Friday, September 30, 2016

Another Compelling Reason to End the Federal Reserve

In recent weeks, Donald Trump has been making the case that the Federal Reserve’s decisions are motivated by politics. There are good reasons for believing this is the case, as we’ve argued previously. (See “The Myth of an Independent Federal Reserve”)
What often gets overlooked in this debate, however, is the alternative.
If the Fed is not political, then the actual explanation for their behavior may be even worse: They are completely incompetent.
Strong words require strong evidence. So we submit this delightful chart, as cited by Zero Hedge.
In the chart above, the FOMC stands for the Federal Open Market Committee, which is simply the part of the Federal Reserve that sets interest rates and monetary policy. In most contexts, the FOMC and the Fed can be used interchangeably.
Meanwhile, the Federal Funds rate is the interest rate that the Fed changes in order to influence economic activity. When the economy is strong, the Fed will consider raising the Federal Funds rate. When the economy is weak, the Fed will typically reduce the rate in an effort to stimulate the economy. Critically, the Fed has exclusive discretion over setting the Federal Funds rate.
Thus, in the chart above, the colored lines represent the Fed’s own projection of the Federal Funds rate in the future, as expressed at the FOMC meetings. They are literally forecasting their own future decisions.
The dotted black line is what actually happened. And there’s the rub.
As you can see, reality bears no resemblance to the forecasts of the Fed. The Fed has been dramatically and consistently wrong, overestimating the future rate path in each case.
This is remarkable because, again, they are forecasting their own decisions. And they still can’t get it right.
At each press conference and interview, Fed officials tell the public that the economy is very healthy and should be able to absorb a rise in interest rates. But when it comes time to actually raise rates, they don’t follow through.
This behavior makes sense if they’re being political–constantly overstating the health of the US economy makes the party in the White House look better. It also makes sense if they’re clueless–they genuinely believe their own narrative that economic growth is always about to accelerate, and they are just constantly wrong.
No other explanation works.
For instance, it may be tempting to imagine a more sophisticated motive for the Fed’s behavior. Perhaps the Fed is deliberately misleading the market about the health of the economy to keep investors confident? Maybe, but this would be a very dangerous approach. After all, investors use expectations of future interest rates in order to make long-term planning decisions. If investors make these decisions using flawed information, they will make bad decisions–which would have severe negative consequences for the economy. Thus, we should not assume the Fed is reckless enough to use deception as a deliberate policy tool.
So we’re left with politics or incompetence to make sense of the Fed’s behavior. Unfortunately, the economy suffers either way.
Because if the Fed can’t even make reasonable forecasts, it can’t possibly be trusted to determine the “correct” level of interest rates for the world’s largest economy.

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