by Bluford Putnam, Chief Economist of the CME Group
Is US monetary policy actually holding the economy back? Has the time come to remove the distortions of Federal Reserve (Fed) policy and give the robust and agile US economy a chance to grow faster, even in the face global headwinds?
Many analysts, pundits, and policy-makers for years now seemed locked into a mindset that the economy needs help from monetary policy. But perhaps now the window is open for taking a new course – as the Fed minutes released just last week from their June meeting show officials were divided on a rate hike.
From the UK-European divorce known as Brexit, to the US and French Presidential elections coming in the fall and spring, the politics of rising nationalism and anti-trade pacts are creating considerable economic uncertainties. Indeed, CME federal funds futures now reflect the probability of no rate increase by the Federal Reserve (Fed) for the rest of 2016 or even in 2017. So, the analysis goes, the Fed has no choice but to hold rates near zero and maintain its massive holdings of US Treasuries and mortgage-backed securities.
We beg to differ. The problems affecting the US economy are in no small part due to the debilitating distortions of unconventional monetary policy. Or, as the aphorism goes, if you want to get out of a hole, stop digging.
First, near-zero short-term rates, held artificially below the trend rate of core inflation, penalize savers, especially retirees. The over-65 demographic cohort is expanding as a percent of the US national population. In the past, retirees have typically held their wealth in lower-risk portfolios, usually involving more exposure to interest rates and less to risky assets. The persistence of the near-zero rate policy by the Fed has decimated this strategy, forcing retirees (and their children who may have to support them) to save more (consume less). This has become a very serious drag on the US economy.
Second, pension funds have had their liabilities artificially increased by the low rate policy and have been forced into a search-for-yield mentality. Near-zero rate policies and massive purchases by the Fed of US Treasuries and government-backed mortgage securities (aka QE or quantitative easing) have depressed yields so that they no longer reflect the underlying risks. This has forced pension funds to take much more risk than is prudent, raising the probabilities of future systematic risk coming from pension funds this time – not banks.
Third, the large holdings of US Treasuries by the Fed have been part of the reason why liquidity in the physical market for US Treasuries has diminished. The liquidity of benchmark fixed-income markets is critical for the functioning of the whole credit creation system, and this distortion has large costs in terms of the potential misallocation or credit.
Finally, we note that monetary policy is not conducted in a vacuum, and the financial regulatory system has been changed with regulation much more centered on imposing tight capital requirements. This means that credit growth is not going to be accelerated by unconventional monetary policy. Neither near zero interest rates nor massive asset purchases can make a meaningful difference because financial institutions are already at their capital limits. Indeed, capital efficiencies have become the mantra in the financial sector, which underscores the unintended consequence of tighter capital requirements – namely, rendering unconventional monetary policy impotent.
The costs of these distortions are hard to measure, but that does not mean we ignore them. It has become fashionable to argue that if you cannot measure it, you cannot manage it. And economists are notorious for assuming away the problem in their models if they cannot publish a statistical paper about it. Yet, perhaps the most important economic risks to manage are those that are hard to measure and can bite you at unexpected times. The serious distortions to the US economy emanating from unconventional monetary policy fall into that category. Take the distortions away, and the US economy will be healthier and grow fast. We are talking only of allowing the US federal funds rate to rise a little above the prevailing rate of inflation, restoring some interest for savers, reducing slightly pension liabilities, and removing the need for a risky search for yield by investors. We have the most robust economy in the world – now is the time to put our trust in the resiliency of the system and not in unconventional medicines with debilitating side-effects.
Bluford (Blu) Putnam is Managing Director and Chief Economist of the CME Group