Fed Policy

by Jerry O’Driscoll

Fed Chairman Jerome Powell testified to the Senate Committee on Banking, Housing, and Urban Affairs. It was the semi-annual testimony mandated by the Humphrey–Hawkins Act.  Powell’s testimony was anodyne. He repeated and reiterated the Fed’s planned policy moves with respect to interest rates, and added suitable caveats on economic growth, inflation, and tariffs. Trade policy is a new factor for Fed policymakers.

The principal policy question Powell addressed was the planned increases in the target federal funds rate. That is the instrument with which the Fed tries to achieve its twin goals of maximum employment and price stability. The FOMC raised the target rate by ¼ percentage point at its March and June meetings. Though the Chairman did not say so explicitly, the FOMC is expected to raise the target rate two more times this year. His generally optimistic economic assessment has been interpreted as indicating the FOMC intends to pursue its tightening moves. The Fed is also very gradually shrinking its portfolio size.

What should economists and financial market participants make of this testimony?

Both groups are most concerned about the flattening yield curve, and the potential for it to invert. The yield curve displays market interest rates from very short-term rates to long-term rates. Financial institutions typically borrow short term (even overnight) and lend longer term. That practice requires that short-term interest rates be lower than long-term rates. In other words, the yield curve must be upward sloping. If the curve flattens, the profit from financial intermediation disappears. If the curve inverts, profits turn to losses. Credit dries up, and recession ensues. Hence, financial markets are concerned.

Powell did not mention the yield curve in his prepared testimony. When questioned by Senators, he was evasive. It is a critical issue and Fed officials need to be more forthcoming about it. The backdrop of higher tariffs, which will slow economic growth or even turn it negative, adds to the urgency for reconsidering Fed policy.

The presidents of four Reserve Banks (Atlanta, Dallas, Minneapolis, and St. Louis) have raised concerns about the pace of Fed rate hikes. Some have mentioned the yield curve.

Powell’s testimony raises other longstanding conceptual or theoretical issues. First and foremost, the FOMC continues to rely on current economic data, which is in fact lagging data, to influence policy. True, the Chairman stated that “the FOMC routinely looks at monetary rules” in deciding policy actions. If the Committee is looking at multiple rules, it is not following any one rule. No matter the gloss put on policy, it remains discretionary. All through 2006, 2007, and 2008, looking at incoming data, Fed policymakers saw no signs of problems in housing and housing finance. We know the outcome of that policy error, the worst since the Great Depression.

Since monetary policy is in fact discretionary, critics can only debate the wisdom of concrete policy actions – as opposed to the choice of a policy rule. At this point, the Fed’s plan for two more rate increases in 2018 seems too aggressive. Policymakers should pay more attention to financial-market indicators, like the yield curve. Financial-market variables are current and not subject to the revisions that afflict real economic data like GDP.