The Fed Should Say No to Forward Guidance
At his June 10 press conference, Federal Reserve Chairman Jerome Powell said, “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.” He suggested that the Fed will keep short-term interest rates near zero through 2022. If he thought markets would be cheered by this news, he was wrong; the Dow-Jones Industrial Average fell 300 points in the two hours after he began speaking and fell another 1862 points the following day. Most analysts attributed the declines to a rebound in COVID-19 cases and the Fed’s relatively gloomy forecast about the economy – “what does the Fed know that we don’t know?” – but perhaps the markets have figured out that low interest rates are not unambiguously positive for economic growth and that forward guidance is counter-productive.
When economic growth turns negative and unemployment rises, the standard monetary policy response is to cut interest rates. But rate cuts are not always stimulative. Markus Brunnermeier and Yann Koby of Princeton have introduced the concept of the “Reversal Interest Rate,” the rate below which interest rate cuts are contractionary rather than stimulative. They point out that low interest rates can adversely affect bank profitability and reduce the incentive of banks to make loans. At some point, this impact more than offsets the positive impact of interest rate cuts on consumer spending, business investment, and, most importantly, residential construction.
You can also get to the “reversal rate” through debt and demographics. As the U.S. federal debt has blown past $20 trillion, the household sector has become a huge net creditor. When interest rates go down, the interest income of households goes down. The reduction in interest income is especially hard on risk-averse investors, many of them elderly, who have their savings in bank accounts rather than in stocks and bonds. During most of the 2009-2017 period, the negative impact of reduced interest income on consumer spending more than offset the positive impact of low interest rates on a housing market that didn’t respond much because of supply constraints. Near-zero interest rates thus impeded the economic recovery rather than aiding it. The benefits of near-zero rates likely exceed the costs right now, but the net stimulus from near-zero rates will eventually turn negative if rates are kept too low for too long.
Even just promising to keep rates low for a long time can hurt economic growth. Because potential borrowers compare current interest rates to expected future interest rates – something that most models don’t take into account – a promise to keep interest rates low for an extended period removes any sense of urgency to borrow before rates rise. If the Fed really wants to stimulate the economy, it should urge potential borrowers to “take advantage of these record low rates before they’re gone forever.” Promising to keep rates low gives borrowers permission to wait, and that’s not the way to boost growth.
I think the Fed probably realizes that interest rate cuts have little direct impact on consumer spending and business investment and that the impact on residential construction is smaller than in the past. But the Fed still believes that by pushing down long-term interest rates through forward guidance and Quantitative Easing, it can support the prices of stocks, bonds, and houses and boost consumer spending indirectly through a “wealth effect.” What the Fed fails to grasp is that the gains to (mostly old) people who own such assets come at the expense of (mostly young) people who want to buy them. When stock valuations go up because bond yields have been pushed down, the gains to owners of stocks are offset by the losses (in the form of smaller future returns) to those who want to buy them. Any positive wealth effect is undone when the asset buyers realize they’re worse off and boost their savings rate in response. The implication is that boosting asset prices via forward guidance and Quantitative Easing helps growth in the short run, but not in the long run. It also weakens the social fabric by worsening the distribution of income and wealth.
If low interest rates can hurt growth, and forward guidance is counter-productive, and the wealth effects resulting from QE are eventually reversed, do we reach a point where monetary policy is impotent? No, we don’t. If paper Social Security cards were replaced with debit cards (with biometric security) and the Fed were allowed to put money on those cards, it could always stimulate the economy, even if it couldn’t push interest rate lower or if lower interest rates didn’t boost growth because banks wouldn’t lend or because elderly savers suffered a reduction in interest income. Astute readers will say, “But that’s helicopter money.” Yes, it’s helicopter money, but helicopter money only seems silly to people who don’t understand metaphors or bankers who think monetary policy should always benefit them.
Near-zero interest rates are appropriate in the current environment, i.e., the reversal rate is extremely low. But as the economy recovers and the threat of mass bankruptcies fades, the reversal rate will rise. The Fed should respond by raising interest rates sooner than it expects to, not to choke off growth but to enable it. And even if the Fed is determined to leave rates at current levels longer than I think appropriate, they shouldn’t advertise that. Forward guidance slowed the last recovery by encouraging potential home buyers to sit on the fence and wait. It shouldn’t be allowed to slow this recovery.