Connecting the Dots

Why the Federal Reserve Should Study Algebra

June 20, 2017

The Federal Reserve hiked interest rates again last week. Yes, it was a tiny hike, but as they say, “A quarter-point here and a quarter-point there, and pretty soon you’re talking about real money.”

Higher rates aren’t entirely bad. They might help savers holding cash—though I wonder why anyone would still hold cash after almost a decade of punishment. The Fed has forced Americans into riskier assets, using every tool but horsewhips.

The bigger question is what this tells us about future Fed policy. Given that the Fed’s composition will probably change in the next year, what if we let the math decide?

Image: Albastrica Mititica on Flickr

Fed Formulas

This summer I’m taking an algebra class at Austin Community College. Math’s right-or-wrong nature presents a nice change from the ambiguity of macroeconomics and monetary policy.

One evening last week, I sat on my deck, happily solving equations from my algebra book—not thinking about economics at all—when I saw this.

Since there’s evidently no escape for the Fed-weary, let’s discuss this formula.

Harvard economist Greg Mankiw designed it to assess what interest rate the Fed should target, based on inflation and unemployment.

At the time (mid-2006), the unemployment rate hovered around 4.6% and core inflation 2.4%. Plug those numbers into Mankiw’s formula, and you get a 5.42% rate target. The actual fed funds rate was 5.25%, so not far off.

However, that picture has changed quite dramatically.

The Fed’s preferred inflation gauge, core PCE, is up 1.7% since this time last year, and the unemployment rate is 4.3%. So according to Mankiw’s formula, we would expect a fed funds rate of 4.86% right now.

It’s not even close. Last week, the Fed raised the rate to the 1.0–1.25% range.

Even the most hawkish FOMC voter (whoever it is) doesn’t foresee rates touching 4% before 2019. And all the others predicted much lower rates than that.

Clearly, this means the rules have changed.

Faith vs. Data

Just to make all this crazier, many folks think the Fed shouldn’t raise rates at all when core inflation is so low.

The real reason Yellen and others want to raise rates: they want to be able to cut rates in the next recession without going below zero.

In other words, they need breathing room. But acquiring it may bring on the very recession they’re preparing for.

Minneapolis Fed President Neel Kashkari disagreed with last week’s decision and explained why in a long blog post. Here’s his main point:

For me, deciding whether to raise rates or hold steady came down to a tension between faith and data.

On one hand, intuitively, I am inclined to believe in the logic of the Phillips curve: A tight labor market should lead to competition for workers, which should lead to higher wages. Eventually, firms will have to pass some of those costs on to their customers, which should lead to higher inflation. That makes intuitive sense. That’s the faith part.

On the other hand, unfortunately, the data aren’t supporting this story, with the FOMC coming up short on its inflation target for many years in a row, and now with core inflation actually falling even as the labor market is tightening. If we base our outlook for inflation on these actual data, we shouldn’t have raised rates this week. Instead, we should have waited to see if the recent drop in inflation is transitory to ensure that we are fulfilling our inflation mandate.

Kashkari considers the risk of above-2% inflation returning to be low—and manageable even if it happens.

Looking at history, he does have a point. Here’s core PCE going back to 1960.

From the late 1960s to the mid-1990s, inflation remained above 2%. Of course, even 2% inflation can be detrimental—sustained for 20 years, it will consume about one-third of your dollar’s buying power. Luckily, it’s ranged below that for most of the last two decades (with the exception of 2005–2008) and seems likely to stay that way.

But why are we even having this argument?

Image: Derek Gavey on Flickr

Algorithmic Central Banking?

We talk all the time about robots taking our jobs. Could they take the Fed’s job?

Presently, the Federal Open Market Committee (FOMC) spends thousands of work hours trying to solve the same problem Professor Mankiw’s equation answers in about one minute.

Some economists think the Fed should just follow fixed rules—not necessarily Mankiw’s formula, but something like it. Put rates on autopilot and get out of the way.

An attractive idea that might even yield better results. But, much like a plane’s autopilot, we need at least one skilled human aboard to take the stick if necessary.

The output—that is, monetary policy rules—would highly depend on the input. Incorrect inflation or unemployment data might produce unexpected results.

President Trump hasn’t yet nominated anyone for the three vacant Fed seats, so a whole different crew could be in charge next year.

Meanwhile, names floating around to replace Janet Yellen include advocates of rules-based policymaking. A recent Bloomberg survey of economists pegged Stanford economist John Taylor, author of the “Taylor Rule,” as a likely candidate for the job. Mankiw got a few votes too.

But whoever occupies the top seat, they will still need a transition plan. An overnight jump from today’s 1% range to nearly 5% would be disruptive, to say the least.

That leaves us back at the same conclusion. We live in a time of maximum monetary uncertainty. US interest rates drive the US dollar, which in turn drives just about every financial market on the globe. It’s that important.

For example, dividend-paying US stocks will be relatively less attractive if new Fed policies drive long-term interest rates higher. But they could also gain value if bond yields move lower. What do you do?

I look for income-generating investments that can adjust to fast-changing conditions. They exist, if you have an open mind and know where to look. 

Only one thing is sure in this transition: Anything can happen - so be ready for anything.

See you at the top,

Patrick Watson

P.S. My newsletter, Yield Shark, is designed to mitigate and lessen that risk exposure for income investors with stable, high-yield opportunities. Learn more here.

Discuss This


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Bob McElroy

July 4, 2017, 6:37 p.m.

I crunched the numbers too and came up with different results.  Let’s review.  The formula is f = 8.5 + 1.4(I-U).  If I plug in the numbers you did, here is what I get:
f = 8.5 + 1.4(.024 - .046)
f = 8.5 + 1.4(-.022)
f = 8.5 - .038
f = 8.469
That produces a target rate at 3% more than your calculation of 5.4%.
With your recent education in algebra at Austin CC, tell me where my calculation is in error.

Thank you,

Adam Schwartz

June 20, 2017, 2:36 p.m.

It seems like you’re accepting the core inflation index as an appropriate measure of inflation. But all around bubbles are expanding—stock market, real estate, high-yield bond market, government and personal debt… Those are real dangers that are going to percipitate a much bigger financial collapse down the road if the Fed maintains such low interests rates. Rates now are lower and have been low for longer than Alan Greenspan’s medicine after the dot-com bust which led to the 2008 financial crisis. So soon we forget…

Walter Meissner

June 20, 2017, 12:20 p.m.

The low interest rate environment is very curious indeed.

My personal thoughts on the this is as follows.

(a) The GDP/Debt ratio is quite high and the government can’t afford to pay more on borrowed money. Thus it is in their interest (no pun intended) to keep rates low.

(b) The FED waited too long to raise rates with the rational that the economy was not robust enough in earlier years to sustain higher rates. Now the dilemma is that everyone’s investment strategy is (excessively for some) weighted toward equities. That most likely include pension funds, annuities, and businesses. The government does not want to be in the position to bailout the economy again. This is another incentive to keep the rates low.

(c) The FED has painted themselves into a corner they find difficult to get out of without risking possible economic fallout, by simply backstopping the Oct ‘08 meltdown and applying the only tools at their disposal.

(d) Since the economies are quite global now, the FED considers how its decisions affect the other countries as well, since those economies will ultimately affect the USA as well. Europe, for instance, was lagging in the their recovery effort, and the FED was giving them some breathing room by waiting for them to catch up.

I suspect this condition will persist until the baby-boomer generation dies out, or some other event occurs that drastically changes the status quo.

In defense of the FED in trying to implement their mandates ...

It must be very difficult to come up with strategies to help the economy. There is no ‘testing lab’ to use to fine tune an approach before rolling out a policy. Economics models using measured inputs are the best they have. However, models don’t always allow for the human factors that will affect people will actually do.

No one want to be the party-pooper that rains on the economic parade. So most policy decision tend to conservative. The issue of whether or not to recognize a bubble and burst it before it can do much more damage, has been brought up before. But even Greenberg couldn’t bring himself to do it. No one can really predict the outcome of such actions, and political parties want to be voted in again.

I am sure more can be said. Perhaps others will have some comments as well.