Quarterly Review and Outlook, First Quarter 2018

Nearly nine years into the current economic expansion Federal Reserve policy actions appear to be benign, as even after six increases, the federal funds rate remains less than 2%. Changes in the reserve, monetary and credit aggregates, which have always been the most important Fed levers both theoretically and empirically, indicate however that central bank policy has turned highly restrictive. These conditions put the economy’s growth at risk over the short run, while sizable increases in federal debt will serve to diminish, not enhance, economic growth over the long run.

Interest Rates

Interest rates are not predictable over the short run but are controlled by fundamental forces on a long-term basis. Milton Friedman (1912- 2006) developed the most complete and internally consistent interest rate model to date, which is an extension of the Fisher equation. Friedman’s model reaches two conclusions: (1) although monetary decelerations may lead to transitory increases in interest rates over the short run, they ultimately lead to lower rates; and (2) monetary accelerations result in higher rates. This reasoning is based on what Friedman termed “liquidity, income and price effects”. When the Fed reduces the reserve, monetary and credit aggregates (or what Friedman called monetary deceleration), initially short-term rates are forced upward through the “liquidity (or initial) effect”. As the Fed further tightens monetary conditions, an offsetting “income effect” follows. These restraining actions moderate growth in the economy, and the rise in interest rates continues but at a slower pace. Thus, in Friedman’s terms, the income effect begins to offset the liquidity effect. When the Fed sustains the tightening process long enough, the inflation rate will decrease as incomes fall and ultimately result in lower rates. This is the “price” or “Fisher effect” from the Fisher equation. Observationally, the highly inflation-sensitive long-term yields reflect the changing economic landscape faster than short-term rates, thus the yield curve flattens, serving to strengthen the Fed’s restraint on the reserve, monetary and credit aggregates.

Empirical studies by Friedman and others indicate this process is lengthy, often playing out over several years. This process appears to be well underway. More than two years have elapsed since the Fed initiated the liquidity effect, and restraint is evident in all of the aggregates as well as in the shape of the yield curve, which has attened significantly.

Friedman's logic for monetary accelerations leading to higher interest rates is the opposite of monetary decelerations. When the Fed accelerates growth in the reserve, monetary and credit aggregates, the liquidity effect is initiated. Short term rates drop rapidly relative to long term rates and the yield curve dramatically steepens. If the Fed continues to further loosen monetary conditions, a reversing income and price effect can, but does not always, occur. Friedman assumed the velocity of money was largely stable. Subsequent empirical evidence, however, suggests that this is not the case.

Three important concepts arise from these patterns. First, when the Fed moves in one direction, they ultimately lay the groundwork for reversal. Second, considerable time (generally two or more years) passes before the liquidity effect has any economic impact. Third, these lags grow longer when the Fed tries to overcome a recession, especially in highly leveraged economies like 1929 and 2008.

The Fed's Ability to Act

The fact that there is such a long lag between policy change and economic impact is critical in analyzing the circumstances today. For instance, suppose the Fed is able to identify the next recession on day one. Also, suppose that on the first day of the recession the Fed drops the federal funds rate to zero. Due to the economy’s extreme over-indebtedness, along with long monetary policy lags, a minimum of one and half years could elapse before even a slight economic recovery is experienced. But, recovering from the next recession, the lag could be much longer since interest rates are so close to the zero bound and indebtedness continues to rise to record levels. Both will interfere with the potency of the liquidity effect. Thus, despite a rapid Fed response, a long recession could ensue.