Powell Moves Markets

Federal Reserve Board Chairman, Jerome Powell, who has been remarkably quiet as he adjusts to his new role at the Fed, finally roiled markets last week. He made comments on Wednesday, during the Atlantic Festival at a session moderated by Judy Woodruff of the PBS News Hour.

Powell said, "The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don't need those anymore."

He added, "(I)nterest rates are still accommodative, but we're gradually moving to a place where they will be neutral. We may go past neutral, but we're a long way from neutral at this point." [Our emphasis added.]

The reaction of the markets was swift and dramatic. The 10-year Treasury note rose from 3.06% on Tuesday to 3.23% on Friday, its highest yield since 2011. From their intraday highs on Wednesday to Friday's close, the Dow Jones Industrial Average fell 1.8%, the S&P 500 fell 1.8%, and the NASDAQ Composite fell 3.3%.

To begin with, we agree completely with Mr. Powell. There are a number of models that purport to measure a "neutral" interest rate – a federal funds rate which does not hurt growth, but also does not lift inflation. Rates above neutral hurt the economy, rates below neutral lift inflation.

One model is the "Taylor Rule," which is based on setting separate targets for real GDP growth and inflation and then adjusting short-term interest rates when these data deviate from the targets. For example, if inflation and economic growth are above the target, then the "neutral" rate should move higher. If the economy or inflation fall, then so should the neutral rate. There are multiple versions of the Taylor Rule and right now these versions suggest a neutral federal funds rate somewhere between 3% and 5%.

While we very much like a rule-based monetary policy, and think the Taylor Rule is a fine rule, we try to simplify things even more. We think the growth rate of nominal GDP (real growth plus inflation) is the best target. Nominal GDP (or total spending in the economy) is a measure of the average growth rate of all business plus government. When interest rates are below this average growth rate there's an incentive for business to borrow even for projects that return less than average. This can cause distortions in the market. When rates are above this average, it can shut down activity.