How Hot is Too Hot?
by John Kernan
Many of our clients have been asking questions about the (real or imagined) “peaking” of the market. They have seen one of the longest continuous bull markets in history and are telling themselves that the party must end sometime. One of the more confusing pieces of this puzzle is the role of the Federal Reserve and its interest rate policy. The Fed plays a delicate game with interest rates. It seems like the markets live or die by the Fed’s moves, and what the Fed does with rates has real consequences for all kinds of investors and businesses.
What is the “game,” exactly? What makes an interest rate “too low”? Wouldn’t we want the economy to grow as much as possible, all the time?
It comes back (as it always does) to the laws of supply and demand. If the economy is doing well, people are feeling good, and businesses are selling their products, it creates a self-reinforcing cycle. More products being sold leads to managers increasing their purchases of equipment, hiring new workers, and extending workers’ shifts. These workers then have more money, start spending more, and so on.
Then, when the cycle eventually turns downward, businesses are left hanging with too many employees, too much equipment, and too much inventory, which results in lower prices, which decreases business income, which results in more layoffs, which means less consumer spending…
The debate comes in when we try to pin down what is causing these fluctuations. Classical economists argue that the causes are mostly exogenous, a result of factors beyond the reach of the markets or their policies, such as a war or a major technological change. Underconsumptionist (or Keynesian) economists argue that endogenous factors cause recessions, with private firms making decisions that lead to inefficient allocations. These decisions must then, they say, be corrected with policy changes¹.
Let’s compare these theories with what the Fed actually does. The Fed’s buying or selling of bonds increases or decreases money available in the banking system. Doing so is an attempt to curb the effects of the business cycle on both ends. Preventing the economy from getting “too hot” means discouraging businesses from overinvesting when times are good by increasing the costs of borrowing to finance those purchases. Stimulating a lagging economy is accomplished by making more money available to businesses for investment, hence the term “easy money.”
These policies sound great in theory, but there are plenty of people who disagree. The aforementioned economists who believe in exogenous (external) causes to market cycles argue that tinkering with interest rates only increases the inefficient allocation of resources. The division is not absolute, and many economists who believe in exogenous factors still argue for some degree of governmental involvement, and vice versa.
We’ve now painted a brief picture of the dizzying field of modern economics. Throw in political pressures, and the Fed has quite a task on its hands. The mandate given by Congress is for the Fed to maximize employment, stabilize prices, and moderate long-term interest rates.
There are many, many factors that the Federal Open Market Committee at the Fed considers when making a decision regarding interest rates. Since inflation is straightforwardly set by monetary policy, it would seem to be simple for the Fed to buy or sell bonds to increase or decrease the money supply, thereby increasing or decreasing inflation.
But in practice, much of the reality of inflation is out of the Fed’s hands, or is inversely linked to employment. What would lower inflation would raise unemployment, and vice versa. Inflation depends not just on the existence of more money, but also on its velocity, or how quickly it is being spent. Since the financial crisis, large financial institutions have been very slow to spend money, resulting in a low velocity of money. If firms suddenly had a shift in preferences and began spending that money (again, which would be largely outside the Fed’s purview), inflation would rise, and the Fed would need to increase its purchases of bonds to keep it under control, potentially interfering with its other policy goals. So, how hot is too hot, when it comes to interest rates? Unfortunately, the answer is highly dependent on how the Fed views the current state of the economy. It depends.
Expectations about what the Fed will do also significantly affect the economy, so an important part of its policy implementation is how it communicates with the public. The Fed conducts and publishes many research initiatives to communicate to the public its expectations for the economy. This allows businesses to better plan for the future and gives decision makers more confidence in their choices.
Coming back to the question at hand. How hot is too hot? If one of the goals is maximum employment, what is the Fed’s unemployment target? Of course, it can’t be zero. There is a natural rate of turnover when people are between jobs. This is confounded by the recent phenomenon of labor force drop outs. What is the “natural” rate of labor force participation? The maximum employment rate is, in fact, a moving and elusive target. The Fed must decide on a level that is right for any given environment. How hot is too hot for unemployment? It depends.
The third mandate, stable interest rates, means that the Fed must also have some foresight into what the short and medium-term effects of its actions will be. If interest rates are to remain steady, the Fed cannot put itself in a position where it must react to sudden swings in employment or inflation. Otherwise, corrective action by the Fed would mean highly volatile interest rates. How hot is too hot? It depends.
¹ There are many other ways to explain booms and busts. A few examples are the Austrian, Real Business Cycle, and Marxist economic theories, as well as pointing to the credit/debit cycle or to politics.