Is it time for the Federal Reserve to get REAL

I don’t claim to be a genius an intellectual or know what’s better for anyone else.

What I do know is that when I deposit my cash I demand the return to exceed inflation and cost of insurance for default (if I wish to purchase).

As can be seen from the above chart since 2000, and especially since 2009, real interest rates have averaged negative.

This is a result of the Federal Reserve implementing a real interest rate dictated by models that are above my pay-grade.

In its latest projections the Fed has Longer run inflation at 2% and the Federal funds rate at 2.5%, giving a long run real rate of interest at 0.5% (=2.5%-2%). i.e. QE infinity and beyond

This is a long way from its original projection in March 2013 of a long run Federal funds rate of 4% or a long run real rate of interest of 2%.

Contrast this with the 2023 August Chinese monetary policy review of keeping a reasonable growth of M2.

Which has updated its 2021 August guidance of keeping growth in line with nominal GDP.

If today’s inflation was caused by anything other than an excess of money supply, we would have seen the substitution out of products and a fall in their prices to compensate for the increase in demand of other products. But now the economy has adapted to QE / modern monetary theory (zero time value of money) and is just as sensitive to changes in interest rates as ever.

Now is only 13 months since the Fed rates interest rates from near zero, but the central bank has forgotten the 1955’s Fed Chairman’s message “take away the punch bowl just as the party gets going”, which implies a lag in effect of monetary policy. Instead, today’s monetary authorities plead their policy to be dictated by data (headline inflation). This ignores the transmission mechanism for monetary policy though the finance industry, by a change in lending ability (data to which monetary authorities also have full access).

It may take decades to repair the economy from the QE experiment, however an immediate solution could be for the Fed to set a nominal effective fed rate of 4% (as suggested in the first dotplot) until inflation comes down to 2%, and then maintain a real interest rate of 2%.

On the flip side a 0.5% real interest rate identifies the hurdle rate for real project returns. As the Fed funds rate is the yield the government borrows at, it must expect real long run revenues (taxes) to increase at greater than 0.5%. If we assume tax revenues remain the same percent of GDP the government must expect real GDP to increase at above 0.5%.

The US government census estimate for population growth in 2022 was 0.4% this implies a minimum required productivity growth at 0.1%. (0.4%+0.1%=0.5%) or expected productivity growth of 1.4% (1.8%-0.4%) at long run real GDP growth projection. But the super productivity gains (way above 1.4% pa) in technology and pharmacy cannot not be fully implemented due to “zombie”: companies and venture capital projects, and inert assets (real estate) utilizing cheap funds. Once higher interest rates have removed funds from these assets, the capital could be applied to the most productive production techniques across the board boosting real GDP/capita growth.

Further, perhaps an easier method on financial regulation is to utilize the behavioural economics of self interest and competition rather than the dictate of intellectuals, bureaucrats and oligopolies.

We have seen that the banking industry is still characterized by too many “too big to fail” (outsized economies of scale) institutions e.g. SVB and Signature. Industry universal anti-monopoly/trust rules could encourage foreign ownership from countries with fair democracy and judicial system and, security vetting, to assist in the reduction in size of banks. Further a rule to require directors/employees/managers of banks to own 50% of its share capital (not options or salaries) may align their interests with clients deposits and further assist in the reduction in size of banks.

In short, simple solutions may be the easiest explained and implemented for a sustainable and distributed real economy, being: 1) sound and fair money 2) ceasing of inefficient government expenditure 3) strict implementation of anti monopoly/trust rules 4) all citizens to be self-sufficient or productive.

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