A decade of historically unprecedented near zero-interest rates provides a good backdrop for assessing the impact the Federal Reserve’s monetary policies have had on stimulating economic growth.
The economy has undergone significant changes over the past thirty years. Are the traditional tools the Fed uses still applicable today?
Any intelligent analysis of the current role the Fed plays in managing economic growth must begin with a review of the consequences of the easy money policy the Fed implemented over the past decade.
After the economic crisis of 2008, the Federal Reserve immediately began to ease back on the money supply by lowering interest rates. The policy called quantitative easing, continued with each passing year after the financial crisis, with rates dropping significantly from their pre-2008 levels.
The chart below tells the story.
During this period of time, the rate on CDs barely cracked the 1% level.
Investors, borrowers and consumers alike, became acclimated to the easy money policies. But did the stimulus have any perceptible impact on the economy?
The two Fed chairmen who served during the Obama Administration, Ben Bernacke and Janet Yellen, were both big boosters of monetary stimulus. They both tried to stimulate economic growth by keeping the federal funds rate at close to zero for over six years after the 2008 crisis.
How effective was this monetary stimulus? Actual economic growth from 2010-2017 averaged only 2.2%, well below the historical average of 3%.
Meanwhile, the national debt during this period doubled. The low interest rates stimulated borrowing, but that doesn’t necessarily improve economic growth.
Opening up the spigot also was detrimental to productivity. Since the recovery began productivity growth has averaged just 1.3%. That rate almost tripled during the first quarter of 2019, due to business confidence and real investment in productivity.
Low interest rates thus had no impact on this important component of economic growth.
The 10-year period of low rates was a boon for the stock market, however. Since bond yields were practically zero investors looking for real return put their money in stocks.
The low-rate environment created a 10-year bull market, one that has yet to run out of steam.
One of the unintended and unforeseen consequences of the prolonged period of quantitative easing was that investors became acclimated to the low-rate environment and the stock market has become particularly sensitive to proposed interest rate hikes by the Fed.
Currently, the economy and the stock market are thus more closely linked than at any other time in our history.
Because of skittishness over curtailing the money supply, the Federal Reserve is now in a sense hostage to the stock market. Yet a booming stock market is not a primary cause of nor the engine that drives sustained economic growth.
All this means that the Fed’s monetary stimulus policy over the last decade had negative or unintended consequences that have meant bad consequences for the economy itself.
The statutory goal of the Federal Reserve is to stimulate economic growth consistent with full employment and low inflation. That mandate has been followed by the Federal Reserve since the Great Depression.
Given the role established by Congress, historically, the two principal concerns of the Fed were taming inflation consistent with maintaining economic growth.
The Federal Reserve achieved something of a cult status that arose out of the need to halt roaring inflation that plagued the economy during the 1960s and 1970s.
Because of the need to find a solution to the runaway inflation politicians were happy to cede power to the central bankers, who were revered as potential saviors of the economy.
During this period, markets deferred to the wisdom of the Fed chairman, in the hopes of killing the ghastly inflation rate, which kept the stock market from advancing. Interest rates at times hit 13%.
Since those days, both the influence of the Fed on the economy and the god-like status it acquired as the tamer of inflation have waned. Runaway inflation no longer imperils the economy.
The effectiveness of the Fed’s policies when matched against actual economic growth have diminished. From an historical perspective, it is interesting to note that shortly after Alan Greenspan’s 17-year tenure at the Fed ended in early 2006 the foundations of monetary policy he had helped build began to slowly collapse, ending in the housing bubble that led to the 2008 recession.
The Federal Reserve’s own decade-long monetary stimulus policies have now severely limited the tools at its disposal. Following in tandem with rates worldwide, the yield on the five-year Treasury bond remains historically low at 1.8%.
In short, the Federal Reserve has limited room to continue adjusting interest rates downwards, should economic conditions warrant such reductions.
Perhaps the biggest factor in the reduced effectiveness of the Fed’s monetary policy is that fear of an inflationary spiral is no longer the bogeyman it has been in the past.
End of the banks
One of the sacred cows of Federal Reserve economic forecasting is the idea, accepted for decades as sacrosanct, that low unemployment and inflation occur in tandem.
Yet the current unemployment rate continues to remain at historically low levels while inflation remains muted. The inflation rate has consistently stayed below the Fed’s target rate of 2%.
This is the perplexing situation now facing Fed Chairman Jerome Powell. The unemployment rate keeps falling without causing an upward tick in inflation, confounding traditional economic theory.
For example, the Fed has adjusted its target federal funds rate since 2015, bringing it up to between 2.25% and 2.5% in December. There are no indications, however that the economy has suffered from the increase.
If so, what is the Fed’s argument for cutting rates now? There is a disconnect between the Fed’s traditional monetary policies and growth in today’s economy.
Perhaps this is what led the Bank for International Settlements (BIS) to assert in its annual report that, “monetary policy can no longer be the main engine of economic growth, and other policy drivers need to kick in to ensure the global economy achieves sustainable momentum.”
The BIS is correct. Central banks have no arrows left in their quiver to influence economic growth. They have driven interest rates down so low that the principal source from which they derived their power has now dissipated.
The economy might grow or shrink, and there’s nothing the world’s central banks can do about it.