Message to the Fed: We’re not in Kansas Anymore

In a recent post, I argued that the Fed should raise the interest rate to return inflation to positive territory. This post is about the possible cost of that action on the nascent recovery and how that cost can be mitigated, or avoided. My views are based on the theory expounded in my academic papers and in my book, Prosperity for All, that will be available from your favorite bookseller in a couple of weeks.

I will argue that a rate rise may have negative consequences on output and employment. But those negative consequences can be mitigated in two ways. First, by raising the interest rate paid on excess reserves (IOR) at the same time as operating in the repo market to raise the Federal Funds Rate (FFR). And second, by operating in the asset markets to offset a potential market crash by standing ready to buy and sell an exchange traded fund in the stock market.

There is a lasting and stable connection in data between changes in the interest rate and changes in the unemployment rate. Past data suggest, that if the Fed were to raise the interest rate at its next meeting, unemployment would increase and output growth would slow. It is fear of that outcome that causes central bank doves to be reluctant to raise the interest rate.

But although an interest rate increase has preceded a slowdown by approximately three months in past data, there is a connection at longer horizons between inflation and the T-bill rate. That connection, sometimes called the Fisher relationship after the American economist Irving Fisher, arises from the fact that, risk-adjusted, T-bills and equities should pay the same rate of return.

The one-year real return on a T-bill is the difference between the interest rate and the expected one-year inflation rate. The one-year real return on holding the S&P 500 is the gain you can expect to make from buying the market today and selling it one year later. Economic theory suggests that the gap between those two expected returns arises from the fact that equities are riskier than T-bills, and importantly, the gap cannot be too big.

Therein lies the policy maker’s conundrum. To hit an inflation target of 2%, the T-bill rate must be 2% higher than the underlying risk adjusted real rate: policy makers call this rate r*. There is some evidence that r* is currently very low currently, possibly zero or even negative.  But if the Fed were to raise the policy rate to 2% at the next meeting, they are terrified that they might trigger a recession.  Let’s examine that argument.

The fact that a rate rise caused a slowdown in past data does not mean that a rate rise will cause a slowdown in future data. This time really is different. It is different because in 2008 the Fed expanded its policy options. Before 2008 the interest rate set by the Fed was the Federal Funds Rate (FFR). That is the overnight rate at which commercial banks can borrow or lend to each other. Before 2008, there was a large and active Fed funds market used by commercial banks to meet reserve requirements.

Commercial banks are required to hold roughly 10% of their balance sheets in the form of reserves. In the past, because reserves did not pay interest, banks kept them to a minimum. Excess reserves for much of the post-war period were essentially zero. Firms and households hold cash because they need liquid assets to facilitate trade. But cash is costly to hold because a firm must forgo investment opportunities.  In the parlance of economic theory, we say that the FFR is the opportunity cost of holding money.

After 2008, the Fed began to pay interest on reserves (IOR) at a rate slightly higher than the FFR. To a first approximation, in the new environment the FFR and the IOR are equal. That fact has a profound effect on the economic theory of the transmission mechanism of interest rate changes on the real economy. In our brave new world, the opportunity cost of holding money is zero.

Let me make a strong assumption. That $100 bills and reserves held by commercial banks at the Fed are perfect substitutes. That is not quite correct, but it is not a bad approximation. To the extent it is correct to assume that cash and reserves are perfect substitutes, an increase in the IOR and a simultaneous increase in the FFR will not change the opportunity cost of holding money. That is an important observation because one of the principal reasons that past interest rate increases caused recessions is that past interest rate increases were also increases in the opportunity cost of holding money.

In a world where the opportunity cost of holding money is zero, households and firms will continue to increase their liquidity to the point where they are satiated. Like a glutton enjoying a feast, there will come a point when holding additional cash in the form of reserves has no additional benefit. And that is exactly where we are now. U.S. corporations are sitting on huge piles of cash because the cost of holding that cash is zero. And those cash piles are reflected in reserve balance of the commercial banks that are currently holding more than $3 trillion in excess reserves.

If the Fed were to raise the FFR and leave the IOR unchanged, there would be an immediate flight from cash. Commercial banks would expand their balance sheets by buying up T-bills. To maintain its control over the FFR, the Fed would be forced to sell off assets to meet this demand and there would be an immediate and massive contraction in the money supply. Cash would once again become scarce and that scarcity would have repercussions in the goods markets as households and firms cut back on expenditure plans to maintain liquidity. The outcome would be a Fed induced recession.

But if the Fed were to raise the IOR and the FFR at the same time, the negative effects of an interest rate rise on economic activity, operating through a possible tightening of liquidity, could be mitigated. But although a simultaneous increase in IOR and FFR would be less contractionary than an increase in the FFR alone, it is likely that a rate increase would still be contractionary. There is a second channel by which an interest rate rise might trigger a recession. That second channel works through wealth effects that could potentially follow a stock market crash.

Let me be clear. I am by no means certain that an interest rate increase would trigger a market decline. In my view, the markets have a life of their own that is governed by the animal spirits of market traders. But it is wise to plan for all contingencies. And because I am concerned that a wealth effect, operating through animal spirits, may still be operative, I have recommended that the Fed be given the power to intervene in the asset markets to prevent the market crash that might otherwise follow a rate rise.  I do not want the Federal government to own private companies, and for that reason, I continue to advocate that the Fed should buy and sell non-voting shares in Exchange Traded Funds.

Let me close by repeating a mantra: two targets need two instruments. To hit a 2% inflation target and maintain ‘maximum employment’, the Fed must not only have authority to set the interest rate. It must also be given the authority to intervene in markets in some other way. An immediate recession need not follow a rate rise, providing the Fed acts to mitigate the effects of a rate rise on the real economy. My preferred central bank action is direct intervention in the asset markets, as opposed to a more traditional fiscal policy enacted by the Treasury. Financial policy is more direct and faster acting and my research on the connection between the stock market and the unemployment rate suggests that it will be more effective. Of one thing I am certain. Inaction or worse, moving the interest rate into negative territory, will not lead to higher inflation. It will lead to stagnation and another lost decade.