Last week, the Federal Reserve chose to do nothing to move short-term interest rates away from zero after nearly 6 years of extraordinary policy distortion. As detailed below, the inaction of the Fed, and the failure of the stock market to advance in response, follows the script that I detailed in February. Policy makers at the Fed actually appear to believe – contrary to historical evidence and contrary even to the recent experience of numerous countries around the world – that activist monetary policy has meaningful and reliable effects on subsequent economic activity. It’s lamentable that otherwise thoughtful policy makers, much less journalists who cover these actions, show no interest in how weak these correlations are in actual data, and seem incapable of operating even the most basic scatterplot. Despite the spew of projectile money creation around the world, the global economy is again deteriorating. The main defense of the Fed’s inaction seems to be that years of zero interest rate policy have been hopelessly ineffective, so continued zero interest rate policy is necessary.
As we’ve demonstrated previously, there’s no statistical evidence in the historical record to suggest that activist monetary policy has any relationship to actual subsequent economic activity (see The Beauty of Truth and the Beast of Dogma). Historically, monetary policy variables themselves can be largely predicted by previous changes in output, employment and inflation. That “systematic” component of monetary policy does have a weak correlation with subsequent economic changes. It’s unclear whether that’s purely incidental, or whether those systematic changes in monetary variables (such as short-term interest rates) are actually necessary for the weak effects that follow. I should be careful to note that monetary policy also seems to weakly influence confidence expressed in certain survey-based questionnaires. But that correlation emphatically does not translate into changes in actual output, income, or employment. Put simply, massive activist deviations from systematic monetary policy rules provide no observable economic benefit, but instead create fertile ground for speculative bubbles and crashes.
Despite its wild grandiosity, Fed intervention was not what ended the global financial crisis. Recall that the global financial crisis ended – and in hindsight ended precisely – on March 16, 2009, when the Financial Accounting Standards Board abandoned FAS 157 “mark-to-market” accounting, in response to Congressional pressure from the House Committee on Financial Services on March 12, 2009. That change immediately removed the threat of widespread insolvency by making insolvency opaque. This might not have meant much if regulators had continued to insist on mark-to-market when evaluating bank solvency. But with regulators willing to go along, the global financial crisis ended with the stroke of a pen.
Those who hail the March 2009 replacement of mark-to-market with mark-to-unicorn as a “necessary” response miss the point (though Iceland has actually done quite well relative to the rest of the world, despite initial disruption, by insisting on massive bank restructuring rather than playing extend-and-pretend). The point is that Fed intervention did not end the crisis, nor would a global financial crisis have occurred in the first place without combination of an activist Fed and a misregulated financial sector. Absent the restoration of Glass-Steagall and greater rules-based constraints on the Federal Reserve, none of the policy responses since 2009 (including Dodd-Frank) effectively reduce the risk of similar speculative bubbles and crises in the future.
Fed easing certainly increased the stock of bank reserves and enabled banks to satisfy withdrawal demands during the crisis – the legitimate function of a central bank. Ben Benanke's violation of Section 13(3) of the Federal Reserve Act (which has since been rewritten by Congress to spell the law out like a children's book) also helped some financial insitututions illegally dump bad securities onto the public balance sheet. Despite these actions, Fed intervention did not produce the economic recovery. The entire recovery we’ve observed in the economy since 2009 has actually represented standard, systematic mean reversion. Indeed, as I demonstrated in March (see Extremes in Every Pendulum), the progress of the economy since 2009 has been somewhat below what would have been predicted from past values of non-monetary variables alone. Adding monetary variables does not meaningfully improve the power to explain either recent or historical economic fluctuations.
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