Institutional investors must wonder why the Federal Reserve Board doesn't have control over the levers of real economic growth.
The market in some ways behaves as if it has.
Fiscal policy — high tax rates and burdensome regulation — is the cause of slow economic growth; monetary policy has little if any control over it.
The Fed has a dual legislative mandate from the Humphrey-Hawkins Full Employment and Balanced Growth Act of 1978, to maintain low inflation and full employment. The basic problem is this dual mandate is impossible for the Fed to accomplish on its own. As a result of these mandates, the Fed has been forced to push down and hold the Fed funds rate at zero to 0.25%, believing somehow that extremely low interest rates will stimulate businesses to invest more and hire more.
Yet the Federal Reserve board's interest rate policies have less control over the real economy than perceived, not to mention that reaching full employment should not even be a mandate. Unfortunately, it is.
Even though the Fed doesn't control employment growth, if the Fed were to successfully pursue these policies, it would create conditions conducive to price stability and real economic growth. But now it takes the pain of extraordinarily high interest rates or the benefit of extraordinarily low interest rates to affect economic activity.
The Fed does have control over short-term interest rates, the Monetary Base and M1 — measures of the most liquid components of the money supply, including cash — and its actions and regulations can impact the future price level and inflation rate. As a result, the primary goals of Fed policy should be the following:
• encourage the proper pricing of credit risk;
• prevent or contain panics;
• protect the purchasing power of the dollar, and;
• stabilize the exchange value of the dollar.
So how do these four goals of the Fed apply to today's economy and financial markets?
The Fed should facilitate the proper pricing of credit risk. This function isn't the support of any particular level of net interest margin or quality spread. If deposits cost 0% and loans can be made at 3%, this spread does not have the same economic impact as if deposits cost 3% and loans can be made at 6%. The difference is significant because low absolute yields that are deliberately suppressed by Fed actions subsidize the borrower at the expense of the lender. It's part of that old economic rule — if you subsidize an economic activity, you get more of it; if you tax it or heavily regulate it, you get less of it. Low absolute yields subsidize financial risk-taking and other forms of leverage for risky real investments as well as subsidize profligate federal government spending with artificially cheap credit. It further encourages too much corporate borrowing as subsidized yields encourage corporations to lever up and buy back stock.
The Fed's role in preventing panic involves both regulation, such as bank rules on equity capital and reserve margins, and reaction, such as supplying liquidity. This is not a mandate, however, to smooth out financial markets and attempt to control volatility. Preventing volatility is impossible in today's world when market-moving news is distributed simultaneously to every desktop around the world. No amount of liquidity will satisfy the desire of investors to buy or sell on the basis of such news that results in huge daily swings in markets.
With the benign level of reported inflation, this Fed goal appears to be accomplished for now. If the Fed were also able to create exchange-rate stability against major trading partners, such conditions would foster economic growth simply due to the increased certainty about the outlook that businesses desire for making long-term investment decisions. Yet exchange rate stability is difficult to achieve from unilateral Fed action.
There's another mathematical identity at work — one borrower's interest expense is someone else's interest income. Low absolute yields and negative real yields each penalize lenders and savers. If pension plans, retirees, banks, insurance companies, and money-market funds can't earn a decent return on short-term investments due to subsidized low yields, they either live with lower earnings and consumption, in the case of retirees, or take more risk to reach for yield. The result is again the artificial and ultimately unsustainable compression of quality risk spreads and the allocation of too much investment to inappropriately high-risk investments. The Fed increases the risk of the next financial crisis by pursuing policies that distort normal market function of allocating credit risk.
So a move by Janet L. Yellen, Fed chairwoman, and the voting Fed governors to begin the process of restoring the normal pricing of credit risk by raising short-term rates by 25 basis points would produce positive economic effects. Historically there is a clear-cut contemporaneous relationship between rising rates and rising economic activity, not an inverse correlation. It should take quite a few rate increases to have any negative impact on Main Street or Wall Street, even if bond markets temporarily freak out.
Monetary policy can't solve current long-term structural problems, but restoring a positive real short-term interest rate of 50 basis points would at least be a step in the right direction. The Fed's near-term increases in short-term interest rates are likely to come in the form of real interest rate increase, because inflation remains low. Higher real interest rates are “good” for economic growth and historically associated with attractive stock returns.
Today's suppression of real interest rates suppresses the incentive to make real, non-financial investments. Letting real interest rates rise would be consistent with a rise in return on investment in the real economy. The Fed has the problem backwards in suppressing rates in order to stimulate investment in the real economy. It's time to restore positive real interest rates and to end the Fed's zero interest-rate policy holding back the real economy.
Andrew W. Bischel is CEO and chief investment office of SKBA Capital Management LLC, San Francisco.
