Dec 19, 2018

Why the Fed was right to hike

Reproduced from Federal Reserve Bank of St. Louis; Note: Trimmed mean PCE inflation rate used as measure of inflation; Chart: Axios Visuals

The Fed's dual mandate — delivering both maximum employment and low inflation — requires a balancing act: Low interest rates help to bring down unemployment, but according to economic theory, they also risk causing inflation. In reality, thanks largely to China, inflation has not been a problem for decades.

The big picture: The Fed's preferred inflation measure, PCE, has been below 3% for more than 25 years. Unemployment, on the other hand, has been a tougher problem to solve: It reached 10% in late 2009. The temptation, then, is always to keep interest rates very low, as President Trump desires.

  • But when interest rates stay very low for an extended period of time, that has the effect of creating asset bubbles like the credit and housing boom of the mid-2000s. Since 1995, the ratio of U.S. assets to GDP has risen from 4.6 to 6.8.
  • To put it another way: If your stocks, bonds and real estate holdings were worth the same today, relative to GDP, that they were worth in 1995, they would have to crash in value by 33%, or $43 trillion. That's more than enough to trigger another financial crisis. (The stock market right now has lost about $4.1 trillion, compared to its all-time high in September.)
  • "Asset bubbles have been a far greater source of economic disruption over the past 25 years than any increase in inflation," says David Kelly of JPMorgan Funds. "While the Fed has kept policy tight enough to restrain general inflation, this has not been enough to slow a too-fast increase in asset prices."

The only way to prevent another catastrophic asset bubble is to allow interest rates to revert to something much more normal. That's what the Fed is doing today.

  • The rate hike also gives the Fed some much-needed ammunition for when the next recession arrives. Cutting rates to zero is easy; then you run into difficulties.
  • By hiking rates, the Fed also does what it said it was going to do. Making sure that the Fed delivers on its promises is the best way for Powell to preserve the Fed's credibility in the face of onslaughts from the president.

The bottom line: In the 50 years before the financial crisis, the real Federal Funds rate was positive more than 80% of the time. Its recent return to positive territory, for the first time in over a decade, is something to be welcomed.

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