Jobs Report Greenlights Irrelevant Fed Rate Move
Friday’s “Employment Situation” report from the Bureau of Labor Statistics (BLS) was more eagerly anticipated than most. This was because, in her recent testimony before Congress, Federal Reserve Chair Janet Yellen strongly suggested that, if the jobs report was at all decent, the Fed would “raise interest rates” (i.e., raise their target for the Fed Funds interest rate) at next month’s FOMC* meeting.
The financial markets’ initial reaction to the BLS report was negative, with the Dow, the CRB Index, and the 5-year Treasury/TIPS spread all falling. Near the end of the trading day, and after the CRB Index closed, the Dow and the 5-year Treasury/TIPS spread recovered to close modestly up.
Why this trading pattern? To the FOMC, the whole point of raising the Fed Funds rate would be to prevent the economy from “overheating.” So it would make sense for the markets to fall in anticipation of a policy move whose purpose was to slow economic growth.
So, why the late recovery? It could be because, upon reflection, the markets realized that, as long as the FOMC is thinking of monetary policy in terms of the Fed Funds rate, it makes no difference what they do. If the economy were a car, the Fed Funds rate would be the rearview mirror. It is possible to turn it like a steering wheel, but it doesn’t affect anything. We’ll have more on this later.
The markets are aware that the FOMC is eager to raise interest rates, and Friday’s jobs report will indeed help make them feel comfortable doing so at their December meeting. The BLS numbers were “pretty good.”
Beyond the 271,000 increase in the closely watched “Payroll Employment” number, total FTE** jobs increased by 356,000. This reduced our distance from full employment by 227,000, to 13.7 million. At this rate, we would reach full employment in five years.
Labor force participation, which has dropped precipitously under President Obama, edged upward slightly. Perhaps most significant to Fed watchers, average hourly wages came in 2.48% higher in October than a year ago (although, because the average workweek fell, average weekly wages were up by only 2.18%).
So, should the Fed raise interest rates at their December meeting?
The short answer is, “No.” Here’s why.
First, the Fed should not be concerning itself with interest rates at all. The Fed’s job is to keep the value of the dollar stable. If they were to do this, we would have a stable, growing economy, as well as stable financial markets.
Unfortunately, even under normal circumstances, there is no causal relationship between interest rates and the value of the dollar. For example, in 1980, the dollar fell in real value (against both gold and the CRB Index***) despite a Fed Funds rate that averaged 13.36%. And, in 2014, the real value of the dollar rose in the face of a Fed Funds rate that averaged 0.09%.
Second, these aren’t normal circumstances. With $2.5 trillion of excess reserves in the banking system, the way that the Fed is planning to raise the effective Fed Funds rate is to raise its “interest on reserves” (IOR) rate. In other words, the Fed expects to have to bid up the Fed Funds rate itself.
Raising the IOR rate might slow bank lending very slightly, thus marginally slowing down the conversion of excess reserves to required reserves, and thereby marginally retarding the creation of dollar liquidity by the banking system. However, there are so many diverse sources of dollar liquidity that it is not clear that the impact of a 0.25 percentage point increase in the IOR and Fed Funds rates would be discernible.
Third, the fact that the FOMC is concerned with the monthly BLS reports at all shows that their minds are in the grip of the Phillips Curve, which is the fallacy that high employment and rising wages cause inflation. In fact, it is a fall in the value of the dollar that causes inflation, and the best indicator of the value of the dollar is the CRB Index.
At the end of October, the CRB Index stood at 195.61. This was down by 36.85% from June 2014, and 37.62% lower than the average in 2005, which is the last year that we had decent real GDP (RGDP) growth (3.34%).
The idea that we need to “fight inflation” when the value of the dollar is 58.35% higher than it was 15 months ago is lunacy. It is also dangerous, given that a rapid rise in the dollar’s value (which, given the way that the commodity markets work, is always unexpected) can precipitate a recession. This is what happened starting in mid-2008, where the value of the dollar against the CRB Index more than doubled within a span of only 8 months.
Even if we avoid a recession, the unexpectedly more-valuable dollar is taking its toll. RGDP growth for 2015 is now likely to come in even lower than 2014’s anemic 2.43%.
Austrian economists correctly point out that inflation (a dollar that is losing real value) can cause malinvestment, which is the allocation of real resources to unprofitable projects. It does this by distorting the price relationships among inputs and outputs.
However, deflation (a dollar that is gaining real value) can also cause malinvestment, by forcing the liquidation of ventures that would have been profitable, had the dollar remained stable.
For example, at current oil prices ($48.00/bbl as of the end of October), much recent investment in U.S. oil production constitutes malinvestment. However, if the Fed were to stabilize the dollar at a CRB Index of 300.00, oil prices would probably rise to at least $70.00/bbl. This is far below the $111.80/bbl price of June 2014 (much less the $133.93 of June 2008), but it is a price that would prevent the senseless liquidation of billions of dollars of investment that would be profitable under stable money.
The FOMC has become obsessed with raising the Fed Funds rate, while curiously not noticing that their previous policy actions (creating $2.5 trillion in excess reserves via “quantitative easing,” and then immobilizing them by paying IOR) have rendered the Fed Funds rate largely irrelevant.
Republican presidential candidates have been handed a golden opportunity to show the voters that they understand our monetary woes, and that they are prepared to force the Fed to adopt a rule-based system that would provide the U.S. and the world with a truly stable dollar.
* Federal Open Market Committee, which is the body that determines the Federal Reserve’s monetary policy
** FTE (full-time-equivalent) jobs = full-time jobs + 0.5 part-time jobs
*** The CRB Index is a commodity price index comprising: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gasoline, and Wheat.
Originally posted on Real Clear Markets.
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