Trump Bashes the Fed Over Rate Hikes
The Federal Reserve and the Holy Natural Rate of Interest
The Federal Reserve is on a Monty Pythonesque search for the Holy Grail of natural interest rates—the Wicksellian natural rate of interest. As the market reels in wild 3-5% intraday declines, it replies to the Fed, “It’s just a scratch. I’ve had worse. C’mon you pansy.” In clueless King Arthur fashion, the Fed continues to slice off market indices gains.
The Fed has captured Monty Python’s absurdity in its search for the natural rate of interest but missing is the comedic punchline. It’s not funny. Certainly, Trump doesn’t think so.
Knut Wicksell was a Swedish economists who in 1898 defined the natural rate of interest as the interest rate that is compatible with a stable price level. A rate too high contracts economic activity, while a rate too low does the opposite. It is the Holy Grail of interest rates. The Fed is no less ridiculous than Monty Python’s King Arthur on his pretend horse–imitated by the sound of coconut husks banging together–traveling the academic theory landscape in search of its interest rate Holy Grail.
The joke of course, for those aware, is that the Fed doesn’t set the natural rate of interest. Nor is there a need to search for it. On a gold standard, the market sets the natural rate of interest, and it is historically low. This is how the Fed operated from its start in 1913 until Nixon abandoned the Bretton Woods gold standard in 1971. The market set the funds rate, and the Fed didn’t tinker with it. The Fed’s only job, besides acting as lender of last resort in a once in a blue moon crisis, was to adjust the supply of base money so that the dollar maintained its fixed value with gold. When the Fed properly linked the dollar to gold at its fixed value, it removed the destabilizing threat of inflation and deflation. Without the threat of inflation or deflation, interest rates were naturally low and stable—the natural rate as Wicksell posited. At the peak of Bretton Woods, the funds rate was 1%. There was no need to search for the natural rate of interest because it occurred organically on a gold standard.
Since 1971 interest rates have been anything but stable. After a decade of QE manipulated interest rates, the funds rate no longer has its historical link to market forces. The result is that the Fed’s attempt to find the natural rate of interest is inverting the yield curve. Since the 2008 financial crisis and the onset of QE, the Fed has created, and exported to global central banks, a monetary mess that has no precedent in history. The global financial system is in uncharted monetary territory and is cluelessly trying to find its way out.
Recognizing the Fed’s attempt at normalization while the other major central banks continued QE, I saw a disconnect that would roil markets. I wrote about this inflection point in February 2018, Market Inflection. Market indices have yet to regain their highs eight months later.
What is missing in the current brouhaha between Trump and the Fed over funds rate hikes is that QE has so distorted the price of interest and misallocated capital that tinkering with the funds rate is ultimately meaningless compared to the severe structural issues that a decade of errant central bank monetary policy has created. One need look no further than the global debt overhang that is threatening local, state, national, and sovereign solvency. Meanwhile, excess reserves and interest on reserves (IOR) continue to distort monetary policy.
Certainly, the Fed abandoning its Holy Grail search for the natural rate of interest with its planned fund rate hikes would be a relief for markets. There would no doubt be a relief rally if that happened. But ending funds rate hikes will not solve the structural problems that are threatening the global financial system. The only closed economy is the world economy. It is a mistake to think of U.S. markets in isolation. Trade wars, currency manipulation, nationalism, and voter revolt are the natural outcome of decades of monetary error. The U.S. cannot isolate itself from these structural global economic issues.
The root of the issue is monetary policy. Until the world returns to stable money, the other structural issues cannot get addressed. Tax cuts alone will not solve the economic issues like they did in the 80s. Today is a completely different monetary environment than the 80s. Stable money has to come first. The only way to get stable money is to negotiate another Bretton Woods-type international monetary system. Gold will once again have to back the system. China seems to be the only country that understands gold’s historical monetary stability. The U.S. should lead the way but is lacking the intellectual foundation to recognize the solution.