Thursday, February 2, 2012

How Does the Federal Reserve Define "Exceptionally Low Interest Rates"

When we read mainstream media articles about Federal Reserve policy, we generally assume that all of the Federal Reserve Bank Presidents and policymakers have fallen into line with their leader, Mr. Bernanke.  Such is not always the case and, most recently, Philadelphia Federal Reserve President Charles Plosser has made it most apparent that he is a dissenting voice among central banker clones.

In recent days, Mr. Plosser has made it quite clear that he was strongly against late-January's decision to telegraph its ultra-low interest rate policies until at least late 2014, pushing the date out by 18 months from its previous forecast.  This, quite naturally, led to a rally in both stocks and bonds.  As additional background, Mr. Plosser also dissented on the decision made by the FOMC back in August and September to intervene further to push interest rates even lower, an action (Operation Twist) that involves selling $400 billion worth of the Federal Reserves' inventory of short-dated bonds to purchase longer-dated bonds in an attempt to push historically low interest rates even lower further out along the maturity curve.

Mr. Plosser is concerned about the actual definition of what is considered to be an "exceptionally low interest rate", particularly since the Federal Reserve has stated the following:

"In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014." (my bold)

Right now, the federal funds rate stands at around 0.1 percent with the Federal Reserve targeting a rate of between 0.0 and 0.25 percent where it has stood since December 16th, 2008.  

Here is a graph showing the Federal Funds rate since the mid-1950s showing that by any definition, a Fed Funds rate of less than 2.0 percent could be considered exceptionally low:

Here is a chart from the Fed showing the Fed Funds Rate back to 2003:

Here is a chart showing the Fed Funds Rate between 1992 and 2002:

As Mr. Plosser suggests, the lack of a definition of what actually is an exceptionally low interest rate is problematic.  When looking back at the historical record, an ultra-low interest rate could be anything up to a range of between 1.5 to 2.0 percent.  While rates of this magnitude are quite low by historical standards, a rise from today's zero percent to a rate approaching the two percent level would certainly cause massive grief to the economy.  Therein lies the problem.

As well, it is interesting to note that, despite the Fed's attempt to boost the moribund United States economy by lowering interest rates to near zero way back in December of 2008, over four years have passed and the economy simply has not co-operated by creating jobs, growing output at meaningful levels or reducing stresses in the housing market.  Not only has the Fed Funds Rate been kept low, but the Federal Reserve has undertaken two programs of Quantitative Easing (in addition to the Twist) that have tripled the size of the Fed's balance sheet; all to no avail.

Mr. Plosser goes on to state the following:

"You may know that I dissented from the FOMC decisions in August and September because it was not clear to me that further monetary policy accommodation (i.e. the Twist) was appropriate. After all, inflation was higher and unemployment was lower relative to the previous year. Moreover, policy actions are never free; they need to be evaluated based on a thorough analysis of costs and benefits. I believed that the benefits of further monetary policy easing were small at best, since, in my view, they would do little to help resolve the challenges we face on the employment front. But the potential costs of this further accommodation could translate into a steady rise in inflation over the medium term, even without much of a drop in the unemployment rate. In my assessment, the potential costs of further accommodation outweighed the potential benefits." (my bold)

I like that, "policy actions are never free".   Indeed, Mr. Plosser is correct.  Every action results in a reaction and, of greatest concern, an unpredictable reaction.  American central bankers have proven that they are hardly a prescient lot; for instance, by missing the impeding implosion in the highly over-leveraged residential real estate market that was at least partially a reaction to the Federal Reserve's interest rate policy in the early part of the last decade.  The Fed has no clue whether the economy will withstand another three years of ultra-low interest rates and what the impact of that measure will ultimately be.  America's economy could well end up in a period of stagflation where the economy ceases to grow despite record levels of monetary easing and the low interest rate environment ends up creating a period of accelerating inflation.

The greatest risk for the American economy lies ahead.  With the world entering a period of declining economic growth (or recession), central bankers are rapidly running out ammunition that could be used to stimulate much-needed future growth.  As well, despite the Federal Reserve's efforts to keep interest rates just above zero percent, the world's bond market may have other interest rate "suggestions" once the reality of a $15.3 trillion debt comes home to roost.

Only time will tell if Mr. Plosser’s concerns translate to reality.  Unfortunately, it may be too late for remedial action from America's central bankers by that time. 


  1. I see discussion of this possibility more and more over the net and expect it will be self fulfilling.