations; The Debilitating Effects of Obamacare; Economic Effects of the Dodd-Frank Act; and The EPA, CO2, Mercury Emissions, and “Green” Energy.
• The government imposes costs on households that depress their ability to demand goods and services from the producers. Historically these costs have been primarily from taxes, but increasingly they are coming from government mandated healthcare imposed by Obamacare. If a household gets healthcare through an employer, the employer may reduce wages or wage increases to finance the additional high premiums, but in all cases the individual households must directly bear the costs of higher deductibles. If a household does not obtain healthcare from an employer, Obamacare forces them to buy government approved health insurance or to pay an IRS imposed fine. Every penny of government imposed costs on individual households reduces households’ ability to demand other goods and services.

Increasingly, the primary causes of our economic woes appear to be due mostly to government suppression of both supply and demand, but especially to supply, and much of that suppression comes from outside the Federal Reserve. None of our problems appear to be amenable to low or lower interest rates.

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