The Hubris of Keynesianism is Driving the Fed’s Interest Rate Hikes

Jun. 13, 2018
by Bob Adelmann

The core underlying principle of Keynesianism is that the massive $21 trillion American economy can be “managed” by “experts” sporting fancy degrees from prestigious colleges and universities. The fact that they take themselves seriously, as does most of the media, reminds one of the story The Emperor’s New Clothes. Everyone in the crowd believed until the little girl exclaimed, “The Emperor has no clothes!”

That time has not yet arrived for the Fed. Amy Scott, writing in Marketplace, continued to believe the emperor is clothed:

The Federal Open Market Committee begins its two-day meeting today to talk interest rates. The Fed is expected to raise its target rate by a quarter of a point for the second time this year [tomorrow]. And with unemployment reaching a new low last month and inflation creeping up, analysts expect officials to keep raising rates throughout the year.

If short-term yields keep rising, that could lead to what’s called an inverted yield curve, when short-term term rates are higher than long-term borrowing costs.

First, Scott is conflating inflation with price increases. Second, she is likely referring to the latest CPI numbers and not the Fed’s preferred measure of price increases, the PCE index.

Inflation has already occurred. The Fed created billions of digital dollars when it bailed out the big banks following the real estate collapse in 2007-2008. In fact its balance sheet is so toweringly massive – over $4 trillion – that it is slowly beginning to sell off some of those reserves.

Price increases are the result of the previous inflation. Those price increases have been held in check largely because banks have been, until recently, unable or unwilling to lend out their residual capital. They have been content to keep their excess reserves encamped with the Fed, which has been paying them a low but predictable and risk-free rate of return.

The CPI accelerated in May to the fastest pace in more than six years, according to a Labor Department report released on Tuesday, rising 0.2 percent from April and 2.8 percent from a year ago. This is serving, according to many commentators, as justification for the Fed’s continual raising of short-term rates. But a closer look at the Fed’s preferred measure of inflation, called the “annual core PCE” price index [personal consumption expenditures, excluding food and fuel], reveals year-over-year price increases at 1.8 percent.

But with the Fed determined to head off what it perceives as incipient inflation (which it caused), it is likely to continue to raise overnight rates steadily. Its belief is that the massive U.S. economy can be managed by its board of “experts” more effectively than can individual consumers voting with their dollars. That is the hubris of Keynesianism, which is the Fed’s core operating manual.

Most “little girls” watching the emperors’ parade see that the only tools the Fed has are 1) bluster and baloney; 2) its digital printing press; and 3) its ability to change what it charges its banks for overnight loans. But those tools are dangerous in the hands of fools. Believing that inflation is about to rise from the ground, the board is determined to raise interest rates to head it off. Some call it “removing the punch bowl just as the party is getting started.” Others are concerned about the Fed’s inviting an inverted yield curve. Right now the “spread” – the difference between two-year rates and 10-year rates is 45 basis points (a basis point is one one-hundredth of a percent), down from 125 basis points just a year ago, and the lowest seen in years. As Justin Lahart, writing in The Wall Street Journal, noted: “This is a longstanding signal that a recession is coming.”

But is it? There have been false positives, as Goldman Sachs’ economist Jan Hatzius pointed out. An inverted yield curve “isn’t the cause of recessions so much as the result of the Fed trying to keep the economy from overheating.” In other words, recessions are more the result of the Fed’s meddling than the natural business cycle operating without outside interference.

The Cleveland Fed is approaching the matter much more calmly. Its internal calculation of the chances of a recession occurring in the next 12 months is a scant 13.4 percent, down from 13.8 percent last month. That’s less than once chance in seven.

For the moment a modest increase in overnight lending rates isn’t likely to slow the Trump freight train. But the Board bears watching for more foolish and dangerous moves in the future.

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Sources:

The Emperor’s New Clothes

The Wall Street Journal: Will the Fed Set Off a Recession Alarm?

Inverted yield curve definition

Marketplace.org: The Fed talks interest rates with an eye toward the yield curve

Bloomberg: Flat Yield Curve May Result in a More Aggressive Fed

The Cleveland Fed: Yield Curve and Predicted GDP Growth, April 2018

Bloomberg: U.S. Inflation Accelerates to Six-Year High, Eroding Wages

FXStreet.com: US: Annual core-PCE price index meets expectations with 1.8% in April

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