“OK” Jobs Report Paves Way for $6.8 Billion Fed Giveaway to Banks
Despite what you may have read elsewhere, Friday’s “Employment Situation” report from the Bureau of Labor Statistics (BLS) wasn’t great. Rather, it was, at best, “Just OK.”
Because of a surge in the percentage of jobs that were “part time for economic reasons,” total FTE* jobs increased by only 91,000. This was not enough to keep up with the growth of our working-age population. As a result, during November, America moved 32,000 FTE jobs farther away from full employment (to 13.7 million).
While the “headline” (U-3) unemployment held steady at 5.0%, the broader U-6 unemployment rate increased by 0.1 percentage points, to 9.9%. Year-over-year wage growth slowed. Labor force participation edged up slightly, but the rate remained at a severely depressed level that had not been seen since the late 1970s.
So, the November jobs picture was not exactly wonderful. However, the reported 221,000 increase in payroll employment provided Federal Reserve Chair Janet Yellen with the cover that she needs to do what she evidently wants to do, which is to raise the Fed Funds interest rate target by 25 basis points (25 bp, or 0.25%/year).
Now that the road is clear for a Fed interest rate hike, three questions come to mind:
- Is this a good idea?
- How would it be implemented?
- What are the likely costs and benefits?
First, is it a good idea for the Fed to “raise interest rates?” No, it’s a bizarre idea.
The Fed should not be targeting interest rates at all; it should be targeting the real value of the dollar (more on this later). However, even if we accept that the Fed must, for some reason, try to conduct monetary policy by targeting the Fed Funds interest rate, raising it right now is obviously the wrong thing to do.
The Fed’s “accommodative” monetary policy effectively ended in August 2014, when the monthly monetary base peaked at $4.095 trillion (it was $4.076 trillion for November 2015). Despite this, over the past 15 months, the yield on 10-year Treasuries has declined to 2.18% from 2.35%, and expected 5-year inflation has fallen from 1.76% to 1.30% (month-end numbers).
By the way, conservatives that denounce the Fed for “printing money” in order to “keep interest rates low” need to wake up and smell the data. The Fed has not increased the monetary base for 15 months, yet interest rates have not only stayed low, they have declined. This would not have surprised Milton Friedman, who observed that unusually low interest rates usually stem from money being too tight, rather than too loose. However, it could come as a shock to the dauntless foes of “money printing.”
For those of us that believe that the Fed should be targeting the real value of the dollar, commodity prices are more relevant monetary indicators than are interest rates. Since August 2014, gold prices have eased by 17.3%, and the CRB Index** has plunged by 37.6%.
Here, again, conservatives need to open their eyes, and stop predicting the imminent arrival of “rampant inflation.” Inflation cannot accelerate while commodity prices are falling. In fact, falling commodity prices signal monetary deflation (and, in a sense, are monetary deflation). Right now, there are many early warning signs of recession, and none for inflation.
“Market monetarists” (MMs), like Scott Sumner, prefer to characterize “the stance of monetary policy” based upon the path of nominal GDP (NGDP). From 3Q2013 to 3Q2014, NGDP grew by 4.8%, which is close to the 5.0% target generally advocated by MMs. From 3Q2014 to 3Q2015, NGDP growth slowed to only 3.1%. This suggests (at least to MMs) that monetary policy is too tight, not too loose.
So, whether you are a believer in a stable dollar or in NGDP targeting, you would not conclude that now was a good time to do something that you believe (rightly or wrongly) would “tighten” monetary conditions. Unfortunately, the FOMC appears to be the last bastion of the (amply discredited) “Phillips Curve” theory, which holds that high employment and rising wages cause inflation.
OK, so the Fed is determined to do something that, at multiple levels, makes no sense. How will they go about it? After all, the Fed Funds interest rate is set via transactions between Fed member banks, so the Fed cannot just “raise the Fed Funds rate.” It has to take some action or actions that will have this effect.
There are a number of ways that the Fed could try to implement a policy decision to raise its Fed Funds target by 25 bp.
First, the Fed could just put out a press release saying that it has raised its Fed Funds target, and hope that the markets cooperate. In the “good old days” (prior to October 2008) this actually worked. Whenever the FOMC announced a new Fed Funds interest rate target, the Effective Fed Funds rate would conform, even before the Fed undertook any Open Market operations to force it to do so.
The reason that the Fed’s announcements used to move the Fed Funds market instantaneously is that the banking system typically had only enough excess reserves to meet the economy’s growing needs for monetary base for a few days. After that, the banks would have to bid up the Fed Funds rate to the Fed’s new target, so that the Fed would inject more reserves.
Today, the banking system is holding $2.58 trillion of excess reserves. This is 1,375 times the level of August 2008, and enough to permit the banks to ignore the Fed’s press releases for about 25 years. So, if the FOMC wants the Effective Fed Funds rate to go up by 25 bp, they will need to do more than make an announcement.
In the end, the Fed will probably simply raise the rate at which it pays “interest on reserves” (IOR) by 25 bp, to 50 bp. This would “work,” in the sense that it would almost certainly boost the Effective Fed Funds rate from its current 13 bp to somewhere around 38 bp. However, it would also double the Fed’s annual interest payments to the banks, from the current $6.8 billion to $13.6 billion. This seems like a high price to pay to do something that should not be done anyway.
Of course, the Fed is considering alternatives to raising the IOR rate. One possibility would be to reduce the amount of excess reserves by doing “reverse repurchase agreements.”
This would amount to the Fed borrowing (at interest) the excess reserves back from the banks. Unfortunately, the Fed would have to do a huge volume of “reverse repos” to have the desired impact. This would be operationally complex, and could end up costing as much as simply raising the IOR rate by 25 bp.
The “old fashioned way” to drive up the Effective Fed Funds rate would be for the Fed to simply sell $2.5 trillion in assets, and thereby extinguish most of the excess reserves. However, it appears that the Fed is loath to do this, because if long interest rates went up in the process, the Fed could suffer portfolio losses that might render it technically insolvent. While the Fed cannot actually go bankrupt (its liabilities don’t have maturity dates), this would be embarrassing.
Now, if the Fed were clever, it could just offer interest-free, fee-free deposit accounts at Federal Reserve banks to the public (say, with a $1 million minimum balance). These would be attractive to large holders of cash-equivalents. Movements of funds from banks into these new accounts would have the effect of reducing both excess reserves and IOR costs.
Of course, if the Fed were clever, we wouldn’t be in this mess.
So, it looks like the Fed is going to start spending an additional $6.8 billion/year on IOR in order to boost an interest rate that it shouldn’t be managing in the first place. What could go wrong?
While the market’s reaction to Friday’s BLS report seemed positive (the Dow was up by 2.12% on the day), it was actually slightly negative. Because gold prices rose by 2.36% on Friday, the “Gold Dow” (the Dow divided by the price of gold) actually declined. Based upon Bloomberg numbers, expected 5-year inflation fell, which implies that expected 5-year NGDP growth also fell.
So, despite the euphoria in the media, it is important to realize that the markets seem to be slightly less optimistic about the real economy after Friday’s BLS report than they were before. It is reasonable to interpret this as meaning that the markets consider it a mistake for the Fed to “raise interest rates,” but not a huge mistake.
The U.S. economy is not doing well. The jobs market is not good, and the Fed’s own “GDPNow” service is forecasting 4Q2015 real GDP (RGDP) growth of only 1.4%. If so, 2015 RGDP growth would come in at only 2.44%. This would make 2015 the 10th successive year for which RGDP growth fell short of 3.0%
The biggest single reason for America’s poor economic performance since 2000 has been the Fed’s flailing, improvisational, 100% discretionary monetary policy. The “noise” that this has injected into economic decision-making has suppressed investment, and has led to considerable malinvestment.
With the Fed gearing up to double its IOR giveaway to the banks, now would be a good time for Republican presidential candidates to lay out their plans to fix our broken Fed.
*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.
***Federal Open Market Committee, which is the body that determines the Federal Reserve’s monetary policy
Originally posted on Real Clear Markets.