The Federal Reserve has been in the news again, with Chairman Jerome Powell apparently having a road to Damascus moment. As we’ve urged in these pages for many months, it’s long past time to retire the emergency measures put in place in the depths of the corona crisis in March 2020. The Fed’s monetary extremism became a problem unto itself, and now even Powell has come around to our view that what was appropriate in the second quarter of 2020 is not appropriate for the fourth quarter of 2021.
The Fed is still operating on monetary mythology, however. It believes it must wind down quantitative easing before raising the fed funds target rate. This appears to have its roots in Ben Bernanke’s original theory of how QE works at the time he launched it. Bernanke argued that QE would work as an extension of short rate policy by lowering yields out the curve. The fed funds target would depress short term rates and the buying of longer term Treasuries would depress long term rates.
The trouble is that it just doesn’t work that way in the real world.
Empirically we just don’t see a reliable correlation between Fed buying of Treasuries and higher prices (lower rates). One might think that buying bonds by the billions might put upward pressure on their prices and downward pressure on their yields. And it may well do that, but that effect may be overwhelmed by other effects. For example if markets believe that QE will be inflationary and reduce the value of future cash flows from securities, that will put downward pressure on bond prices and upward pressure on rates. This is a powerful effect and may well help explain why in reality we don’t see bond prices rise in concert with Fed buying and bond prices fall when the Fed reduces its buying. In fact we’re not seeing that right now … since the Fed announced it would reduce its purchases, bond prices have risen and yields have fallen.
Don’t expect reality to get in the way of Fed policy though. The Fed may realize its fed funds target is way too low, but is taken with the myth that QE is only an extension of rate policy, and that QE has to be terminated before rates can rise. So the result of its newfound realization that accommodation must be reduced is that it will taper QE faster. The result will be that the opportunity to raise rates will come sooner.
But make no mistake … it is the higher rates that are most desperately needed … a faster taper just gets the Fed where it needs to go a little sooner.
How will we know my analysis is right and Powell’s is wrong? It has observable consequences. Monetary policy remains extremely accommodative, with real fed funds several points below zero. This is an economic emergency and inflation will remain a serious problem until it is finally addressed. This by the way is consistent with Synthetic Systems projections that another surge in industrial commodity prices is on the way and that relief from inflation won’t come until late next year … not incoincidentally when the Fed now expects rate hikes to be in progress.
The right policy too late, however, will not come consequence free. For having fallen so far behind the curve, the Fed will have triggered a painful recession, probably even a global financial crisis. It’s a very expensive mythology.