An Urban's Rural View

It's a tribute to how low interest rates fell during the 2008 financial crisis that 10 years later, and despite three years of Federal Reserve increases, they're still well below historic norms. Everyone expects they'll continue to go up.

The question is how far. Alas, the experts can't provide the definitive answers farmers and other business borrowers would like. Consider the varying interpretations two Bloomberg pundits gave to a fairly clear major speech by the Federal Reserve's new chair, Jerome Powell (https://www.federalreserve.gov/…).

To Tim Duy, an economics professor at the University of Oregon, "Powell left the unsettling feeling that monetary policy can be summarized as 'We plan to keep hiking until something breaks.'" (https://www.bloomberg.com/…) Duy detected in Powell's speech a real danger that the Fed will continue tightening even after it has returned the baseline short-term interest rate to its historic "normal," "neutral" or "natural" level, the level at which the economy is growing at potential with inflation contained.

Noted Wall Street economist Mohamed El-Erian read the speech very differently. He thinks the Fed will raise rates one more time, at its Sept. 25-26 meeting, but may well stop there rather than continue with yet another increase at its December meeting. "I wouldn't be hugely surprised if a rate increase in September wasn't followed by one in December," El-Erian wrote. "In another scenario, the Fed would carry out the September and December increases but take a longer pause in March." (https://www.bloomberg.com/…)

How can two knowledgeable people disagree so profoundly in their reading of a speech? In part, it's about the men as much as the speech. El-Erian, for example, is an expert on developing-world financial crises, and he sees one coming soon. He thinks the Fed will be forced to halt its hikes to stop the crisis from spreading. (Powell's only reference to this possibility? "As always, there are risk factors abroad and at home that, in time, could demand a different policy response.")

The more important reason for the difference lies in the speech itself, which truly is subject to different interpretations. I can testify to that; my reading of it differs from both Duy's and El-Erian's.

Early in the speech, Powell says the Fed will continue to raise interest rates "gradually" (code for in quarter-point increments) until they reach "normal" levels. So, let's calculate.

The Fed's baseline interest rate is currently in a range from 1.75% to 2%. The normal rate? It's a matter of debate. Powell talks a lot in this speech about the Fed's difficulties in determining what's "normal," not just for interest rates but also for the unemployment rate and economic output. Still, the norm -- the level that neither stimulates nor slows the economy -- for the Fed's baseline interest rate is by all accounts somewhere between 2.5% and 3.5%.

To get to normal, then, would require from as few as three to as many as six quarter-point increases. Either number would be more than El-Erian's interpretation but fewer than Duy's.

It's pointless to argue with El-Erian's crisis speculations, other than to say if the Fed believed him, Powell would have given a very different speech.

We can ask why Duy thinks the Fed would continue to raise rates past "normal" and into tight-money territory. I reread the speech in search of passages justifying his view. I found but two.

One was the uncertainty over "normal" interest-rate levels, which Duy might read as implying the Fed will redefine normal upward as it goes along. The other was a statement of current Fed policy at the end of the speech that differed from the one I cited in not referring to normalization: "If the strong growth in income and jobs continues, further gradual increases in the target range for the federal funds rate will likely be appropriate."

Do these passages support Duy's view that the Fed will keep raising rates until a recession occurs? Taken out of context, maybe, but not if you've read the rest of the speech.

Powell dwells at length on the monetary-policy errors the Fed has made over the years by incorrectly estimating the natural rate of unemployment, the rate producing the most jobs without touching off inflation. The lesson Powell says he has learned from Fed history is the importance of anchoring long-term inflation expectations.

"With expectations anchored, people expect the central bank to pursue policies that bring inflation back down, and longer-term inflation expectations do not rise," Powell says. "Thus, policy can be a bit more accommodative than if policymakers had to offset a rise in longer-term expectations."

Note, please, that Powell believes long-term inflation expectations are currently well anchored.

Powell cites with approval Alan Greenspan's mid-1990s reluctance to raise rates even though the unemployment rate was below the "normal rate." Instead of agreeing that this would spark inflation and justified tightening, Greenspan kept saying, "Let's wait one more meeting" before raising rates. He was rewarded, Powell says, with falling inflation.

As for the Fed's uncertainties about "normal" rates, Powell says they argue for proceeding cautiously if long-term inflation expectations are anchored.

Does this sound like a man who's going to keep raising rates until something breaks? Not at all.

Eurodollar futures market have priced in an expectation that there will be only three more rate increases (https://www.bloomberg.com/…). In the estimation of this Powell reader, the market is closer to right than either El-Erian or Duy. If so, we're looking at interest rates topping out a year or so from now at most a percentage point above today's levels.

Urban Lehner can be reached at urbanize@gmail.com

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