In a new Q&A format, Chief Investment Officer Jeff Mills and Director of Fixed Income Jim Barnes discuss the Federal Reserve banking system, starting with the basics and moving to more granular topics. What is the Federal Reserve system? What does the Fed do? What is the central bank? What is monetary policy? What is the Fed’s dual mandate? Listen for these and more – like a deep dive into interest rates – in BMT Wealth Management’s latest podcast.
Introduction (00:02): Welcome to the Bryn Mawr Trust Wealth Management podcast, providing commentary on what’s moving the financial markets, financial planning, and other timely business and monetary topics. Please welcome your host, Jeffrey Mills, chief investment officer at BMT Wealth Management.
Jeff Mills (00:19): Really excited to be with Jim [Barnes] today. I think this is a little bit of a different format. You know, we do these podcasts and they tend to be monologues. So I think Jim and I do most of them on the investment side. So Jim’s either talking about fixed income or I’m talking about our outlook. So we figured we’d mix it up here a little bit and actually have a discussion between the two of us and what better person than our director of fixed income to talk about our subject today. And we were thinking about different subjects. We want to do, we want to do more of these Q&A’s. So we thought we would start with something that’s front and center, but that may be, it’s still a mystery to a lot of people. And I think that that’s the Federal Reserve (Fed) and monetary policy and interest rates. I think if you, if you read the newspaper or you watch CNBC or, or any of these financial media outlets, you’re constantly hearing about record low interest rates and the fed and monetary policy.
Jeff Mills (01:11): And I think for the average person even the average investor, who’s fairly engaged in the markets. I think a true understanding of, of what’s going on with monetary policy, what the Fed is, how central banks function is really important. So we’re going to, we’re going to lean on Jim’s expertise there today. So thanks Jim.
Jim Barnes (01:33): No, this is great. I’m very excited to do this with you, Jeff. This is an awesome, awesome topic and, and you know, let’s go, let’s
Jeff Mills (01:43): Let’s dive right in here. So I’ve got a list of questions in front of me. We’re not going to stick to that list. I’m sure. But why don’t we just start with the basics and I’ll kind of lump a bunch of things together and then you can take them in any direction you want. So I have here sort of, what is the Federal Reserve system?
Jeff Mills (02:01): What does the Fed do? What is the central bank? What is monetary policy? I mean, all of these really basic tenants of what we want to talk about today, and you can maybe take those in any order that you would like or you could take them one at a time. I’ll leave it to you, but I think that’s a good place to start.
Jim Barnes (02:19): Yeah, absolutely. I guess the best way to, to theme and tackle some of those questions, Jeff, is that you know, when people say that the central bank, what is the, who is the central bank here in the, in the U.S. And just as the name applies, it sounds like it’s, it’s any institution. And that’s not true. You actually have you have 12 Federal Reserve banks that are spread out all across the U.S., San Francisco, Dallas, Atlanta, Boston, New York, Minneapolis, St. Louis. I mean, there’s, there’s 12 of them that are all spread out within the U.S. They’re not necessarily based on specific territories. It’s more, when it was set up back in 1913 through the Federal Reserve Act, it was more based on what their economies were. And so you have these 12, these 12 Federal Reserve banks and then above them, you have what we refer to as the Federal Reserve board of governors. And that could be up to seven individuals. So they’re basically overseeing the whole Federal Reserve system. You can have up to seven individuals. They are all appointed by the, by the president of the U.S. Confirmed by the, by the Senate. And so they’re the ones who were overseeing the, the Federal Reserve banks, the Federal Reserve system. And then the other piece that gets a lot of attention is the federal open market committee, the FOMC, and they’re the ones that, to one your question about monetary policy, that’s the, that’s the organization that’s really in charge of conducted, conducting you know, monetary policy for, for the U.S. What’s interesting, and a lot of people don’t know this is that the when we think about the Federal Reserve board, that governors that it’s actually, it’s a, it’s an agency of the, of the U.S. That’s how, that’s, how they function as an agency of the U.S. And they’ve been given you know, specific mandate responsibilities from Congress. And we hear about them all the time in terms of price, stability, maximum employment you know, moderate long-term interest rates, probably the two that always gets the most attention. They always call it that, that dual mandate. And a lot of times they’re focused there on just the overall price, stability and maximum employment. So when you bring up monetary policy, when we think about monetary policy here in the U.S., they’re trying to achieve the goal that the responsibilities that Congress has given to them and they utilize different types of monetary policy tools and strategies.
Jim Barnes (04:48): And really what they’re doing is they’re out there trying to impact the availability and cost of, of credit you know, among market participants, households, businesses, and so forth. And that’s a, and that’s the whole idea is basically conducting monetary policy. That’s a, that’s a, that’s a huge piece of it. And there’s other responsibilities for, for the Federal Reserve system as well. But that’s, that’s the one key takeaway here is that when we talk about the central bank here in the United States, don’t think about just one institution. Think of it in terms of, if you have the, the Federal Reserve board of governors, you also have the 12 Federal Reserve banks that are spread out across the U.S., and then you have this other committee, the federal market committee, and they’re the ones that are actually in charge of conducting the country’s monetary policy.
Jeff Mills (05:32): No, that’s, that’s a great place to start. And I think you brought up a couple of key points that I will dive into a little bit. So you talked about monetary policy, what it is, what the goals are. So I’d be curious to hear from you a little bit about, you know, how they go about impacting interest rates, how they go about actually affecting the things that they want to affect. So what are the tools that they have maybe first, just on the traditional side, kind of, you know, typically how does the central bank, how does the fed specifically operate as it relates to having an effect on interest rates?
Jim Barnes (06:07): Yeah, so so we talk about traditional tools. There’s really, there’s three, there’s a reserve requirements. There’s the discount rate, the discount window, and then the more common, that I’m probably going to spend the most time on, and that’s on with the Federal Reserve target rate all three are important. The Federal Reserve target rate gets the most attention and it’s, it’s the most, that’s historically been widely used by the Federal Reserve, because…
Jeff Mills (06:39): The funds rate, that’s what people are talking about, fed funds rate. That’s what we always hear. You know, that’s the most common term. So that’s, that’s another, the target rate or the funds rate sort of use synonymously, right?
Jim Barnes (06:52): Yeah. It’s the, it’s the funds rate, as I said before, we think about it in the context of that dual mandate price, stability and maximum employment you know, basically what they’re trying to, in order to achieve that mandate, they try to control borrowing costs. And if you think about it, if you have a, if you have a, you know, a really good economy, the Federal Reserve is trying to get the economy going again. Then you want borrowing costs to be low. I mean, that’s the whole idea because if you have low borrowing costs, people are barring spending, borrowing spending, and it just has a natural who push on the, with the economic growth and so forth. And so the federal funds target rate, they want a low rate there, and that’s going to influence others who are term rates as well, such as treasury bills, commercial paper.
Jim Barnes (07:37): And if investors out there and market participants feel that the Federal Reserve might want to lower that rate even more in the future, it will have more influence on a medium term and long-term rates. So there, we’re talking about you know, mortgage-backed securities, corporate bonds, treasury bonds. And so the question then becomes, well, there’s federal funds target rate, what do they do then they just say, let’s just drop it in and that’s it? It automatically goes down? And the way the Federal Reserve, the way the federal target rate works, you have just a number of banks, thousands and thousands of banks within the banking system here in the U.S. And as I said before, each bank is going to have a there’s a reserve requirement. So amount of reserves, you know, each bank has to, has to hold at the fed right now, I believe it’s 10%.
Jim Barnes (08:19): And so if you think about, you have thousands and thousands of transactions ACH (Automated Clearing House) type transactions, deposits that are going on among banks all across the, all across the U.S. So what ends up happening here at the end of the day, they’re going to have some banks that, that might need some money in in order to have enough, to satisfy that reserve requirement. And you might have others that, that have some have some excess. So that federal funds target rate, that’s basically the rate that all these banks use to lend money to each other. And so, as I said before, if the Federal Reserve is trying to lower that rate, what will end up happening is that’s going to influence other short term rates. And basically what they’re trying to do is they’re trying to increase the amount of reserves out there in the system.
Jim Barnes (09:01): And then take that a step further. When we think about increasing reserves, well, how do they go about increasing reserves? This is an, and this is very, very important. One of the key activities that the FOMC does, they could, they do open market operations – it’s all done through the reserve bank out there in New York. So they’re in charge of open market operations. So when they’re out there and they want to go ahead and increase the amount of reserves out there in the system, increase the amount of funds out there in the system what they’ll do is they have number of primary dealers that they’ll actually transact with, and they will buy U.S. Government or government guaranteed securities. And they’ll take some of these securities off the balance sheets of banks, and they’ll put them on the balance sheet of the Federal Reserve. And then they’ll go ahead and they’ll credit these banks with additional funds.
Jim Barnes (09:43): And so anytime you have more of something in that context, it just ends up lowering the price. So again, just to recap that, if they’re trying to put downward pressure on the federal funds target rate, and that’s the rate that banks use to lend money back and forth to each other, in order to satisfy the reserve requirement at the Federal Reserve, they’ll go out there, the New York Federal Reserve bank in New York will go out there, they’ll buy government bonds, guaranteed government bonds from the banks that are out there, puts more reserves out there in the system, puts downward pressure on the target rate to the area where the Federal Reserve wants to target.
Jeff Mills (10:14): And as the Fed is affecting interest rates at that very basic level. So you think about sort of where things start for banks relative to their cost structure. You know, the lending back and forth between banks. When that cost goes up and down, that then can trickle through to other areas of the economy, other interest rates that then may affect our daily lives or affect corporate borrowing and things of that nature. So that federal funds rate is really something that’s used to manipulate that cost of lending back and forth with banks. And then therefore that translates into other areas of the economy. So I think that was, it was really a great way to put it, and I think it, it’s, it’s a pretty clear explanation for, for how all of this works. So let me, let me take it one step further and just I’ll keep us on interest rates for a second.
Jeff Mills (10:59): So we’re talking about really short term rates. So the federal funds rate is a very short term, you’re talking about overnight lending between banks. So they have, they have a lot of control over that short maturity short term part of the yield curve. When thinking about rates further out. So the 10-year treasury yield, mortgage rates, et cetera, they’ve used some tools that maybe are a little bit more unconventional over the past number of years to try to impact longer term rates. Maybe we should talk a little bit about what those tools are and how those work.
Jim Barnes (11:29): Yeah, so, so the two most popular quantitative easing (QE) and forward guidance, I mean, those are the, those are the two non-traditional tools – and both of those are controlled via the FOMC, the federal open market committee. It’s another avenue, you know, that if the Federal Reserve wants to continue to ease financial conditions out there within the, within the financial markets, that they continue to believe that in order to achieve their statutory mandate, that the environment needs more accommodative monetary policy and an environment where the fed funds might already be pinned up against zero, this is where they will defer to those two types of policy tools, non-traditional policy tools to try to influence more longer parts of the yield curve. So to take them one at a time, when we think about forward guidance, forward guidance, really, it came to the surface during financial crisis.
Jim Barnes (12:16): And that’s whet the federal funds target rate hit 0%. And if you remember the Federal Reserve, once it was down to 0%, they felt, you know, what we need to you know, kind of guide the markets into where the federal funds is going to be going forward. And then we’ll use language such as you know, based on the current conditions out there you know, we’re in need of you know, the federal funds target rate remaining at 0% for, at this low level for an extended period of time. And it’s very important because when you think about trying to ease financial tensions out there, if you’re out there, if you are a borrower, the more, the more transparency there is, the more that, you know in terms borrowing cost, it could be today, tomorrow, next month, next year the more knowledge you have to make decisions. So that all kind of factors into that, but that’s your forward guidance.
Jim Barnes (13:05): The other examples that I would give for forward guidance is the summary of economic projections that’s another key one. So the summary of economic projections, this is something that comes out on a quarterly basis from the FOMC meetings, where they’re basically the participants of FOMC. That would be the, the Federal Reserve board of governors, as well as each president of the Federal Reserve banks. So those 12 individuals, collectively, they will tell you where they think the federal funds target rate will be at the end of this year, at the end of 2021, at the end of 2022, at the end of 2023. And that’s all based on all these individuals’ expectations of the amount of monetary policy, the amount of accommodative policy stance that needs to be out there in order for the Federal Reserve to meet its, again, its dual mandate of price stability and maximum employment.
Jim Barnes (13:56): So right now, they’re saying that the federal funds target rate needs to be basically at 0% until the end of 2023, because the economy right now that’s the type of policy that is necessary in order for the Federal Reserve to, to achieve its objectives. And then through quantitative easing, Q.E. Is a little different. As we said before, the Federal Reserve bank of New York, that’s out there and are doing these open market operation transactions. And what they’re doing is they’re controlling the amount of reserves that are out there in the system. And we explained it before how, you know, buying, buying U.S. Government security who has government-guaranteed securities, it takes the securities off the balance sheet of the banks that they’re dealing with. And it puts it on the balance sheet of the fed. In doing that, they’re creating some additional excess reserves.
Jim Barnes (14:42): Well, the same thing when they’re actually, when they’re doing operating that they’re continuing to do open market operations. But here, when you think about what’s, what’s the influence that it’s having on the yield curve, think of it like this. It’s not only creating more reserves out there in these systems. So it’s creating a lot more liquidity. Right now, they’re buying $120 billion worth of securities each month, at least that amount. So that’s an additional $120 billion worth of reserves that are now floating out during a system, $120 billion worth of additional liquidity out there in the system. That’s a positive, that’s easing financial conditions. That’s providing more accommodation out there to the system. The other thing, just think about this: when they’re out there buying bonds, it puts upward pressure on prices, downward pressure on yields. So depending on what maturity they’re buying across the yield curve, it’s influencing those yields within that segment.
Jim Barnes (15:30): So it can have more influence on more parts of the yield curve. The other thing too is that, just think about it, the fed reserve they’re out there buying all these safe assets. So it kind of takes them out there in the public, where it puts them with the balance sheet of the fed, and you have some of the riskier stuff that’s there for, for others to buy. Because at the end of the day, you know, if you’re trying to get the economy going again, if you’re trying to achieve your mandate you know, you want people to borrow, spend. You want them to take on risk. So that’s another influence that that by implementing quantitative easing that where it could be impactful to you know, to putting a positive influence on economic conditions.
Jeff Mills (16:05): Let me stay on, let me stay on the long end of the yield curve there, so longer term interest rates for a second. And I’m going to broaden the conversation a bit into what global central banks have been doing. So I think interestingly, you’ve seen monetary policy conducted in a way that suppressed interest rates throughout the world. So one additional point that I would make relative to the longer end of the curve, is that you’ve had international central banks. You can actually see negative interest rates throughout many parts of the world. So even though rates in the U.S. Remain historically low, they actually remain relatively high compared to some international economies. So even when you take foreign exchange risk into account, you can actually see foreign buyers coming into the U.S. To try to take advantage of that relative interest rate differential. So meaning being able to earn a higher rate of return in the U.S. Government bonds versus foreign government bonds. And that puts more demand on the longer end of the yield curve and can further suppress interest rates. So I guess my question would be in relation to that dynamic, I mentioned negative interest rates. Do we feel like negative interest rates at any point in time could become a reality here in the U.S., given what we’ve seen with other, other central banks throughout the world?
Jim Barnes (17:25): Probably not right now. I would never say take it off the table completely. Probably take it off the table in the current circumstances based on where we are, but based on what’s been happening with monetary policy over the years, and what’s been happening to that, the natural rate for the federal funds target rate and how it keeps going lower and lower and lower. And I’ll get back to that in a second. It’s very possible that somewhere down the line, you might get some, some type of shock that that negative interest rates become inevitable, but, but, but just on that same point, we should make a distinction right here before I get into another piece of this in that you know, the Federal Reserve controls the target rate. That’s, that’s a policy rate. They control that and we see that. They could drop it down to zero, which they have, they can lower it into negative territory, but like the 10-year U.S. Treasury yield, they can try to influence that as best they can, but if that goes negative, there’s nothing that’s not, but that’s an, that’s a market rate that’s influenced, you know, buyers and sellers for their own specific reasons to your point before.
Jim Barnes (18:31): So it’s very possible that you can have a 0% set policy rate, but a negative 10-Year Treasury – and I don’t think that’s going to happen this time around, but I think as I said before -I’ll get back to this in a second – that the you know, it’s possible somewhere, if you get another shock just based on a transgression of a policy over the years, that that’s definitely possible. Going back to what I was talking about before though, Jeff, with the Federal Reserve system here. So it’s not just, when we talk about monetary policies, when we think about a central bank, conducting the country’s monetary policy is ridiculously important. But that’s not the only responsibility that the Fed has. The Fed also has to promote financial market stability. It also has to oversee, to some extent, individual financial institutions. So going back to your point before regards to a negative policy rate, so the quick answer is, well, right now, the Federal Reserve, they say over and over again, they don’t want to do negative interest rates. But part of that has to do with some of their other, not necessarily from a monetary policy perspective, from just financial markets, they’re concerned that if you were to get into negative policy rates, what’s that going to do to the financial system? What’s that going to do to financial institutions? And that part is based on their research and experience, looking at some of these other central banks and what it’s done. At this point, they don’t like what they see, so they’re taking them off the table for now, but a lot of it has to do with that, you know, promoting financial market stability and overseeing financial institutions. And it’s it muddies the water to some extent when you start to alter that policy rate into negative territory.
Jeff Mills (19:54): Talk a little bit about the, the promoting financial market stability for, for a little bit, because I think that’s interesting, you know, when, when you go back to what the real core tenants of monetary policy, or at least supposed to be, it’s really promoting full employment and stable prices. I want to talk about stable prices in a second, but now you have this kind of third thing that’s floating out there, which is financial markets stability. How does that interact with really the primary mandate of the fed as it relates to employment and prices? And do you think at some point that’s going to be part of their official mandate, you know, financial markets stability? Or should it be in your opinion?
Jim Barnes (20:32): Yeah, so that’s a great… [laughing Slightly].
Jeff Mills (20:34): I don’t want to open up a can of worms here because this is a, this is a whole other discussion, but I think it’s interesting.
Jim Barnes (20:39): No, that’s a fun question. So when we think about monetary policy, monetary policy needs a functioning financial markets. Because when you think about people that have money, you know, that’s one part of that’s out there in the financial markets. You have people that households and businesses that need money, and then you have the people in the middle, it could be markets and intermediaries, banks, and all those different parties all make up the financial system. What the Federal Reserve is doing, they’re overseeing the system to make sure that, you know, not necessarily that everybody has zero financing costs, they just want to make sure that the system is operating efficiently so that the lowest possible cost is available. You know, I was thinking consideration of the risk of the credit risk and so forth. But the key takeaway here is in order for monetary policy to even have a chance of working, you need stable financial markets.
Jim Barnes (21:22): And you also have to think about the fact that when we – your question before – when it comes to traditional monetary policy or the policy tools, the discount rate, the reserve rate, the reserve requirement, federal funds target rate. That discount rate is used to lend money to member banks and the fed reserve banks. And the financial market, if nobody wants to lend a specific bank money, they can always turn to the Federal Reserve as a lender of last resort. But what we’ve seen this past year, we saw it during the financial crisis, the same thing that sometimes you have other types of entities that, they’re not banks, and they can’t get financing, commercial paper, asset-backed securities. You know, people that or entities that companies rely on commercial paper for just basic things, such as payroll, accounts receivable, things of that nature.
Jim Barnes (22:07): And when that market is not functioning right, because investors are concerned that, you know, there’s something out there and it’s we can’t really gauge what the overall credit quality is of these borrowers. That’s a problem because it starts to impact their business. Now, traditionally, the Federal Reserve, they’re supposed to be this lender of last resort. But companies, they’re not thanks. So you can’t really… That connection between the discount window is not there. So that’s where in the Federal Reserve Act of 1913, and in this act too, which was put together by Congress, and it’s evolved over time, but you keep hearing this 13th grade, 13th grade. These facilities, these programs were set up by the clause that 13th rate during times of emergency, things of that nature.
Jim Barnes (22:51): This is where the Federal Reserve kind of sets up these programs, these facilities, they step into these markets such as commercial paper, asset backed securities, corporate bonds, muni bonds, they set up these facilities so that they’re, they’re acting as lender of last resort. And it’s important too, just think about this: Very basically, the Federal Reserve wants low interest rates. The target rates already at 0%. But if we remember back in March, it’s at 0%. They want low rates. They want accommodative easing. But borrowing costs for all these people that have that operate within the financial system are going through the roof. So what’s happening? The Federal Reserve sets up these facilities. They step in as lender of last resort, hoping to calm things down until we can get some other lenders out there that are more comfortable with the environment.
Jim Barnes (23:34): And, and they do this just to kind of act as a, as a bridge until things stabilized. Now there’s some, there’s some couple of key points here that I want to make because I think it’s really important. As I said before, the Federal Reserve Act of 1913, it’s changed all the time. And when we think about what happened during the financial crisis, because this is key: When we think about the financial crisis, I mean, what do we do? The Federal Reserve was out there and they, to some extent, they bailed out Bear Stearns, AIG. Lehman Brothers, they did not. When you think about the Federal Reserve, they can’t enter into transactions where it’s expected they’re going to lose money. So the Lehman brothers case, for example, they couldn’t, they didn’t really understand what the value of these securities were on Lehman’s balance sheet.
Jim Barnes (24:13): So they couldn’t justify lending them money. But Congress took a step back when all the dust settle and said, well, we don’t want the Federal Reserve in the business of deciding who they’re going to bail out to who they’re not going to bail out. So since then, and this is the, this is a key point, I think cause it kind of speaks a little bit to the Fed’s independency, is that any programs that are set up, it can’t be specific to an institution. It has to be more broad based. And the second thing that was really key is that the Federal Reserve, in order for these things to get approval, it’s you need the approval from the board of governors, at least five individuals from the board of governors. But then you also need the, you need these programs facilities to be put together in consultation with the Secretary of the Treasury and with his approval. You need that as well. So when people always ask is the Federal Reserve independent? Well, I would say the Federal Reserve is independent as relates to monetary policy, as it relates to not having to go to Congress before deciding that they need to do quantitative easing, or forward guidance, or to alter the federal funds target rate. On the other side, if they want to set up a facility for municipal issuers or for corporate issuers, they do need some authority there to do that. And that’s where that treasurer comes in.
Jeff Mills (25:19): No, it is interesting. And that’s a, it’s a gray area for sure. And I think, you know, more recently given the political backdrop, I think the independence of the Fed has come up over and over again. Maybe, maybe I’ll go down this road and maybe I shouldn’t, I don’t know. And if you don’t have an opinion, you can tell me that too. But obviously we’re, we’re, doably going through some sort of a transition of power in the white house right now. Do we anticipate any sort of change in terms of who is controlling the fed right now? Jerome Powell, the fed chair, has there been any discussion about him being replaced or if, if we do think he would be replaced, do we think that that would change the direction of monetary policy in the United States in any large degree?
Jim Barnes (25:59): Not going to change the direction of monetary policy because this goes back to monetary policies should be implemented in a, in an independent way. You know, fed governors or at least for the, for the chairman and the vice chair they’re elected in four-year terms. Everybody else has done it with 14-year terms. And so it is possible that they could, they could look to change them. If they did, I don’t think that’s going to go alter the course of monetary policy. That, right now, has been laid out through, as we talked about before, through some of the summary of economic projections and so forth. I’m not sure if they’re looking to change that or not, but if there were, I don’t think that’s going to change the overall course. I mean, if you think about it, you don’t have one individual making decisions. Chairman Powell is at the front there, but you have as we talked about before, you have the other members of the board of, and then you also have the bank presidents at least five of which are also voting members as well. So, you know, to me it would be, they would remain the current course that they’re, that they’re on now.
Jeff Mills (26:53): Yeah. I think that’s a really important point because over the next number of weeks months, there may be headlines surrounding who’s going to control the fed, what that may or may not do to policy. So I think keeping a grounded view in terms of really understanding how the decisions are made and really getting a clear understanding that look, things really aren’t likely to change all that much. I think, especially given the situation that we’re in. I think there’s probably more agreement across the FOMC now than maybe there has been in times past, because it’s so clear where policy needs to be given the challenges that we’re dealing with. So perhaps the, the recession and the pandemic and what we’re dealing with now is actually made future monetary policy, regardless of who’s sitting at the chair, a little bit more transparent and clear. So I think that’s, that’s important to keep in mind.
Jeff Mills (27:39): So listen, before we wrap up, because I think Jim and I could probably talk about this stuff the entire day, and we might be in the minority in terms of folks who would be interested in having a discussion about he fed for that long. But let me, let me wrap it up with this. And it’s, it’s a little technical, but at the same time, it’s very basic. And number one, it’s, it’s the target rate of interest versus the neutral rate of interest, which you often hear about. So you hear about whether monetary policy is tight or whether monetary policy is easy. And I think a lot of times it’s hard to distinguish what they mean by that. So just to give a quick background, you know, there is a, there is a presumed neutral rate of interest and that neutral rate of interest is a rate which shouldn’t really be stimulative nor detract from economic activity.
Jeff Mills (28:28): It’s kind of right down the middle. So whether the target policy rate is above or below, that should have an impact on, on whether policy is quite loose or tight and whether it’s going to stimulate or cool down the economy. So I think talking a little bit maybe about the target rate and, and the relationship between actually stimulating the economy or trying to pull back the reins would be interesting. And then I also think talking about the target rate of inflation is also something that’s very interesting because, you know, one of the mandates is stable prices, and stable prices as defined by the Fed is 2% inflation. So I think maybe trying to understand why it’s 2%, why is it at 1%? Should it be 2%? Maybe some points of view on that too would be, would be interesting.
Jim Barnes (29:13): Yeah, a lot of great points, a lot of great questions. And it’s very timely too, because the Federal Reserve right now they just altered their statement of long-term policy and monetary policy, their strategy for monetary policy going forward. You know, it is, it is interesting to see how times have, have evolved. So the first thing that I would mention when that statement came out, back in early 2012, that was the first time they actually put down on paper at 2% long-term inflation target. So it was never written down anywhere. That was, I mean, it was probably more informal, but they formalized it back in January of 2012, you know, 2% long-term inflation. And how do you get the 2% inflation? Well, you don’t want too much inflation where it’s killing purchasing power where people don’t want to households and businesses don’t want to hold assets because they don’t feel it’s going to be worth anything the next day. So you don’t want too much inflation. On the flip side of that, you don’t want deflation, where nobody’s buying anything because they feel as if they hold off till tomorrow, it’s going to be lower. The product or service will be, will be priced lower. So how do they get to 2%? There’s no specific formula. That’s 2%, it’s where they would define price stability. The other thing is that, what’s interesting, they don’t have a goal there for the labor market. Full employment in the labor market is, has come down over the years, which has been good. So in other words, you can have a lower neutral rate to your point yet without necessarily spurring you know, enough wage inflation that factors into more higher inflation for, for goods and services. But that’s key because what we’ve seen is that that neutral rate and that neutral rate where things aren’t too hot, they’re not too cold, where the Federal Reserve feels that the neutral rate is at that spot where they’re achieving their dual mandate – price stability and full employment.
Jim Barnes (30:57): It’s where their maximum employment. What is that number? And that number over the years it’s come down. It was around four-and-a-quarter back in 2012. And right now it has come all the way down to about two-and-a-half or two-and-a-half percent of that. And I know, Jeff, you’re always keep talking about, you know, growth and the formula for growth when it comes to, a very simple equation: it’s your population, what’s your capital, what’s the technology behind efficiency, and you have your growth. With that being said here in the U.S., the population growth rate has come down. When you think about our labor force, we’re getting older. So that growth rate, it’s just not, it’s not as powerful as it used to be. And so that neutral rate that’s necessary to achieve the Federal Reserve’s dual mandate, where it was at four-and-quarter back in 2012. If you were to asked the participants of the FOMC, they would tell you that today it’s more around two-and-a-half percent.
Jim Barnes (31:52): So that’s important because if the federal funds neutral rate is at two-and-a-half percent, you’re already operating very close to the 0%, closer to that zero bound. So that’s one of the key things as to, well, how does monetary policy now function going forward, knowing that that neutral rate is already close to zero? And that’s where the use of some of these non-traditional tools might become more powerful going forward. The other thing too, and this, this is also interesting: in 2012, they talked about 2% being the long-term inflation target, but what’s been happening here, which is probably more important to the fed. It’s not so much what actual inflation is, it’s inflation expectation, placing expectations because, if people think inflation is going to do a certain thing, that’s going to influence their buying behavior. And what they’re concerned about is that if you have inflation that at some point within an economic cycle is below 2%, and then during another period it’s at 2%, it’s a good chance that overall inflation expectations might just naturally fall.
Jim Barnes (32:54): And that’s not a good thing. So what the Federal Reserve said is that going forward, what we’re going to be paying very close attention to is, yeah, we do want long-term inflation to be at 2%, however, in order to, to make up for the periods where inflation falls below 2%, we also want to have some periods where inflation is above 2%, just so that inflation expectation stays anchored at 2%. So with that being said, earlier I had said that a formal long-term inflationary target at 2% was, was probably put down on paper back early in early 2012. What they did back in August, they revised it and they added to it and said that 2% long-term inflation is still the goal. Inflation expectations, we also want that now at 2%. And then they also justified having during periods of where inflation is missing the mark, they will be tolerant of inflation going north of 2% for a certain period of time. Again, just so that inflation expectations stay anchored at 2%. And that’s the key I think, is that in place an expectation component.
Jeff Mills (33:55): Well, I think that, I think that wraps it up really nicely actually, in terms of an outlook for where interest rates might be going. And I think all of those points that you just made a really critical. So number one, you have a lower neutral rate of interest, or at least a perceived neutral rate of interest. So that has come down. So that’s one point, and then you have this average inflation targeting where the federal actually tolerate inflation a little bit above their 2% target. So when you combine a lower neutral rate of interest with the willingness to accept slightly higher inflation, that probably means the Fed can keep interest rates lower for a longer period of time, because there isn’t this impetus to rise rate significantly because the neutral rate has come down so much. And then also you’re not necessarily going to be fighting inflation the minute it breaches 2%.
Jeff Mills (34:46): So I think in terms of where we think interest rates might go, I think we believe that they can certainly creep higher from here as, as things recover in the economy as we move into 2021. But I think overall from a monetary policy perspective, it’s very likely that the Fed keeps their target rate low for quite some time. And I think I think that that’s our, that’s our very general point of view there. So listen, I’m going to wrap us up here. I think it was a really good discussion, extremely interesting. I hope that we do more of these, you know, I think the back and forth Q&A, it’s a little bit more engaging, a little bit more interesting. And you can hear a little bit in terms of how Jim and I interact in the office when we’re talking about our research and points of view, and, and these are kind of some of the things that we try to hash out. So a little bit of a window into that as well. So anyway, we hope you enjoyed the podcast. Please give us feedback, please reach out to your investment advisors. We always love to hear from you and until next time, thanks so much.
Jim Barnes (35:42): Thanks Jeff.
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