The Fed’s Road to Perdition

This commentary was written yesterday by Dr. Daniel Thornton of D.L. Thornton Economics. Thornton spent over three decades at the St. Louis Fed as vice president and economic advisor.

In response to a previous essay (here) a good friend and retired Fed economist, Bob Hetzel, commented:

I agree that the Fed does not control interest rates. The market determines the real interest rate, except at the short end where the Fed is dominant. The real interest rate is part of the working of the price system, which the Fed must respect. If the Fed does not have procedures by which it tracks the natural rate of interest (the natural real yield curve), it becomes a source of monetary instability.

I agree completely. The interest rate is a price. It’s the price one pays to borrow (the price of credit). Like any price, interest rates are best determined by the market. As the name implies, the natural rate of interest is a market-determined rate. As Bob suggests, if the Fed’s setting of its federal funds rate target veers too far from the natural rate for too long, the Fed becomes a source of monetary and market instability. The Fed itself becomes a source of monetary and market instability. Consequently, the effectiveness of the Fed’s stabilization policy depends on how well the Fed can track the natural rate.

We begin by noting that the natural rate of interest is a “real” interest rate. It is the nominal interest rate (the rate you actually pay) less the expected rate of inflation over the period of the loan or security. There are two definitions of the natural rate. The first and original one is due to the classical economist, Knut Wicksell. In 1898, Wicksell suggested “there is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor lower them.” The natural rate of interest Wicksell was referring to was a lending rate where prices neither increased or decreased, i.e., where the inflation rate is zero. Wicksell was a classical economist and classical economists’ theory of interest was a theory of the rate of return on real capital. The equilibrium rate of interest is equal to the real rate of return on capital—plant and equipment. Consequently, Wicksell’s natural rate was likely the interest rate on long-term loans to businesses for the purchase of capital, not a short-term rate.

There are several other definitions but they are all variants of the one used by John C. Williams, President of the Federal Reserve Bank of New York: “the real fed funds rate consistent with real GDP equaling its potential level [potential GDP] in the absence of transitory shocks to [aggregate] demand. Potential GDP, in turn, is defined to be the level of output consistent with stable price inflation, absent transitory shocks to supply.” Basically, it is the real rate of interest when the economy is at “full employment” and the inflation rate is “stable.”

The Fed refers to this natural rate as r-star. The Federal Open Market Committee (FOMC) uses an estimate of r-star to guide its monetary policy decisions. While economists always cite Wicksell’s definition when talking about the natural rate of interest, e.g., John C. Williams, the definition used by the FOMC bears little resemblance to Wicksell’s. In particular, the federal funds rate is not the lending rate Wicksell had in mind. Indeed, only banks and a few other institutions that are permitted to hold deposits in Federal Reserve Banks can participate in the federal funds market. Moreover, as I pointed out in The Unnatural Natural Rate of Interest, since the late 1980s the federal funds rate has been determined by the FOMC—it is not a market-determined rate.

Back to the fundamental question: How well can the FOMC track the natural rate? No matter which definition is used, you have a tiger-by-the-tail when you try to track (estimate) it. The real rate is defined as the nominal interest rate minus the expected rate of inflation over the maturity (or expected holding period) of the security. It is essentially impossible to know the expected rate of inflation.

Indeed, it’s difficult to know the actual rate of inflation. Is it the inflation rate determined by consumer price index (CPI), the implicit price deflator, the personal consumption expenditure index (PCE) or the PCE without food and energy—the FOMC’s favorite index?

Then there’s the problem that like stock prices, exchange rates, interest rates, recessions and a variety of other economic variables, inflation is essentially impossible to predict. If the actual rate of inflation cannot be predicted with any reasonable degree of accuracy, how can you possibly estimate the rate of inflation market participants expect?

If you use the FOMC definition of the natural rate, you must also estimate “potential output.” As I pointed out in The Myth of Potential Output, potential output is a concept that has no real-world counterpart. For any practical purpose, it doesn’t exist. The Congressional Budget Office’s (CBO’s) estimate, the one most commonly used, is essentially the trend of real output over the available historical data. This is similar to the way John Williams and his colleague estimate it. It is not surprising that the CBO has reduced its estimate of potential output nearly every year since 2007 as output remained consistently below the 2007 estimate of potential output (see Figure 1, in The Myth of Potential Output). For any or all of these reasons, it is extremely doubtful that the FOMC can track the natural rate of interest with the degree of accuracy required to make it a useful method for implementing monetary policy.

In any event, it was a huge mistake for the Greenspan Fed to start using the federal funds rate as its policy instrument in the late 1980s. Doing so has caused the FOMC to keep the federal funds rate too far from market-determined rates for too long. Contrary to the FOMC’s intention, its interest rate policy has been destabilizing.

That this decision was ill-advised can be seen in the figure below, which shows the FOMC’s use of the federal funds rate as its policy instrument has distorted interest rates along the Treasury yield curve. The figure shows the spread between the 10-year and 1-year Treasury rates and the spread between the 1-year Treasury rate and the federal funds rate over the period from July 1954 to January 2020. The vertical line denotes May 1988, the date my research (Greenspan’s Conundrum) indicates the FOMC began using the funds rate as its policy instrument.

The spread between the 10-year and 1-year rates tends to widen when the federal funds rate declines over the entire sample period. However, the spread is much larger since May 1988, and nearly always positive. Moreover, the spread between the 1-year Treasury rate and the federal funds rate is smaller. This is very evident when the FOMC reduced the target aggressively and kept it low for a long time, which it did three times since May 1988; the funds rate target was progressively lower and stayed low longer.

Prices determine the allocation of resources. Hence, they should be determined by the market and not by some government agency. There is a wealth of evidence—theoretical and empirical—showing that administered prices lead to a misallocation of resources. The FOMC’s decision to use the federal funds rate as its policy instrument has distorted the interest rates and, hence, distorted the allocation of economic resources.

But don’t take my word for it. Donald Kohn, former Vice Chairman of the Board of Governors, made this prophetic statement at the March 16, 2004, FOMC meeting when the funds rate target was at the then historically low level of 1%:

Policy accommodation—and the expectation that it will persist—is distorting asset prices. Most of this distortion is deliberate and a desirable effect of the stance of policy. We have attempted to lower interest rates below long-term equilibrium rates and to boost asset prices in order to stimulate demand. But as members of the Committee have been pointing out, it’s hard to escape the suspicion that at least around the margin some prices and price relationships have gone beyond an economically justified response to easy policy. House prices fall into this category….If major distortions do exist, two types of costs might be incurred. One is from a misallocation of resources encouraging the building of houses, autos, and capital equipment that won’t prove economically justified under more-normal circumstances. Another is from the possibility of discontinuities in economic activity down the road when the adjustment to more-sustainable asset values occurs.[i]

There is little doubt that the Fed’s low interest rate policy during this period contributed to the massive rise in home prices and to the eventual bursting of the home-price bubble which produced the financial crisis and what some call the “Great Recession.” Interfering with market-determined interest rates is the road to perdition. This is why I have suggested Congress require the FOMC to adopt what I call Reality-Based Monetary Policy.