This is hardly the place to launch into a history of the central bank, but it is a pretty interesting one. Once upon a time the central banks of the world were nothing more than a tool of the current political leadership in a given country and, as one would expect, they were expected to support the goals and aspirations of whoever was in charge at the time. That generally meant the banks were expected to focus on economic growth at all costs. In other words, inflation threats were ignored until they became so serious it started to affect the overall economy and business community. The fact is that politicians do not like being told that the economy needs to slow down as a means by which to tame inflation, as this means fewer jobs and reduced revenue for the government.
After a series of disastrous inflation spikes that ruined many a government, it was determined that central banks needed to be independent of the political leaders so that they could follow the ebbs and flows of the economy rather than the desires of the politicians. The U.S. Federal Reserve is such an independent body with a Board of Governors whose members are nominated by the President but approved by the Senate. Their terms do not match the terms of the President or Senators and the decision-making process is consensus based. The body that makes the important decisions regarding the Federal Funds Rate is the Open Market Committee and it is composed of the members of the Board plus four of the regional Fed Presidents that rotate in for one-year terms. They are selected to the role of regional President by a local board. The point of all this description is to demonstrate that the Fed is truly designed to be independent.
Since the central banks were formed, they have had dual mandates: maintain a lid on inflation and promote job growth. These can often be mutually exclusive goals. If one opens up the flood gates to push growth, there will be significant issues with inflation under control, the impact on growth will be swift. The primary tool used to adjust between these two goals has been the Federal Funds Rate. Raising interest rates will clamp down on inflation and lowering them will result in growth. Atleast that is the way it is supposed to work. The problem is that this system has not worked as it should for the better part of a decade and the Fed ( as well as most of the other central banks ) are now engaged in a radical rethink.
There are at least three fundamental questions to be addressed. The first is whether there is going to be a future threat from inflation sufficient for the Fed to worry about. The second is whether the Fed could do anything about that if it wanted to. The third is whether the Fed even has the tools to stimulate the economy these days.
There are many factors that drive inflation. The three that are at the top of the list have been wage inflation, commodity inflation and the inflation of the money supply. None of these are manifesting as they would be expected to. Just a few months ago the unemployment rate stood at a record low of 3.5 percent and yet there was no wage inflation. The Phillips Curve states that there should be but it was nowhere to be seen. Now the unemployment rate is over 10 percent and that certainly mitigates against higher wages. There has been no surge in commodity prices either – even when demand was strong. Oil prices stayed down and at one time hit record lows. Metal prices, farm prices – all of them have remained low despite some temporary spikes. One would have assumed that dumping trillions of dollars into the economy would have created the inflation that comes with an expanded money supply but it hasn’t. What has been accounting for this?
The primary issue is lack of demand. The latest surge of spending by governments trying to stimulate the economy has coincided with a lockdown recession. The decisions to close businesses and restrict others has meant that people have fewer options available to them as far as spending is concerned. Even before this crisis there was reduced demand due to simple demographics. The Baby Boomer has long been the spending machine and now they are at the point in their lives when spending slows. the Millennial and the Gen-Z consumer has not picked up the slack. The Fed has put a lot of money in the hands of the banks but they are not lending aggressively as the economy is weak and there has been both reduced demand and fewer qualified borrowers. The bottom line is that inflation has simply not emerged nor is it likely to any time soon.
This leads to the decision by the Fed to declare their intent to leave interest rates very low and for an extended period of time. There has been an expectation that rates would go up when the rate of core inflation reached 2.0 percent to 2.5 percent, but now the Fed has indicated they will not automatically move interest rates up in the event inflation hits that level. There has not been a replacement goal suggested so it becomes anybody’s guess what level would trigger a response.
At this point there is nothing on the horizon that would indicate any rise in inflation. None of the triggers are active and until there is full recovery from the pandemic-inspired recession there is little to move them. The Fed has all but stated that rates will remain where they are for the next year or more. That can always change but this is the pattern for now.
A bigger question is whether the Fed or any other body can do much to spur growth. It has been assumed that lowering rates would trigger lending and borrowing but rates have been down for years and that has not occured to the extent expected. The fiscal side has dumped money in the economy through a variety of spending efforts and reduced taxes and there has been tepid response at best. The best description of the consumer these days is tired. Most markets are saturated ( there are almost two cars for every household in the U.S.)
Consistently low rates will have long-term implications for investors as well. Bond yields will remain low and that will mean low mortgage rates as well. The dollar will weaken to a degree but since every other nation has low rates, the dollar is not all that adversely affected. Returns on investment will be reduced and that pushes investors away from bonds and towards riskier equity markets and even commodity markets.
It was once the case that strategies needed to take account of both high and low inflation periods and therefore high and low interest rates. This is not the case for the immediate future as there is little or no chance of rising interest rates or rising inflation.
Chris Kuehl, Phd., is an economist and Managing Director of Armada Corporate Intelligence. Visit armada-intel.com for more information.