An Urban's Rural View

The Case for an Independent Fed

Urban C Lehner
By  Urban C Lehner , Editor Emeritus
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Throughout history borrowers have always outnumbered lenders, which is why low interest rates have always been politically popular. Sometimes, though, high interest rates are necessary -- to cool an overheating economy, say, or to tame raging inflation.

Ideally, then, central banks such as the Federal Reserve in the U.S., which set short-term interest rates, are independent agencies. It serves the public interest that they be insulated from political pressure. We want them to base their decisions on the state of the economy, not on the demands of Congressmen and Presidents. We need them to be able to "take the punch bowl away when the party's getting good."

It's good news, therefore, that in deciding to forego interest-rate increases for the indefinite future, the Fed showed no sign of caving to pressure from President Donald Trump, who had accused the central bank of "going loco" and ruining the economy. No one who follows the Fed thinks its pause was about the president.

But there is a question about the pause and the Fed's independence. It's whether the central bank bowed to pressure from the financial markets.

Should farmers, ranchers and other business borrowers care whether the Fed exerted its independent judgment or caved to the markets? Either way, rates will remain low -- right?

Actually, maybe not.

Here's the background behind the question. During last year's final quarter, equity and credit markets were as unhappy with the Fed as the president. Stock prices were plummeting because investors smelled economic weakness and therefore thought the Fed shouldn't be raising rates. It's no exaggeration to say the markets threw a tantrum.

For its part, the Fed saw an economy growing at more than 3% with unemployment below 4% and interest rates still at historically low levels. It, too, saw signs of weakness, but mostly overseas. Thus the Fed felt justified in continuing the gradual return of rates to something approaching normal.

Today the Fed says it sees signs of economic weakness here at home and therefore is putting rate increases on hold. Chairman Jerome Powell says the Fed will be "patient." Individual Fed members' forecasts, which had been indicating two interest-rate increases for 2019, are now leaning toward none.

Thus the question: Did the Fed change its view of the economy in light of new data? Or did it adopt the market's view because the tantrum was becoming intolerable?

Many market commentators think the Fed caved and will stay caved. By this logic there will be no more rate hikes this cycle, even if the weak data doesn't persist, on the theory that the Fed would not risk looking indecisive by changing its mind yet again. Markets are now predicting the next move will be a rate cut, with some market measures pricing in a cut this year.

If, however, the Fed's pause was truly data driven, if it wasn't just picking up the howling baby called the markets, it could resume raising rates should the data strengthen. A truly data-dependent Fed would not worry about appearing indecisive; it would just follow the data.

Whether the Fed caved, then, could indeed matter to farmers and ranchers. If the Fed was just following the data and if the data doesn't continue weak, there could be more rate hikes ahead. That's a couple of ifs, to be sure, but it's a possibility worth keeping in mind.

It's pertinent to ask whether caving to the markets is any different, really, from caving to the politicians. Isn't the Fed's independence undermined either way? The markets, arguably, represent the collective decision of millions of investors, the "wisdom," such as it is, of crowds. Aren't markets exerting the same kind of pressure for low interest rates as voters?

No, because voters always want low rates, regardless of what's happening in the economy. Investors want them low sometimes (in economies like today's, with slow inflation and an uncertain growth outlook) and high others (economies with rapid growth and surging inflation). If inflation raged, investors would dump bonds and rates would rise, even with the public and politicians screaming to keep them low.

If the markets, like the Fed, are data-driven, do we really need a Fed? Wouldn't the markets do the rate-setting job for us?

Sort of. But the markets react hair-trigger to every new number, while the Fed, sensibly, tends to weigh a variety of numbers over time. Markets also react, and sometime overreact, to political events, some of which end up being one-day wonders.

Moreover, much of the trading these days is done by machines programmed to anticipate how other traders will react to a number or an event and then get there first. This creates a pile-on effect that exaggerates price movements. In short, if we left the job to the markets, interest rates would be far more volatile than they are now.

So it boils down to this. Low rates are politically popular, but farmers and ranchers should be careful what they wish for. They might benefit in the short run from a Fed cave. In the long run all Americans will be better off with a truly independent Federal Reserve.

Urban Lehner can be reached at urbanize@gmail.com

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