Fed Funds Fanaticism Will Keep on Failing

"Fanaticism consists of redoubling your efforts when you have forgotten your aim." -George Santayana

On December 16, 2015, the Federal Reserve doubled its target for its Fed Funds interest rate from 0.25% to 0.50%. On March 16, 2016, the Fed backpedalled from its indication that there would be four 0.25 percentage point rate hikes during 2016, and is now suggesting that there might be only two. Even so, it is interesting to note that, if carried out, this would still amount to a redoubling of the Fed Funds rate from its level of the past seven years.

With $2.5 trillion of excess reserves in the banking system, the only way that the Fed can raise the Fed Funds rate is to raise the interest rate that it pays on bank reserves (the IOR rate). Accordingly, the only thing that raising the Fed Funds rate accomplishes with absolute certainty is to transfer money from the U.S. Treasury (which receives all of the Fed's profits) to the banks.

The Fed's December 16, 2015 interest rate move doubled IOR costs, from $6.25 billion/year to $12.50 billion/year. If the Fed were to go ahead with two more 0.25 percentage point Fed Funds rate hikes, this would double IOR costs again, to $25 billion/year. Before doing this, it wouldn't hurt to take a look at the impact of the Fed's first 0.25 percentage point Fed Funds rate increase.

Napoleon famously observed that if your aim was to take Vienna, you should take Vienna. By this standard, the Fed's December 16 interest rate move was a failure. The market interest rate on 10-year Treasuries was 2.30% on December 16, 2015, and it was 1.91% on March 18, 2016.

Federal Reserve Chair Janet Yellen and the FOMC* believe in the Phillips Curve, which postulates that low unemployment causes inflation. With the "headline" (U-3) unemployment rate moving below what the Fed considers NAIRU (the Non-Accelerating Inflation Rate of Unemployment), the Fed's goal in raising the Fed Funds rate was "to head off inflation."

If heading off inflation was the goal, the markets are saying that the Fed's interest rate hike was a failure at this, too. The expected 5-year inflation rate** was 1.20% on December 16, 2016, and it was 1.59% on March 18, 2016. Also gold prices are up by 17% since the Fed's interest rate move.

Of course, expected 5-year inflation is still below the Fed's official 2% target (over the past 6 years, expected inflation has averaged 1.70%, and actual inflation has averaged 1.87%), so one has to wonder why the Fed is looking to its internal models (which have been consistently wrong), rather than to the markets for policy guidance.

This having been said, one really has to wonder why the Fed is so preoccupied with the Fed Funds interest rate. Other central banks share the Fed's interest rate obsession, to the point where some of them (including the ECB and the BOJ) have actually set negative policy interest rates, something that makes no physical or operational sense.

Central banks have been setting interest rates for so long that they have forgotten why they started doing it, and haven't noticed that the practice has become irrelevant and dysfunctional.

Under the classical gold standard, raising interest rates actually reduced the real value of the dollar, by reducing the willingness of the public to hold physical gold. Higher interest rates would reduce today's real market value of gold. This would cause people to convert gold to dollars, thus increasing the dollar money supply, thus (all things being equal) reducing the real value of the dollar.

With a fiat dollar, no IOR, and an insignificant quantity of excess bank reserves (i.e., from August 15, 1971 to October 6, 2008), raising interest rates tended (all things being equal) to increase the real value of the dollar, by slowing the rate at which the banking system created new dollar liquidity.

Today, with $2.5 trillion in excess reserves in the banking system, there is no obvious relationship between the Fed Funds interest rate and, well, anything. The Fed has created its own little world, where it has to bid for Fed Funds itself (via IOR) in order to raise the Fed Funds rate. Meanwhile, the contribution to dollar liquidity made by the banking system is being determined by a complex interaction of loan demand and regulatory constraints, with the Fed's "monetary policy" playing essentially no role.

The economy will always function best with a dollar that is stable in real value. Accordingly, it is unfortunate that the Fed has abandoned its most important responsibility in order to go off and play interest rate bingo.

This having been said, given that the Fed seems determined to set monetary policy via its Phillips Curve model, it may be fortunate that its Fed Funds-based monetary policy doesn't actually work. This is because, if the Fed is both all-powerful and determined to prevent real wages from increasing, the vast majority of American workers will never be able to get ahead.

There is a way out of the Fed's current impotence and wage suppression. The Fed must give up its monetary policy discretion, give up its desire to control interest rates, and implement a rules-based system designed to stabilize the real value of the dollar.

Under current conditions, the CRB Index*** is a "good enough" indicator of the real value of the dollar. If the Fed were to create sufficient dollar liquidity to bring the CRB Index up to 300 (it closed at 176.35 on March 18), and then just kept it near 300, investments could be made with certainty, and workers could get ahead. CPI inflation might (or might not) accelerate for a time, but inflation as such could not get out of hand, because the value of the dollar would be fixed in terms of something real.

Prosperity requires stable money, and Fed Funds fanaticism will never yield stable money. The next president needs to put monetary reform at the top of his "to do" list.

*The Federal Open Market Committee, which is the body that sets monetary policy.
**As indicated by the spread between the interest rates on 5-year Treasuries and 5-year TIPS.
***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.