Yellen's Dots

The dots are moving higher.  Yikes!  Now more Federal Open Market Committe participants expect the Federal Funds target rate, which they control, to be at 1% at the end of 2015.  This is a move up from December's expectations and up from the current target at 0 -0.25%.  This reflects their view that the economy will be better and inflationary pressures beginning to head towards 2%.

IMHO, it is a sad state of affairs that Fed-watching has gotten to this point; but it is an inevitable outcome of a policy that tightly controls the most important price in the economy - the price of money. Deciding to reduce or increase this price via short-term interest rates favors or penalizes primarily real estate and autos, in the process thereby shifting or taking resources away from other sectors of the economy. 

Thinking through the consequences of tightly controlling interest rates answers some of the questions asked at Yellen's press conference, one of which questioned why the labor market improvement has been anemic despite aggressive policy stimulation.  Simply, in 2003 the Greenspan Fed pushed rates down to 1% and the worker force shifted to real estate - becoming brokers, mortgage lenders, construction workers, etc.  Then with a 2x4, it hit the labor market square on and pushed rates higher--throwing those sectors out of work.

To make a long story short, the labor market is not a simple commodity market.  Workers get experience in a certain area; they do not just change on a dime as prices are manipulated and their sector goes in and out of favor.  At every Fed Chairperson press conference, the question will be asked on why the recovery is taking so long.

Wall Street's perspective is simple:  the Fed is printing money and that money is going into stocks. Starting to close the spigot means stocks will have to trade or be priced the old-fashioned way--on earnings.  And that is scary, especially at present lofty levels.

The best policy move the Federal Reserve could take is to abandon controlling interest rates and to let the market set the price of money.  After all, that's what a free market is supposed to do.  Then Yellen's dots (based on FOMC member forecasts of economic activity which are themselves typically way off base) would be an academic exercise--which is what they should be. 

What is the Federal Funds Rate?

The federal funds rate is the rate banks pay each other for borrowing reserves. The Federal Reserve, the nation's central bank, requires banks to hold reserves against deposits. The Federal Reserve controls the federal funds rate. In effect, it is the price of money that they control.

Understanding the record in controlling this important price is key to understanding the housing crisis and the legacy of former Federal Reserve chairman Greenspan and the role of current chairman Bernanke.

Source: Baltimore Sun

As shown in the graph, the Federal Reserve lowered the rate to the unprecedented level of 1% in mid-2003 and kept it there for a year. Why? The party line was that the Fed was worried about economic weakness. This was after the dot-com meltdown in the stock market and the 9/11 attacks. Inflation had ratcheted down and  deflation was a worry. Looking over their shoulders, Fed governors saw Japan mired in a long-term economic slowdown because they didn't act aggressively  with macro economic policy.

But how weak was housing? The graph shows that single-family housing sales were on the upswing in 2003 as the Fed was aggressively cutting rates! Compare where housing sales were then to today, and think about the Fed and many others wondering why unemployment persists at such a high level.

Of course, all of this is history.  The Fed held the rate at 1% for a year starting in mid-2003 as the housing market went ever skyward!. Exotic mortgages were created. Mortgages were made with no down payment, no income requirements, and even the ability to have the principal increase over time as a payment option. Chairman Greenspan actually encouraged home buyers to use adjustable rate mortgages and take advantage of low teaser rates.

Gasoline was poured on a roaring fire. Bankers packaged and sliced and diced and manipulated ratings to push mortgage-backed structured product around the world. 

Then the Fed pulled the rug out from under the housing market. As shown in the first graph, they pushed the fed funds rate from 1% to above 5%. Again, the rest is history. Housing prices faltered, foreclosures rose, and the securities started to fall in price.

Today the federal funds rate is close to zero and has lost its capability to enable a pick-up in the economy. After all, it can't be pushed into negative territory.  Instead the Fed has come up with a new policy approach - "quantitative easing."  Quantitative easing is essentially an attempt to control the price of longer term money.

Part of the reason for the Chairman's recently instituted press conferences is to convince the American public he knows what he is doing.

Based on the record, I, for one, am not convinced.