Central Bankers Wandering in the Woods

"Systematic monetary policy means a framework where tools such as the level of the Fed funds rate and the size of the Federal Reserve’s balance sheet maintain a reasonably stable and predictable relationship with observable economic data such as output, inflation, employment, and the ‘gap’ between real gross domestic product and its estimated full-employment potential. Departures from systematic monetary policy distort behavior in ways that cause misalignments between financial quantities and real economic quantities, and as a result, they invariably produce damage as the two are ultimately realigned.

Systematic policy recognizes that the ‘Phillips Curve’ is an observation about the relationship between unemployment and real wages, not a ‘tradeoff’ that can be manipulated. It recognizes that suppressing interest rates and drowning banks in liquidity has weak and unreliable effects on real economic activity and employment, but massive effects on financial speculation and resulting instability. Systematic policy is content to align monetary aggregates with output aggregates. Systematic policy is content to set interest rate targets based on reasonable policy benchmarks informed by observable economic variables. Systematic policy is content to achieve those targets by modestly changing the ratio of base money to GDP, "John P. Hussman, Ph.D., Fabricated Fairly Tales and Section 2A, April 24, 2023.

In recent quarters, the Fed has shown admirable resolve in responding to inflationary pressures. On the interest rate front, the Federal funds rate is now close to systematic benchmarks that have historically been consistent with prevailing core inflation, nominal GDP growth, and unemployment. Though we estimate that core inflation may remain in the 3-4% range longer than investors seem to expect, an easing of inflation, nominal growth and labor tightness would make it reasonable to ease interest rates as well. Unfortunately, a couple of percent in above-target inflation is probably not the central problem the Fed will face in the next few years.

While the Fed has suspended the “zero interest” part of its experimental policies, it has been extraordinarily slow to reduce its balance sheet to a size that would allow it to manage interest rates without hundreds of billions of dollars of annual public expense. The Fed has done only half its job, and seems insistent on maintaining a ruinously bloated balance sheet. The real problem is that a decade of experimental distortion encouraged unprecedented speculation in every conventional asset class, not to mention fringe speculation in assets detached from any standard of value, including meme stocks, pictures of bored monkeys, and digital Pokémon posing as “currency.” As with every similar episode across history, the unwinding of this bubble in the form of financial crisis is already quietly baked in the cake.

In defending the deranged and experimental notion of an “ample reserves regime,” the Fed is defending continued misalignment between monetary aggregates and economic output. It is defending exactly the element of monetary policy that contributed to a decade of yield-seeking financial speculation, forced $8 trillion of uninsured deposits into the banking system, encouraged the passive acceptance of enormous government deficits, leaves in place the fuel for future episodes of inflation, and has already produced trillions of dollars of losses both in commercial banks and in the Fed itself – invisible because the assets are not marked to market. Even as the Fed battles the flames of a fire-breathing dragon, it insists on keeping that dragon as a house pet.

Apropos of September’s summit of central bankers at Jackson Hole, it may be useful to discuss what “data dependent” means, if the phrase is to mean anything at all. There are two key aspects of monetary policy that the Fed has to get right, if it wishes to serve the public and support the economy, without inadvertently setting up destructive consequences. One is to act as a lender of last resort for the banking system, subject to important constraints. The second is to align monetary quantities (mainly currency and bank reserves) with economic quantities (mainly economic output), ideally in a way that supports certain goals including employment, price stability, and moderate long-term interest rates.

In the discussion below, notice the unintentional risks, instabilities, and public costs that have been introduced by a decade of dogmatic quantitative easing and zero interest (until recently) policies. Some segments may be familiar – if I repeat certain points from time to time, it is to counter the nonstop deluge of data-free gibberish that passes for economic analysis. I’ve updated and extended some previous charts and commentary to describe how various systematic, activist, or reckless policy decisions can produce beneficial, weak, or economically damaging consequences. What follows may also build context around the current economic outlook and some of the most salient risks.