Don’t Think of Rates As ‘Going Higher’, Think of Them As ‘Getting Back to Normal’

I spent the past week in Maine, fishing for smallmouth bass and discussing policy with largemouth economists. It is an annual trip, and one where the wine flows freely and the debate is sincere and robust and perhaps best of all, very unguarded.

The open nature of the discussion is the result of the Chatham House Rule; it governs the proceedings, and ensures that “participants are free to use the information received, but neither the identity nor the affiliation of the speaker(s), nor that of any other participant, may be revealed.” I can tell you the titles of people who were there, but no one can be identified, directly or indirectly.

That frees up people to be less circumspect, more blunt and honest. They are less politically correct in a professional organizational sense, meaning they are free from simply repeating official policy line. You find out some interesting things when a media handler isn’t hovering nearby ready to cut off the conversation at the first sign of candid discussion.

The cost of entry requires that each person ship “a half case of a favorite wine.” It flows from lunch until late in the evening, so in addition to the lack of a nearby PR person, there is also that additional conversational lubricant. Hence, people tend to discuss policy matters in a way that you would never hear on television.

I would order the featured topics as follows: employment, commodity prices, wages, inflation, the Republican debate, China, housing and energy. The theme underlying all of these debates was the prospective Federal Reserve rate increase.

I often participated in or observed several well-oiled debates. Perhaps the one that would be most interesting to readers of this column involved a regional Fed president and a chief economist at a major wire house (there were multiples of each of these, so I am not outing anyone). Let’s call these two people Rosalie and Charlene.

In this debate, Rosalie made the case that the economy, although improving, is still weak. Wage gains are disappointing, the housing market is still below par and underemployment has become a feature of the system. That was before we looked abroad, where China’s stock bubble is popping and the economy is slowing and is perhaps already below a 7 percent growth rate. “We have not yet achieved escape velocity,” she said. “Now is not the time to raise rates.”

Charlene’s response was simple: I don’t know what “escape velocity means” from a policy perspective. It certainly isn’t part of the Fed’sdual mandate. Regardless, as of last month’s employment report, the U.S. has created more than 11 million jobs since the end of the Great Recession in June 2009. Inflation is contained, but we are seeing early signs that the slack in the labor market is finally being replaced by wage growth. The number of job openings is rising, companies are finding it harder to replace workers and labor mobility is improving.

Perhaps the most telling part of the discussion involved a comparison between the initial period of zero interest rate policy and today. ZIRPbecame a Fed policy amid a financial credit crisis and the worst economic slump since the 1930s. The economy was shedding 800,000 jobs a month, gross domestic product was plummeting and stock market values were cut in half. Credit had frozen and banks needed bailouts. There was genuine panic among professionals across the economic spectrum.

Today, the panic is a receding memory. Interest at zero is an emergency setting. Why do we still have a Fed policy designed for an economy that needed life-support?

At least, that’s how I remember it. As noted earlier, there was some consumption of wine (a very nice Napa Cabernet Sauvignon), and it is quite likely that my own selective perception and retention is at work here. It is even possible that I aided Charlene in her counter to Rosalie. But in the sober light of day the part of the debate that stays with me is the question of continued need for a policy intended for an economic emergency.

So don’t think of it as rates going higher; think of it as moving to normal.




Originally published as Fed on Verge of Getting Back to Normal



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  1. scone commented on Aug 10

    Catch anything?

  2. rd commented on Aug 10

    The thing that has baffled me about the various “Taper Tantrum” types of events in bonds is that the Fed Funds rate increase would likely be anti-inflationary and therefore it should help keep bond yields suppressed. The worst thing for bond yields is what happened in the 70s when short-term rates did not increase soon enough (along with other factors) to keep the lid on inflation, eventually requiring Volcker to bring the hammer down and go double-digit. Showing that the Fed has the will to start small incremental increases back towards the “normal” rate which would be close to the inflation rate (1% – maybe 2%) should help keep the notion in people’s heads that the Fed really is prepared to prevent future inflation, which should keep T-bond yields low.

    One of Bernanke’s goals in 2009 was to kick-start a “wealth effect” with low rates, but that was also an emergency measure, not part of the dual mandate. It is a fine line between bringing stock and real estate prices back from the dead vs. kick-starting the resurgence of bubble economics. Ultimately, Greenspan’s legacy in trying to control asset prices at a permanently high plateau for a decade was three massive asset price crashes (, US real estate, 2008 financial crisis). ZIRP is likely setting us up for another one.

    • rd commented on Aug 10

      BTW – Ben Carlson has a good post here illustrating why it is so important that the Fed keep inflation below 6%, and preferably in the 1%-3% range (Carlson doesn’t discuss it, but even though the market returns are good in deflationary environments, the economy usually really sucks and the overall societal price is too high to allow deflation for extended period time as Bernanke correctly addressed in the post-financial crisis Fed actions).

    • KDawg commented on Aug 10

      Preventing a Volcker style recession is exactly what the Fed should be thinking about.

      A very well written comment. I’m glad to see that they still pop up from time to time here.

      I’d also say it’s not beyond reason that a quarter spent at 4% annualized inflation might make the Fed raise rates too fast for something that is merely a blip. I doubt they would even need to raise rates that much drive to the economy back into recession.

      Slow is the way to go for a lot of different scenarios.

  3. Molesworth commented on Aug 10

    With the big dogs back in town, market is moving.

  4. RW commented on Aug 10

    Normal is as normal does and when 2% economic growth has become the new 4% it would not be surprising if short-term interest rates failed to rise above either number for a rather long time; e.g., a decade or more in the case of the latter %.

  5. BenE commented on Aug 10

    It’s sad and scary that economic leaders have this bias toward higher rates being the normal.

    Throughout history negative real rates were the normal for safe savings. Before financial systems existed, almost all investments, had negative returns if you didn’t put work and energy into them. The only way you had to store value was to accumulate stuff, buildings or land. All options either had high maintenance costs, were subject to risk of damage from natural causes and theft, were very volatile or required hard labor to get production out of.

    Even in societies with good financial systems, getting risk free, hassle free, positive real returns has been difficult for most of history. This just reflects the laws of thermodynamics that tell us that things tend to decay without work and energy put into them.

    The 20th century was the most notable exception. Because of unprecedented demographic and technological growth, positive risk free returns were easy to find. A recency effect probably explains the bias of confused economists.

    Untold damage is caused by economic leaders itching to raise rates without enough justification.

    I like to make simplified agrarian economy metaphors:

    Say you had an isolated farming village where people wanted to save to be able to eat in the winter. Because there is some spoilage, crops stored for the winter are only worth 90% of the initial investment required to produce them, that is they have a real return of -10%.

    It is important that people int his village invest their profits into additional production to have something to eat in the winter, even if, the real returns on these investments are -10%.

    If instead, this village mandates its government to create a currency that always keeps 98% if its real value even when private market savings can’t retain this much, most farmers are going to work to produce enough food for the summer, trade part of the crop they don’t want to eat to diversify their diet and keep their cash profits to be able to buy something to eat in the winter. They will not produce a crop to store for the winter since it would only return -10% and their central banks promised to keep money at at least -2% real value.

    However, when comes winter, all farmers have cash but few have anything to sell because they didn’t reinvest their cash in the production of a crop to be stored!

    It’s going to be difficult for their government to control inflation in such conditions because there will be too few goods for the amount of money people will want to spend.

    If the government does manage to control inflation, it will be by depressing the nominal value of the crops of the few farmers who did invest into a crop for the winter. The central bank might do this by giving high enough interests payment on cash to prevent people from wanting to spend it immediately. In any case, people won’t eat much during the winter.

    This dire situation could all have been prevented if the central bank had kept money devaluating sufficiently (in this extreme case, inflation above 10%) and farmers would not have kept their savings as idle fiat but would have reinvested them into an extra crop for the winter and have continued to trade during the winter.

    Note that there are parallels with farmers saving for the winter and a baby boom saving in preparation for retiring and stopping to work.

    On top of slowing technological improvements and slowing working age population growth, the cause of low natural rates may well be an increased need for things that you can work for now and consume later.

    The fact that western world central banks have been too timid to even meet their already too low inflation targets has been turning people’s saving into excess fiat reserves which are not sufficiently tied to economic activity to fulfill future consumption needs. Putting people to work, and creating value even if the risk adjusted return are well into the negatives would achieve much more wealth and welfare now and in the future.

    • lucas commented on Aug 10

      Here is your premise, “Throughout history negative real rates were the normal for safe savings. Before financial systems existed, almost all investments, had negative returns if you didn’t put work and energy into them. ” And it is true that if you conceive of your savings as being buried in a hole in the ground in the biblical way, sure, you will have a negative real return because of inflation. However, people have taught forever that saving their money in a bank is a kind of investment. The bank lends the money, gets back principal and interest from the borrower, and shares some of that interest with the depositor. The rest of your post seems to be suggesting that whereas other lenders are entitled to a positive rate of return, somehow savers are not. Is that your position?

      And your farmer analogy is just too full of holes, the first one being that the main reason farmers do not have a winter crop is because most geographical areas do not have year-round growing seasons. Therefore, farmers have no real choice in the matter.

  6. Iamthe50percent commented on Aug 10

    You ignore the time value of money, especially in this age of instant gratification.

  7. VennData commented on Aug 10

    And that goodness the “Bond Market Liquidity” nonsense seems to have evaporated.

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