Central Banks Now Need Government Cooperation

Michael Rudd, CFA | President, CEO and Portfolio Manager

Since 1913, the United States Federal Open Market Committee (FOMC), which is a collection of regional Federal Reserve Bank Chairmen and Chairwomen, has been attempting to manage the US business cycle. More recently, they have been focused on a dual mandate of price stability (inflation) and maximum sustainable employment. Stable inflation has traditionally been defined as 2% per annum, while full employment has traditionally been defined as an unemployment rate below 5%. Many readers will remember the 1970’s when inflation was much higher (just under 15% year on year) and Paul Volker, FOMC Chair at that time, raised administered rates to 20% in March of 1980 to bring inflation under control. It took 5 years to accomplish that task (please see Figure 1).

After the commodity boom of the early 2000’s came the Great Financial Crisis. As administered rates and inflation were already somewhat lower, central banks started to use alternative measures (called quantitative easing or tightening) in attempt to impact the business cycle. This included purchasing bonds and mortgage backed securities in order to provide liquidity but also in attempt to further decrease interest rates with the goal of sparking economic activity. Figure 2 presents the time periods and fixed income rates during the multiple quantitative easing periods from 2009 through 2015.

  • Further review of Figure 1 shows the decreasing highs of the administered rates indicating a structural decrease in the ability of US monetary policy to influence the business cycle. This makes sense if you think about it in the context of your own mortgage. If mortgage rates get cut in half from 10% to 5%, people will buy a house and/or potentially move to a larger more expensive home; however, a 50% drop in mortgage rates from 4% to 2% does little to incentivize already overly indebted homeowners to further purchase again.
  • Figure 2 shows that interest rates, even with quantitative easing, have dropped over time and are now at new lows. Given the lackluster performance of the economy, this puts in questions the effectiveness of future monetary policy.

“This means that” we have become less confident in the FOMC’s ability to influence the current economic situation with monetary policy. While we believe that the committee will be able to provide sufficient liquidity to keep the financial system functioning normally, fiscal policy, promulgated by federal governments will be the only stimulus that truly impacts the ongoing economic situation.

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