The great helmsman?

Don't steer the car, move the road

[Long time readers will recognize part 1—how to steer the (nominal) economy down the center of the road. Part 2 will look at how to move the road.]

Part 1: The Great Helmsman

So now we are being told that an increase in interest rates is a virtual certainty. Here’s Bloomberg:

As Kevin Warsh takes the helm at the Federal Reserve, bond investors are betting he’ll prioritize the central bank’s inflation-fighting credibility over President Donald Trump’s push for lower interest rates.

With the Iran war unleashing the biggest inflation surge since 2023, traders are pricing in that the Fed is virtually certain to start raising rates by December. That’s a sharp reversal from just three months ago, when markets were betting there were deeper cuts ahead.

I’d like to see “virtual certainty” defined in numerical terms. Is it 99.9%? Or 99.99%? I’d also be interested in seeing the probability of recession over the next 6 months. Is it virtually certain that there will be no recession? And if there is a recession, what would the Fed do to interest rates?

I hope you see the problem here. Economists have shown they have no ability to predict turning points in the business cycle. Because interest rates are highly cyclical, this also means that we also have very little ability to predict movements in interest rates. I’m not suggesting that market forecasts are completely meaningless, merely that they fall well short of “virtual certainty”.

On the day of the Bloomberg article, I checked the fed funds futures market and this is what I saw:

Unless I’m mistaken, that suggests that financial markets expect only a very modest increase in rates between now and December. (15 bps?) Surely this falls far short of virtual certainty.

Recall that the Bloomberg article started out:

As Kevin Warsh takes the helm . . .

Is Warsh at the “helm”, or is the FOMC at the helm, or is the market at the helm?

For months we’ve been told that Trump picked Warsh because he was committed to cutting interest rates. Warsh has frequently insisted that a cut in interest rates would be appropriate. So why is the media now telling us that a rate increase is a virtual certainty? Did Warsh deceive us? Or is it possible that Warsh is not “at the helm”?

A helm is sort of like a steering wheel. When I drive my car, I can use the steering wheel to go over to the right side of the lane, right up against the bike lane. Or I can go out to the left side of the lane, right up against the center stripe. If I’m feeling particularly aggressive, I can even briefly cross the (dotted) center lane to pass a car. But I better get back quickly!

I can even turn the steering wheel in such a way as to completely leave the road, in which case I’m likely to have an accident. But why would I want to do that? If you were trying to forecast my manipulation of the steering wheel, would you forecast a traffic accident, or would you forecast that I adjust the wheel as needed to keep the car in its lane?

To be clear, traffic accidents do happen. But they usually happen when least expected. If you knew an accident was about to happen, you would presumably adjust the wheel to prevent it from occurring. The best model of car steering is that the steering wheel will be set at a position that keeps the car on the road. And the best model of interest rates is that the Fed will target rates in such a way as to keep the economy relatively stable—too much spending will trigger inflation and too little spending will trigger a recession.

Once you see the world this way, most of what you read about monetary policy begins to seem like nonsense. I don’t know how many times I’ve seen people claim that if the US government debt situation becomes too burdensome, the Fed may be forced to hold down interest rates so that the burden of the debt doesn’t become too onerous. Really? And just how is the Fed supposed to “hold down” interest rates without causing an accident? With a magic wand?

Imagine if Greyhound Bus Company hired a driver that insisted buses needed to turn the steering wheel to the left more often. Would you feel comfortable having him steer your bus on the road shown below?

Photo by Jacob Kiesow on Unsplash

I understand that Kevin Warsh needed to say that he intended to cut interest rates in order to get Trump to nominate him to be Fed chair. I do not understand why anyone would take his pronouncements seriously. When have Fed chairs ever determined the path of interest rates?

This Financial Times story points us in the right direction:

Bob Michele, chief investment officer and head of the global fixed income, currency and commodities group at JPMorgan Asset Management [suggested]

“The bond vigilantes are back and have taken control of the market. If central banks aren’t going to respond to inflation pressures, the vigilantes will make it more painful for them to borrow.”

The bond vigilantes are sort of like the twisty road in the preceding analogy. I would not say they are “back” in control, rather they never gave up control. If at a moment in time the vigilantes seem to have disappeared, it reflects the fact that policy is roughly on target, and the bond markets are not signaling an imminent need to adjust interest rates.

If the Fed lets inflation accelerate, then the “bond vigilantes” will force the Fed to raise rates sharply (as in 2022-23), and this will be painful. Better to avoid that situation by running a monetary policy consistent with low inflation.

Back in the 1950s and 1960s, the Chinese referred to Mao Zedong as “the Great Helmsman”. In fact, he was arguably the worst helmsman in world history, at least in terms of economic policymaking. The best helmsman is probably the financial sector. The Fed should end the policy of paying interest on bank reserves and then use open market operations to set monetary policy at a position expected to produce 4% NGDP growth. Let the market set interest rates.

Part 2: Why don’t we just move the road?

Thus far I’ve treated the natural rate of interest as an exogenous factor. In fact, the Fed can influence the natural rate, indeed in the long run they have much more control over the natural rate of interest than they do over the actual policy rate.

This is where my steering the car down the road analogy comes up short. The Fed can influence the expected rate of growth in nominal GDP, and hence they can influence the (nominal) natural rate of interest, which is positively correlated with NGDP growth. Using the road analogy, the Fed can move the road to where they wish to drive the car.

Let’s start with a simple example, the 2% inflation target. Moving the inflation target from 2% to 3% would tend to raise the long run path of nominal interest rates by one percentage point. Indeed, any credible change in the Fed’s inflation target would move the natural interest rate, at least to some extent. Adopting NGDP targeting would impact the natural rate, as would the adoption of level targeting.

On any given day, you can find people on twitter offering advice as to what the Fed should do next. In most cases, that advice takes the form of recommendations to adjust the fed funds target up or down. I have no interest in playing that game, as the Fed’s big mistakes in the 1970s, in 2008 and in 2021 were not caused by tactical errors. They were not caused by an inability to stay on the road (although that failure did happen). The biggest mistakes were caused by the Fed moving the entire road in a bad direction.

In the 1970s and in 2021-22, the Fed either explicitly or implicitly choose an excessively inflationary road. They did not even attempt to bring the level of NGDP growth back to the previous trend line, rather they allowed market expectations of very high NGDP growth, relative to trend. The Fed’s mistake in 2021 was not in setting the interest rate at the wrong level, it was abandoning its promise to engage in flexible average inflation targeting (FAIT), which would have required it to keep close to a 4% NGDP growth trend line. The Fed set rates at a level that it knew would dramatically overshoot the 4% pre-Covid trend line for NGDP.

If the Fed had actually adopted the FAIT it promised, then market expectations of NGDP growth in 2021-22 would have been much lower. This policy would have dramatically reduced the natural rate of interest in 2022. Surprisingly, the actual path of interest rates in 2022 would probably have been lower than what actually occurred, and inflation would also have been much lower. That’s right, a tighter policy in 2021 would have meant lower interest rates in 2022 and 2023.

This is why it is not possible to make meaningful statements about whether interest rates are too high or too low. The Fed’s most important tool is not moving its policy rate above or below a stable natural rate of interest, it is moving the natural rate of interest by adjusting its policy target for NGDP growth. In other words, moving the road. The exact same interest rate today might be either expansionary or contractionary depending on what sort of forward guidance the Fed is providing about how much NGDP growth it will allow.

I could not care less what Kevin Warsh thinks about interest rates. Tell me what sort of goal he has for inflation and/or NGDP, and whether he supports level targeting or a “let bygones-be-bygones” approach that fails to stabilize NGDP. That will determine the path for interest rates.

PS. Slightly off topic, I recently read Mark Koyama’s review of a new book by Tyler Goodspeed. I particularly liked this passage:

Goodspeed shows that British and American expansions do not resemble Dorian Gray, looking beautiful but hiding an inevitable accumulation of malinvestments (objectively bad investments that are destined to fail) and distorted decisions (mistaken economic decisions taken on the basis of bad regulation or flawed prices) that make a correction inevitable. If they did so, he argues, one would expect that as expansions get longer they get more and more likely to end. In his data, however, the relationship between the age of an expansion and the probability of death is essentially zero. Nor do measures of increased investment during the boom correlate with the severity of a downturn. Nor do longer expansions have longer recessions after them.

This is why recessions remain essentially unpredictable. Any perceived regularity is likely to be a statistical illusion. Goodspeed shows that attempts to forecast recessions such as inversions of the yield curve (where long-dated government bonds have lower interest rates than short-dated ones) or the Sahm rule (which says a recession is likely underway if the unemployment rate spikes high above its recent lows for three months) are overfitted to US data and don’t work for the UK. The same proved to be true of the Phillips Curve, a strong correlation between unemployment and inflation that existed in British data between 1860 and 1960, which broke down after governments attempted to target it and fine tune the economy in the 1960s.

In fairness, Claudia Sahm has argued that her “rule” is not inevitable, rather it is a useful tool for policymakers to avoid repeating the mistakes of the past. I’ve made somewhat analogous arguments in pointing out that whereas the US doesn’t have any mini-recessions (until now?), countries such as the UK do have them on occasion.

This is also music to my ears:

Not all shocks are necessarily exogenous in nature. Chapter 7, entitled ‘Firefighters and Arsonists’, notes that while policymakers can play a vital role in smoothing shocks and responding to a crisis, they have often themselves acted as arsonists.

The actions of the Federal Reserve during the Great Depression are a famous example. Wary of speculative finance, the Fed allowed the money supply to fall precipitously and failed to halt the banking collapse. The shock here was hardly exogenous to the economy itself but the type of unforced error that is sadly not unusual in the historical record.

Similarly, conventional accounts at the time of the Great Recession of 2008 emphasized financial malfeasance in the housing market with subprime mortgages being repackaged to unsuspecting lenders. But why should these issues in the banking sector produce a worldwide recession? Moralizing accounts that emphasize the greed of bankers can be politically and emotionally satisfying but they don’t explain the scale of the downturn. The vast majority of the homes built during the bubble between 2002-2006 turned out to be entirely consistent with subsequent demand.

I wrote a 392-page book that provides additional support for that argument.