Thursday, September 22, 2016

Monetary Policy is like backing up a trailer.

I like to think of monetary policy like backing up a trailer.  In this graph of interest rates and GDP growth, think of the Federal Reserve as backing up a trailer through time.  When the trailer goes to the right, inflation and interest rates go up.  When the trailer goes to the left, inflation and interest rates go down.

The truck is short term rates.  The Fed has direct control of the steering wheel.  The trailor is long term interest rates.  The Fed only has indirect control of the direction the trailor is going.
In the 1970s, the Fed was slightly biased towards accommodation, so as the trailer started to veer right (long term rates rising), they would turn the steering wheel to the right.  But, they wouldn't steer it far enough to get the trailer to start turning left again.  So, as happens when you back up a trailer, interest rates would just keep moving in the same direction.
Eventually, they would turn past the tipping point, and the trailer would veer back to the left (long term rates falling).  Then, just as with a trailer, they would have to quickly turn back to the left (lower short term rates) in order to keep the momentum from swinging to far in the other direction.
In 1981, Volker took a very hard turn to the right.  He really cranked that wheel.  Then he took a hard turn to the left, then straightened it out.  It was a little wobbly, as backing up always is, but for the next 30 years, the Fed was backing up on a vector slightly to the left.
In the 1980s and 1990s, if the trailer started veering left, the Fed would turn left enough to get straightened out again, but that was about it.  They would turn the wheel back to the right and then straighten it before it got moving too far to the right.
In 2002, they straightened out the wheel, before the trailer started turning right.  Then, while the trailer was still basically going straight, they started turning the steering wheel to the right.  NGDP was moving along at 6% or so with no sign of acceleration and long term interest rates were moving along at 4% with no sign of acceleration.
Misunderstandings about the causes of the housing bubble made everybody freak out.  We made ad hoc theories about how low short term rates cause asset bubbles, even though the NASDAQ bubble had just happened 5 years earlier while both short and long term real rates were relatively high.  Even though housing Price/Rent ratios had been pretty high in the 1970s and 80s with double digit mortgage rates.  Even though inflation (especially outside of shelter inflation) was low.  We reasoned from a price change about housing and ignored every other indicator there was, and started cranking that steering wheel to the right.
The inevitable happened in 2007.  And, when the trailer took a hard turn to the left, the Fed reacted by turning the steering wheel sharply to the left.  But, when a trailer gets that far from straight, you have to turn that wheel like crazy to correct it.  It sure felt like the Fed was turning the wheel like crazy, but they never really even turned enough to the left to get the trailer straightened out.  When we hit the zero lower bound, we were jackknifed.
QE helped to get things straightened out a little.  But, with a few wiggles along the way, the trailer has basically spent the last decade still veering to the left.  Now, we are in an even worse position than we were in 2004.  The trailer hasn't even straightened out yet.  It's still veering left, and yet the Fed has started turning the wheel to the right already!  GDP growth and long term rates are giving a clear signal.  We are so wound up, we will be jackknifed again before the Fed has time to even crank the wheel back to the left.  When that happens, I just hope they see what's happening quickly enough, and have the resolve to counter with the QE to end all QEs until this thing gets straightened out.
But, considering that some Fed officials still talk as it they had the steering wheel pinned to the left in 2008, when they objectively had straightened it out at 2% as the trailer was careening for the ditch, I'm not sure we can count on that.
In the meantime, much of the public, including the financial community, is standing along the road, "helping", saying, "Yeah.  Crank 'er right.  You got it.  Give 'er a good hard turn."  All I have to say is, when Wall Street layoffs start coming down, I hope the former fixed income traders that have been "helping" don't go into trucking.


  1. Kevin--You have topped yourself again. Superb blogging.

    Send the Fed to 18-wheeler driving school!

    And hey, QE is nice, but really it is time to send in the helicopters. Let it rip. Hueys, Chinooks and Sikorsky I love you.

    Actually, I favor money-financed fiscal programs, but those being tax cuts on working. (But it is more fun to call in the choppers.)

    My favorite is a holiday on FICA taxes offset by Fed purchases of bonds that are placed into the Social Security and Medicare trust funds.

    But hey, that would increase incentives for working and hiring. In fact, the only people who would benefit (immediately) would be those people in the above-ground economy who work and hire,

    But why help them?

  2. Lol, fixed income traders shouldn't go into blogging. That was funny Kevin.

    I hear Bill Bonner and others say QE will cause this inflation or that inflation, but it is sterilized. It is nothing. Ben is right, time for helicopter money. Japan won't do it so somebody else should do it.