I have previously written about the inherent risks of banks and why regulation is unlikely to eliminate them.
I suggested that the banking issues I highlighted were one example of a broader theme: citizens want their government to reduce or mitigate the risks they face. Unfortunately, government may not be able to do that – the “reduced” or “mitigated” risks may re-emerge in unexpected ways. In addition, the government’s actions may produce unexpected consequences.
In the case of banking, banks make risky loans with their depositors’ money, while depositors believe that their money is safe. The government attempts to protect deposits with deposit insurance and regulation (telling banks how to behave so they don’t go broke). Unfortunately, sometimes bank losses are so large that deposit insurance and regulation aren’t enough to protect depositors. Then we have bank runs and bank failures.
Can the Fed really manage economy-wide risks?
Today’s example of the difficulty of managing risks away is the Federal Reserve (the Fed). The Congress has charged the Fed with controlling inflation and unemployment. Sounds good, right? People don’t like inflation – prices and their dollars don’t go as far. People don’t like unemployment either – it’s hard to pay your bills if you don’t have a job. We’ll just get the Fed to set inflation and unemployment at reasonable levels – life will be better.
There are several important problems with this approach:
- The Fed does not have a precise understanding of how to influence unemployment and inflation.
- The Fed’s tools have side effects.
- The Fed’s efforts distract participants in the economy from economic fundamentals.
- The economy’s complexity makes it hard to assess whether the Fed’s policies are working well enough to be worth the side effects and distraction.
- Overall, government’s efforts to reduce risk often make us too complacent about the risks we face.
The Fed has a limited understanding of inflation
A New York Times article about the European Central Bank’s 2023 annual conference quoted central bankers themselves saying that they don’t understand inflation well. For example (emphasis mine):
“It’s been surprising that inflation has been this persistent,” Jerome H. Powell, the chair of the Federal Reserve, said.
“Our understanding of inflation expectations is not a precise one,” Mr. Powell said.
“…we don’t trust models enough now to base our decision, at least mostly, on the models,” said Pierre Wunsch, a member of the E.C.B.’s Governing Council and the head of Belgium’s central bank. “And that’s because we have been surprised for a year and a half.”
Mr. Powell’s comments came less than two years after he said, “Inflation at these levels [4.2% and 3.6% for the prior year] is, of course, a cause for concern. But that concern is tempered by a number of factors that suggest that these elevated readings are likely to prove temporary.”
The Fed’s tools have side effects
- Many economic models suggest a link between higher interest rates, lower inflation, and higher unemployment. That’s because under high interest rates, consumers and companies borrow less and spend less. The models say lower spending should lead to lower inflation. Unfortunately, companies that spend less tend to hire fewer workers. That could lead to higher unemployment.
The Federal Reserve controls two primary mechanisms it uses to raise (or lower) interest rates.
The federal funds rate
The Fed sets the federal funds rate, the interest rate banks use when borrowing and lending to each other. If banks can earn higher rates when lending to other banks, they become more willing to pay depositors higher rates. If banks must pay more to borrow from other banks, they’ll charge borrowers higher interest rates.
Bonds and cash
The Fed can exchange Treasury bonds and other bonds for cash, and vice versa. This changes the proportions of cash and bonds available in the economy. In theory, more cash and fewer bonds should make bonds scarcer, resulting in higher bond prices and lower interest rates.
- Selling bonds for cash should have the reverse effect. More cash in the economy also makes cash more plentiful. Cash that is too plentiful drives inflation.
“Surprising” effects of The Fed’s adjustments
In the November 2021 speech I quoted, Fed Chair Jerome Powell said he expected the Fed to keep interest rates low until the economy reached full employment and inflation was on track to “moderately exceed 2 percent for some time.”
“Full employment” is not well-defined. Inflation accelerated more slowly in 2022 than in 2021. The chart shows annual inflation rates in green and monthly changes in inflation in blue. Big dots mark the figures released just before Powell’s speech and the Fed’s first interest rate increase.
The Fed imposed its first interest rate increases in March of 2022, just 4 months after Powell’s speech. It increased rates from 0% to 4.65% within a year. Inflation was already running at 6% per year in November 2021, which some might see as more than “moderately exceeding 2%.”
Inflation continued to accelerate through February of 2022. This led the Fed to increase interest rates in March 2022. The point is not to quibble with the Fed’s assessment in November of 2021, but rather to observe that the Fed was unable to forecast inflation changes. Its knowledge of inflation dynamics is incomplete at best.
Silicon Valley Bank, Signature Bank and First Republic Bank were casualties of the Fed’s interest rate increases. When rates rose, the value of many banks’ assets declined. Depositors at these three banks became particularly concerned and withdrew their deposits, sparking “runs”. If these three banks relied on the Fed’s 2020 and 2021 stable interest rate statements as they made long-term loans, it cost them their businesses! The bank failures were side effects, unanticipated consequences, of the Fed’s interest rate increases.
The Fed confuses people by distorting economic fundamentals
Appropriate or “market” interest rates reflect the interaction between people’s willingness to wait to spend and the economy’s ability to deliver more in the future. When the Fed changes interest rates to influence inflation or unemployment, it distorts that interaction in favor of its own judgment.
When the Fed raises interest rates, it reduces the price of transferring resources from now to the future. Saving becomes more attractive. Consumers delay their spending – saving today will deliver more purchasing power tomorrow. Higher interest rates also make future payments worth less today. This makes investment less attractive. Investors are less motivated to invest in things like research and development, job training, commercial real estate development. Students become less likely to go to college.
On the other hand, when the Fed holds interest rates below what the market would set, it encourages investments that wouldn’t pay off if interest rates were correct. This leads investors to waste their money on low return projects.
The economy is too complex to tell if the Fed’s policies are effective
There’s an old joke about a man sitting on a park bench, reading a newspaper. After he reads each page, he crumples it and throws it over his shoulder. An onlooker asks the man why he’s throwing newsprint balls over his shoulder.
“To keep the elephants away!” the man replies.
The onlooker says, “But there aren’t any elephants anywhere near here.”
The man on the bench has the last word – “It’s working!”
The Fed can assert that its policies are working – that inflation and unemployment aren’t too high because of its decisions. We don’t get to see how high inflation and unemployment would be if the Fed intervened less. And, it’s difficult to assess the impact of the Fed’s economic distortions. For example, did the Fed inadvertently mislead those three banks, or were their failures due to incompetent, greedy bank leadership?
The government’s risk-reduction efforts make us complacent
When financial planning, we face many risks. Some are personal, like risks to our health or prosperity. Others come from the broader economy. Economic downturns can lead to slower-growing earnings or even lost jobs. Inflation eats away at our savings. Stock market crashes can dramatically reduce the value of our investments.
We ask the Fed to minimize inflation risk and keep unemployment low, to moderate the ups and downs of booms and recessions. We ask banking regulators to insulate depositors from their banks’ bad loans and inaccurate forecasts of interest rates. We ask securities regulators to protect us from fraudulent investments.
The government is not as good at any of these tasks as we would like. While the government may be able to moderate their effects in some circumstances, we still have business cycles, unemployment, inflation, bank failures and Ponzi schemes. If we rely on our government to smooth away all risk, it will disappoint us.
In the end, we are responsible for managing the risks we face. Specifically, we can:
- Seek out employers more likely to survive recessions without layoffs
- Make sure that all our bank deposits are insured
- Put excess cash in money market funds, since money market fund investors know who borrows their money
- Buy iBonds and TIPS to protect our savings against unanticipated inflation
- Diversify our investment portfolios
- Refuse to make investments that we don’t understand, especially if they seem too good to be true
The world and the economy are risky places. Our financial lives are more likely to succeed if we are wary of the risks and take full account of them in our financial plans and actions.