An OK Jobs Report Has the FOMC Rate Obsessed
Federal Reserve Chair Janet Yellen and her merry band on the FOMC* seem determined to raise interest rates at their next meeting, which is scheduled for mid-September. If so, Friday's "Employment Situation" report from the Bureau of Labor Statistics (BLS) probably won't dissuade them.
The BLS report was mixed. The number of FTE** jobs increased by 486,000, mainly because of a decline in the percentage of jobs that are part time. However, labor force participation fell to yet another modern low, and year-over-year growth of the weekly wages of "production and non-supervisory workers" came in at only 1.8%.
There was nothing in the BLS report to suggest that the economy is "overheating" (which is something that seems to concern Keynesians, like the members of the FOMC). Meanwhile, on July 30, the Bureau of Economic Analysis (BEA) revised out of existence $321 billion (in 2Q2015 dollars) of the past three years' real GDP (RGDP).
The revisions cut the feeble 2.22% RGDP growth rate that we thought that we had seen during President Obama's economic recovery thus far down to a pathetic 2.11%. And, with the Fed's own ‘GDPNow" model forecasting RGDP growth of 1.0% for 3Q2015, there is even less reason to be concerned about the economy "overheating."
When people talk about the Fed "raising interest rates," what they are referring to is the Fed's policy target for the market interest rate on Federal Funds, which are overnight loans that the Fed's member banks (and certain other entities, like Fannie Mae) make to each other.
The public conversation about the Fed Funds rate (which borders on an obsession) assumes that the Fed Funds rate is a useful tool for managing the dollar and the economy. The belief is that raising the Fed Funds rate target has the effect of "tightening" money (and slowing the economy down), while lowering it makes money "looser" (thus speeding it up).
Accordingly, if the FOMC raises its Fed Funds rate target in September (as expected), its purpose will be to "tighten" money, supposedly to head off inflation.
Before explaining why the Fed Funds rate doesn't matter in the way that it used to matter, it is important to note that the FOMC's focus on the Fed Funds rate is insane. It's as if Janet Yellen were trying to control the direction of a train while looking in the rearview mirror and steering with the radio volume control knob.
First, one shouldn't be trying to steer a train at all-it's supposed to be "on rails." Second, one can't see what is ahead by looking in the rearview mirror. And, third, the radio volume control knob isn't connected to anything relevant.
The Fed's job is to provide a dollar that is stable in real value, not to centrally plan and manage the U.S. economy. With a stable dollar, we would have stable financial markets and a stable, growing economy. If we were then to reduce taxes on savings and investment, and implement cost-conscious federal regulation, Jeb Bush's RGDP target of 4% RGDP growth "as far as the eye can see" would be achievable.
OK, now back to the Fed Funds rate.
Yes, there was a time when the Fed's Fed Funds rate target mattered. However, this is not the case today. Today, the FOMC's Fed Funds rate target has no impact on anything, except perhaps as a kind of "forward guidance" (i.e., public relations) tool.
Here is an example of how the Fed's monetary control system used to (sort of) work. In 4Q1999, NGDP was increasing at an annualized rate of 8.81%. As nominal GDP (NGDP) expands, an economy (typically) requires more base money. So, the monetary base was rising briskly during that period.
In November 1999, the Fed raised its Fed Funds target by 25 basis points (bp), from 5.25% to 5.50%. The effective Fed Funds rate followed immediately, rising by 22 bp.
What the Fed was saying to the economy was, "If you want more monetary base, you will have to be willing to (effectively) borrow it from us at a higher interest rate."
At the time, excess reserves were $1.3 billion, which was only enough to fund NGDP growth for about 9 days. So, the financial markets gave in immediately, and paid the higher Fed Funds rate. Interest rates on 90-day T-bills rose by 21 bp. However, 10-year Treasury rates actually fell by 8 bp, showing that the Fed did not really "control interest rates," even back then.
Raising the Fed Funds rate is supposed to "tighten money," which, if this term were to have any meaning at all, would have to equate to increasing the real value of the dollar. Here, the picture was mixed. Gold and silver prices fell, but the CRB Index*** rose slightly.
By the end of 1Q2000, the Fed had boosted its Fed Funds target by a total of 75 bp, to 6.00%. Meanwhile, the effective Fed Funds rate was up by 65 bp, and the 90-day T-Bill rate had risen by 84 bp. The 10-year Treasury seemed less impressed; rates on those had climbed by only 15 bp.
Again, the indicators regarding the real value of the dollar during this period were mixed. Gold and silver prices fell by 6.72% and 3.65% respectively, although the CRB Index was up by 6.38%.
The Fed was Keynesian even back then, and Keynesians believe that you have to fight inflation with slower growth. If so, the mission was accomplished. NGDP growth in 1Q2000 was cut by more than half, to 4.23%. Measured inflation actually rose slightly, but Keynesians tend not to notice such things.
The Fed's experiment with a 100% discretionary monetary policy implemented via a Fed Funds target did not end well. The Fed eventually managed to improvise its way into a recession, followed by a housing boom, followed by a housing bust, followed by the worst economic and financial collapse since the Great Depression.
This brings us to today, and to the question of whether the Fed will raise interest rates in September.
Although the FOMC does not seem to realize it, changes in Fed policy and operating procedures have eliminated whatever usefulness the Fed Funds rate might have once had as a monetary policy tool.
The Fed has maintained its "0.00% to 0.25%" Fed Funds target for 80 months now. Even though the Fed has paid "Interest on Reserves" (IOR) at a rate of 25 bp the entire time (thus effectively bidding for Fed Funds itself), the effective Fed Funds rate has wandered between 7 bp and 22 bp (with an average of 13 bp). Meanwhile, the rate on 90-day T-bills has varied between 1 bp and 30 bp (and has averaged 8 bp).
More significantly for people that believe that the Fed can control interest rates, the 10-year Treasury rate has ranged between 1.53% and 3.85% during this period.
Meanwhile-and this has been crippling to long-term investment and to economic growth-the real value of the dollar has fluctuated wildly during the past 80 months, with month-end gold prices ranging between $882.05/oz and $1,813.50/oz. The oscillations of silver prices ($11.40/oz to $47.91/oz) and the CRB Index (202.57 to 370.56) have also been dramatic.
Try to imagine the economic chaos that would ensue if, on a moment-by-moment basis, the foot were to fluctuate randomly between 5.6 inches and 15.7 inches. If you do, you will have some idea of the enormous cost of the Fed's 100% discretionary, rules-free monetary policy. It's actually amazing that we have been able to eek out 1.71% RGDP growth since 4Q2008 in the face of this monetary regime.
Now, let's suppose that, despite the utter failure of its discretionary Fed Funds targeting regime over the past 15 years, the FOMC decides to raise its Fed Funds target in September.
If the Fed were to try to implement their new policy the way that they implemented previous Fed Funds rate increases (announce the new target, and then refuse to supply additional reserves until the actual Fed Funds rate moves up to the target), nothing would happen. This is because there are currently $2.5 trillion of excess reserves in the banking system. This is approximately a 25-year supply of monetary base. In other words, it could be 25 years before the Fed Funds market would be forced to respond to the Fed's new policy.
Of course, the Fed could always sell assets, and thereby remove the excess reserves from the banking system. This (along with eliminating IOR) would "normalize" monetary policy (i.e., return the system to the configuration that it had before the financial crisis).
However, although this would be the most straightforward approach, the FOMC does not seem to be considering this course. For one thing, portfolio losses driven by rising interest rates could easily render the Fed technically (although not functionally) insolvent, and that would be embarrassing.
Instead, the Fed appears to be planning to raise the Fed Funds rate by raising the IOR rate. In essence, the Fed would raise the interest rate at which it lends to itself.
Raising the IOR rate would probably raise the effective Fed Funds rate by the same amount. However, rates on 90-day T-bills have been consistently below the effective Fed Funds rate, suggesting that the marginal source of debt capital to the economy is not the banking system. Accordingly, it is not clear that pushing up the Fed Funds rate via IOR would have any impact on the interest rates that matter to economic decision-making.
Given the experience of the past 15 years, it is bewildering that the FOMC is focusing on interest rates. And, it is frightening that the Fed seems to believe that its next move should be to attempt to "tighten" monetary policy.
On August 7, the CRB Index closed at 198.32. Looking at month-end values, this is below the trough reached during the financial crisis (211.57 in February 2009), and it is the lowest number seen since February 2002.
It is dangerous-and crazy-for the Fed to be considering "tightening" monetary policy while commodity prices are falling. This is a good way to cause a depression.
Republican presidential candidates should demand that the Fed stop manipulating interest rates, and call for the Fed to stabilize commodity prices (and thereby the real value of the dollar). Over the past 10 years, the monthly CRB Index has averaged 302.01. Accordingly, the nice, round number of 300.00 would make a good target for a Fed commodity price rule.
Jeb Bush is right: America needs 4% economic growth. Nothing will do more for jobs and wages than fast RGDP growth. However, if pro-growth Republican presidential candidates want to be taken seriously by the voters, they will have to show that they understand America's #1 economic problem: our unstable, unreliable dollar.
*Federal Open Market Committee, which is the body that determines the Federal Reserve's monetary policy
**FTE (full-time-equivalent) jobs = full-time jobs + 0.5 part-time jobs
***The CRB Index is a commodity price index comprising: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gasoline, and Wheat.
