By Joseph Y. Calhoun
Well, thank goodness that’s over. The Fed met last week and decided to maintain the Fed funds rate in the 0 – 0.25% range in which it has been confined since the great financial crisis of 2008. Of course, the fed funds market is essentially kaput having been usurped by the Fed itself during the crisis so the rate charged to borrow in this non-existent overnight lending market is basically irrelevant. That isn’t what we’ve been told though so we all pay attention and wonder what it all means like some freshman philosophy major but the truth is that whether the Fed funds rate is 0 or 0.25% or 0.50% just isn’t all that important. The attention the Fed gets is way out of proportion to its ability to influence the economy, especially in a world awash in debt. Ironically, despite concentrating on the wrong things and being generally clueless about how the economy and markets work, the Fed may have gotten things right last week.
Now before you blow a gasket wondering what the heck Joe has been smoking, let me explain. In leaving rates unchanged Yellen and the FOMC cited, to a degree I’ve never seen, global economic and financial conditions. They further said that they will be monitoring developmentsabroad in assessing future policy. In other words, they think the US economy is just fine but things outside the US are so dicey that it might negatively affect the US economy and therefore the Fed’s timetable for hiking rates. Whether that part about the US economy is correct or not is up for debate but in looking abroad for clues about how to adjust monetary policy the Fed is actually moving closer to conducting monetary policy in a rational, market oriented way.
What the Fed really said last week is that the dollar matters for monetary policy, something I expected and wrote about when Stanley Fischer was appointed Vice-Chair. Fischer at the Bank of Israel made the shekel an important part of monetary policy and I expected he would do the same at the Fed with the dollar. Which is exactly what they should be doing by the way and why I think they actually got things right last week. I’d love to see higher interest rates for my and my clients’ savings but we won’t get them just because the Fed decides to raise the Fed funds target; we’ll get them when nominal growth rises and not a minute before. It really isn’t the rate that matters anyway but rather how it affects the dollar. If a rate hike pushes the dollar higher, in a world with a mountain of dollar debt, the negative impact on the global economy would likely just push rates right back down again.
With interest rates essentially at zero the Fed’s ability to influence economic activity is limited, something that would seem pretty obvious from the path of growth since rates hit that ignominious level in late 2008. It also seems obvious, although apparently not to the Fed, that QE doesn’t have the impact on growth they thought it would. That or the economy is even worse than we thought and QE is the only thing that kept us out of a full blown depression. That can’t be proved either way but the point is that reaching zero interest rates is evidence by itself that the Fed has little control over interest rates. Presumably they haven’t been targeting interest rates since the late 80s with the goal of reaching 0% and ending their ability to influence growth. Bureaucrats aren’t generally known for doing things that reduce their power.
Based on the market movements after the Fed decision, I think the Fed’s decision was largely correct. The dollar has been trading in a pretty narrow range since the spring and while it was down a bit after the meeting, it is still in the same range. After the rapid rise of last year – ironically based on expectations the Fed would hike rates – the Fed now should concentrate on keeping it stable at this new, higher level. This new, stronger dollar has pushed down commodity prices, a positive for most of the world, and will eventually lead to a better allocation of investment capital. That may mean more pain in the short term as commodity producers adjust to lower prices, but shifting investment from punching holes in the ground to almost anything else has to be a positive development.
The drop in stocks and interest rates is probably rational as well since the transition to a better economy is probably far off even if monetary policy is on the right track for a change. If the Fed has little control over growth that leaves only fiscal and regulatory policy as potential levers to return the economy to its former growth path. Unfortunately, we’re coming into an election year and the potential for positive change in either of those areas is limited at best. The odds of tax reform or regulatory relief are slim and none until at least January of 2017 which seems a long way off to a stock market dominated by traders whose idea of long term is this afternoon. And since those global problems are unlikely to be solved any time soon, bonds also felt some relief as the chances of a hike, at least this year, fell close to zero.
The psychology of the market also appears to have changed. A dovish Fed like the one that wrote the FOMC statement and the one Yellen represented at the press conference, would have in the recent past been interpreted as an all clear signal for stocks. But after initially buying, stock players reversed course and sold en masse Friday. When stocks are in a bull trend all news is interpreted bullish but that doesn’t seem to be where we are right now. Maybe it isn’t a bear market yet but the trend is now down and the news will be interpreted within that context. Bad news is probably going to be bad news while good news will get discounted. That’s a big change but you probably ought to get used to it.
The most anticipated Fed meeting in many years – maybe ever – is behind us now. Unfortunately, what lies ahead may be even more treacherous. If the global economy falls into recession any time soon, there is little the Fed can do and little the politicians will do. Right after the crisis in 2008 I wrote about my expectation that the economic cycle would be elongated. If one thinks of the economy as a sine wave, monetary, fiscal and regulatory policy can dampen the swings, compress the amplitude of the wave. But the price of doing so is a longer wavelength, an elongation of the cycle. We’ve just experienced that in the expansion phase of the cycle and it would seem naive to think that the contraction phase will not be affected. When the next recession arrives, it may not be as deep as the last one – we probably won’t have a financial crisis – but it may well last a lot longer than anything in recent memory. And there’s probably little the world’s central bank can do about it.