Fed Up

John Lim, 2:32 am ET

IS THE U.S. ECONOMY strong or weak? If you believe it’s strong—and apparently many investors do, judging by the U.S. stock market’s all-time highs—why is the Federal Reserve keeping the federal funds rate at zero? These days, it seems like we take the Fed’s policy of 0% short-term interest rates for granted. Yet such policy measures are truly extraordinary and typically reserved for an economy that’s in the ICU.

On the other hand, if you believe the U.S. economy is weak, why did the Fed just announce the tapering of quantitative easing (QE)? The Fed insists that tapering doesn’t mean a higher fed funds rate is around the corner. Instead, raising short-term interest rates would depend on the economy reaching full employment—whatever that is.

Still, tapering QE can be viewed as a form of monetary tightening. Researchers Jing Wu and Fan Xia modeled the economic effect of QE, which they dub the “shadow” federal funds rate. This shadow rate attempts to translate the effect of QE by estimating the equivalent fed funds rate necessary to have a similar economic impact. According to the Atlanta Federal Reserve, the current shadow federal funds rate is -1.7%.

If the Fed succeeds in tapering QE to zero by June 2022, that might be equivalent to raising interest rates by 1.7% or almost a quarter of a percent per month. Imagine the market’s reaction if the Fed announced a quarter-percent rate hike every month for the next seven months.

Whatever your view of the economy, I would contend that the Fed has already erred or is on the verge of erring. If the economy is strong, its zero interest-rate policy makes little sense. In this scenario, the Fed is behind the curve and should have raised interest rates already.

But if the economy is so weak that it needs the life support of zero rates and QE, then tightening monetary policy by tapering could tip the economy into recession.

Of course, there’s a third possibility. The economy could be lukewarm, neither too hot nor too cold. If this describes the current state, does it really make sense for the Fed to keep interest rates at zero until the economy reaches full employment?

As the purveyor of the price of money—namely interest rates—in the world’s most important economy, the Fed wields enormous influence. But in the end, its hand may be forced by stubbornly high inflation that isn’t as transitory as the Fed once assumed. The risk: The longer the Fed keeps rates at zero, the harder it may eventually be to rein in inflation. It would be especially problematic if inflation expectations were to shift permanently higher.

What does all this mean for how you invest? Not that much, really. More than anything, it’s a reminder of how much uncertainty exists—and how important it is to manage investment risk, particularly those risks that you can control. Given the complexity and vagaries of the economy, I wouldn’t make any major changes to your portfolio’s overall mix of stocks, bonds and cash investments—unless, that is, your allocation has deviated significantly from your target portfolio percentages. In the end, most economic predictions are next to useless from an investment standpoint.

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John McHugh
John McHugh
7 months ago

I suspect the Fed is just as clueless about what’s happening and what to do as all the rest of us, and is just making it up as they go along.

I’m also guessing all the policy makers are equally clueless.

It’s a big experiment and we are its subjects.

7 months ago

I for one trust (perhaps naively) that the Fed, with their enormous number of seasoned analysts and the staggering level of data they receive and have access to, are doing what they believe makes the most sense. We certainly are in an interesting period and while I continue to hear “listen to the bond market” from my fixed income friends, I do think the Fed will figure this out and navigate it smoothly. I’ll just continue to focus on the important questions (1) my time horizon and then requisite withdrawal rate and (2) my risk tolerance. But no bonds here, cash instead.

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