Yellen’s Footnote 8 Would Put Interest Rates On Autopilot by John Mauldin
Yellen’s Jackson Hole speech was widely reported, so I’ll spare you the summary.
What wasn’t widely reported was her Footnote 8. Yellen cited approving a mathematical formula that could put interest rates on autopilot. The Fed hasn’t yet followed the rule, but its presence in Yellen’s paper suggests its use is on the table.
In his 2021 year-end letter, Baupost's Seth Klarman looked at the year in review and how COVID-19 swept through every part of our lives. He blamed much of the ills of the pandemic on those who choose not to get vaccinated while also expressing a dislike for the social division COVID-19 has caused. Q4 2021 Read More
Footnote 8 lays the groundwork for negative rates
For Yellen to adopt any fixed rule would be a major strategy shift. She has declined to use the so-called “Taylor Rule” favored by some economists, claiming the Fed should be flexible but “data-dependent.”
The rule described in Yellen’s Footnote 8 uses variables like core PCE inflation, the Fed’s inflation target, and the unemployment rate to calculate an optimal Federal Funds rate target. If the Fed had been following the rule during the last recession, they would have dropped rates to -9%.
Yes, you read that right, -9%.
As a point of reference, the ECB right now is at -0.4%. Europe is now experiencing all kinds of bizarre consequences.
Yet, here’s our own Fed chair bringing up a method that would send rates far lower.
To be fair, Yellen didn’t say she endorses this idea or wants to adopt it. She concedes it would have been impossible to drop rates that far in 2008.
So why even bring it up?
A generous interpretation: Yellen wanted to demonstrate that the Fed’s control over interest rates has limits as a tool for stimulating economic growth. And in her speech, she does go on from there to talk about other policy tools.
Still, it was no accident that she mentioned the rule for autopilot rates. This was another in a series of small nods to the idea that negative rates might be appropriate in some situations.
The Fed’s muddled assumptions
The Yellen Fed’s mental status gets clearer every day. They think that their crazed ideas—ZIRP, QE, Operation Twist, and the rest—are what brought the economy back from the brink of collapse. Last December’s one-and-done rate hike was the victory lap. They think everything is fine now and have turned their attention to preparing for the next recession.
But, this thinking is completely wrong. Yes, the economy did recover (slowly), but it did so in spite of the Fed. Not because of anything the Fed did.
The Fed’s base assumption, as I explained in “Six Ways NIRP Is Economically Negative,” is that making interest rates go down will stimulate demand for goods and services. That is true on the margin. It is not true always and everywhere.
It’s especially not true for non-bank private businesses and consumers. To them, interest rates are one of many costs… and not necessarily the most important. On the other hand, interest income is very important to this group.
The Fed is banker-driven
Bankers think differently. This matters because bankers have the most influence on Federal Reserve policy. To them, short-term interest rates are a kind of fuel cost. Liquidity is to bankers as crude oil is to refinery owners. You pump it into your refinery, process it, and out comes something your customers will buy.
Banks are lenders, but they are also borrowers. They borrow cash from depositors and bondholders. Then they loan it to borrowers at a marked-up interest rate. Cost of funds is critical to bankers.
It is not critical to most other businesses. The decision to open a new factory doesn’t usually hinge on getting a lower interest rate. It depends on whether or not customers will buy the goods that the new business produces.
But because the Fed is banker-driven, it thinks cost of capital is everything. Therefore, a lower interest rate will stimulate activity. They’re right—up to a point—but that relationship is not linear. It flattens out as you get closer to zero.
Yellen is aware of this. Her point with Footnote 8 was that interest rates aren’t always an effective stimulant. But also, she isn’t the only vote. She has to convince the other governors and regional Fed bank presidents. And they are all influenced to varying degrees by the banking industry, which loves lower rates.
Footnote 8 is a warning
Negative rates are death to commercial banks. A -9% NIRP would kill many banks.
So maybe that footnote was a warning, the Yellen equivalent of a brushback pitch to overly eager bankers. “Look what can happen if we don’t do it my way.”
I don’t think Yellen will take us down to -9% or anywhere close to it. I do think she is prepared to go below zero if she sees no better alternatives according to her personal economic religious beliefs.
I’m also confident that she and her colleagues won’t take rates much higher from here. I think we will see 0% again (and below) before we see +2%.
Sooner or later, a recession is coming. This feeble recovery is already long in the tooth. There is the real chance we will enter at least a mild recession no later than the end of 2017, brought about by a crisis and recession in Europe.
How will the Fed respond when that recession hits?
The Fed is making those plans right now. If you think 2008–2009 was a wild ride, fasten your seatbelt and prepare to take an airbag in the face. The next ride will be wilder.
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