A Funny Thing Is Happening On The Way To Rate Normalization
In the old vaudeville days of theatre, the comedian would often start his sketch with the familiar phrase, “a funny thing happen on the way to the theatre”. Adapting that line to the Federal Reserve’s policy stance, a funny thing is happening as short-term interest rates head back to the so-called normal range.
I have written in previous blogs about the deflationary forces that prevent the monetary authorities from reaching their inflation target of 2%[1] [2]. So, the first“funny thing that happened “ is that rate of inflation, not only did not pick up but actually decelerated in the past year. The low level of inflation, once considered to be transitory, seems to have a much greater hold on the economy.
The second “funny thing” is economic growth projections declined as rate increases were introduced. Growth and inflation are correlated. Inflation can be a by-product of rapid growth, just as deflation can be a by-product of a growth slowdown.
The Fed has had to recalibrate its growth projections yearly. In 2010, the Fed projected that economic growth in the longer run (no specific time period was set) would return to 2.6%. Ever since that year, successive projections have consistently declined to the point where the rate projected in the most recent meeting this December was set at 1.85 %. The central bank does not foresee a permanent boost to growth either from monetary or fiscal policy changes.
As the Fed funds rate moves towards “normalization”, the growth projections are ratcheted down. The Fed’s dot plan anticipates that rates will continue to move up steadily into 2019. The members, as a whole, expect to raise rates another 4 times in 2018. The consensus is that implied Fed funds rate in 2018will be 2.50%, moving up to 3.0% in 2019. Yet, all the while, their growth forecasts move in exactly the opposite direction. Interest rates move up and economic growth rates are scaled back. It is as if growth has no influence on setting monetary policy.
[1] The Digital World Challenges Central Bankers
[2] More On Why Central Bankers Find It So Hard To Reach Their Inflation Targets
Disclosure: None.
The whole question of a slow down in growth is related to the supply side of the economy. Namely, the labour force is slowing, participation rates are very low, productivity growth is weak and capital formation is low. The last item should be higher given the cost of capital, but the additional supply from added capital stock is not needed. Again, it is a matter of excess supply of labour and capital. The Fed never acknowledged this because monetary policy does not work on the supply side.
I think there are two problems with why there seems to be a lack of correlation between the two these days. 1. The way inflation is calculated purposefully and incorrectly under weighs inflation in housing costs and arguably other sectors. Housing costs and medical costs along with education costs are sucking up all the people's money leaving little room and smaller houses to buy and consume anything else keeping inflation and demand low much like Japan. 2. Dropping rates so low undermines growth and capitalism and rate increases back up have may have a larger drag the economy than regular, thus more strongly working against inflation. This encourages the status quo and is why it is so hard to escape zirpish rates and QE and normalize the economy.
Japan is the best example of the black hole of zirpish rates and QE. It is amazing that the US allowed the Federal Reserve to copy this failed experiment at all.