The Fed Did Indeed Loosen Monetary Policy Wednesday
There’s actually an article out there in Barron’s that claims that the Fed did not loosen monetary policy with this latest rate cut. This view actually merits a little more discussion.
The financial world is full of commentators who share their take on things. Keeping people abreast of what is going on in the financial world is not just a matter of reporting the facts like a news reporter would, even though regular news is a lot more colored than it may appear.
It is important to provide perspective with financial articles, although the level of perspective in most financial articles is pretty shallow or non-existent. This is our main goal here actually, as you can read about the facts anywhere but we want to interpret them for our readers and we always look to do our best with this with every article.
Matthew Klien of Barron’s has just penned an article arguing that these rate cuts are not serving to expand monetary policy, which on the face of things sounds pretty crazy. An article like this can serve to expose what the real issues that people may have may be, in addition to giving us an opportunity to provide further clarity on these issues.
We know with certainty that rate cuts are expansionary, and this is not dependent upon any observation, it is within the nature of the cuts themselves. We do need to understand what expansion means here and what this expands before we consider whether something does serve to be expansionary or not.
This is actually a pretty easy concept to understand, even though not a lot of people may know much about how monetary policy works. What rate cuts do is to have the Fed lend money to banks more cheaply, which ultimately means that they will borrow more, which expands the credit market.
As it turns out, this is the goal and it is what is being expanded, and while we call it expansionary, even though money supply is the actual target here. By expanding credit, you expand the money supply, and as you do this, this expansion becomes expressed.
It won’t even do any good to argue that, if the money supply contracts after a rate cut, that the rate cut wasn’t expansionary, because it does expand credit and that’s the expansion that it serves to accomplish, nothing more and nothing less. Of course, this normally flows through to the money supply, as credit is what primarily defines it, but it’s possible that it might contract anyway, from a lot of defaults contracting the credit market and the money supply like we saw in 2008 for example.
If not for these cuts, in this instance, the money supply would contract even more, and therefore the expansion that the cuts provide will always produce a positive effect upon money supply and therefore the economy as a whole, regardless of whatever else may be going on.
We don’t have any real barriers to the flow through of an expansion of credit to the economy, but regardless, we can never claim that a rate cut isn’t expansionary unless we are very confused about how these things work.
Rate Cuts Also Always “Loosen”
The word Klien uses is “loosened,” which presumably means expand, although loosened seems to refer to the direction of the policy, versus the neutral of doing nothing or the tightening we would describe a rate hike as causing.
The tightening part is easy to understand, as if rates are increased, this tightens credit and there will be less borrowing as a result. Rate cuts loosen credit and increase it. This is all pretty simple.
Klien shows his hand though when he remarks that “what matters is not the level of interest rates, but the level of rates relative to economic and financial conditions.” We now know that what he really means is not that cuts don’t loosen, but they may not loosen things up enough. That’s a valid concern, and the biggest thing that the Fed looks at when making policy changes is whether they are doing enough or even too much of something, on both the loosening and tightening side.
This actually brings us to the crux of all the debate that has going on about what the Fed is doing and not doing, because this raises the question of how much they should be doing, in this case how much loosening, which takes us to why many think that they should be doing more.
He points out that this is not a matter of just looking at how high or low rates may be, and says that “sometimes short-term interest rates of 2% are too high to keep spending and borrowing on stable trajectories, just as there can be circumstances when rates of 5% are too low.”
This is true without question actually, and this is exactly what the Fed does when it considers its policies, as there of course has to be a reference point, and economic data is the only thing that could serve as one. Perhaps some of his readers think that interest rate targets are fixed to some sort of reference point apart from economic conditions, so this remark may not have been wasted.
He points out that the Fed’s targets haven’t changed and therefore the cuts are neither dovish nor hawkish, even though rate cuts by definition are dovish, as a matter of pure semantics if nothing else. They do expand credit and we call that dovish as well.
While we may disagree with these targets, we cannot say that retaining the targets but pursuing a more dovish path to achieve them isn’t being dovish. Maybe we can redefine dovish as requiring both, dovish cuts and a dovish expansion of economic targets, but this is not currently within the definition.
One of the primary goals of monetary policy is to seek out an appropriate level of dovishness and hawkishness such that we can attempt to stabilize the economy. If we are too dovish, this will cause too much expansion relative to our targets, and we will need to counter this by being hawkish to remedy the problem. There’s enough cutting and raising that goes on anyway and the ultimate goal is to do as little of this as possible while guiding the economy toward our goals.
We Can Be Loose, But We Do Not Want to be Too Loose
While there is a trade-off here between growth and inflation, the overriding focus with monetary policy is actually on inflation, which is why the Fed errs on that side more. We only need to look back to 2018 when the hawks were in the air all year and only were beckoned back into their cage a few weeks ago actually, when we went from rates that arguably were set too aggressively to our now pulling back a half of point in total.
We just don’t get to pick the amount of inflation we would like to see, even though people want to, and this is actually at the heart of all this discussion. Most people have no trouble understanding why we would want to increase growth, but struggle much more grasping why controlling inflation in a tight range is also important and at least as important.
Why this wouldn’t be a good path or be sufficiently loose isn’t really discussed very much in his article, but Klein makes mention of yield curves, which he at least apparently finds issue with. Yield curves have nothing to do with any of this though and this is merely the market pricing assets as it wishes. Yield curves may react to the Fed, but the Fed isn’t concerned with such things, although they very much are concerned with economic fundamentals.
Yield curves are basically just a result of bets on securities, and while these bets are often made on the short-term direction of bonds, and their predictions are a lot more short-term than most realize, the Fed isn’t going to just give themselves over to these predictions over their own ones.
If you think that keeping yields up is one of the major goals of monetary policy or even a goal at all, then you might think that this half-point rate cut is not very loose, even though rate cuts actually put yields down not up.
The main gripe here presumably is that with yields so low and especially with gaps so tight between periods, this means a diagnosis of ill health for the economy which should therefore be met with more looseness. That at least is closer to being on point, but this just means that the bond market expects low levels of inflation, and once again, the Fed isn’t going to take these predictions at face value and act without careful consideration of their own.
When people are looking at yields and yield spreads and not liking what they are seeing, perhaps thinking that the economy will be slowing down too much as a result of these predictions, the decision as to what slowing down means and what is too much is decided independently of securities prices and on actual economic analysis and reasoning.
Another issue that gets exposed more here is the fact that some people just don’t seem to like 2% inflation and don’t understand that this is a very nice number indeed, and perhaps even the ideal. You want inflation to be as low as possible without getting so close to zero as to expose us to too much risk of it going negative, and 2 actually seems like a perfect number.
In terms of growth, in isolation, it’s better to grow more than less, but there is the other side of the coin to consider, which is that when you increase growth, you increase inflation. 3% growth may therefore be too much growth, and we’d love to see President Trump taken to the blackboard after school to write lines and we’d have him write “we don’t want too much growth” 100 times or so in case this might sink in.
On the other hand, he may not care about jacking up inflation too much anyway, if what happens plays better to his audience, the one that will decide his fate soon. In a democracy, the people being fooled in a way beneficial to you is a real plus if you are a politician.
Thankfully, we do have the Open Market Committee who get to decide on monetary policy based upon economic merits, and if the people don’t understand, or even the President doesn’t, no matter, because they don’t get to decide.
This recent looseness by the Fed is actually looser than many expected, but many people are like dogs in the way that you can feed them but they still want to eat more, and will eat until they become sick if allowed the opportunity. The Fed is more like a cat, who will eat small meals and only when needed. The cats are in charge, thankfully.
Editor, MarketReview.com
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