Opinions

The Myth of the All-Powerful Federal Reserve



Many investors and policy makers are concerned about the narrowing gap between yields on short- and long-term Treasurys. They warn that an inverted yield curve—when short-term Treasurys have higher yields than long-term ones—would presage a recession. But evidence from the past six decades suggests the conventional wisdom is outdated: Federal Reserve interest-rate policy no longer plays a decisive role in determining economic growth.

The Fed remains intent on returning the short-term interest rate to its “normal,” prerecession level. In 2007 the fed-funds rate averaged 5%. Today long-term Treasury bonds yield around 3%. That means that normalizing the federal-funds rate would require inverting the yield curve. Would this threaten the economy’s newfound vitality?

Inverted yield curves and recessions have been linked for decades, but the connection is deceiving in two respects. First, it’s the increase in rates, rather than their actual level, that correlates with recessions. Before 2007 recessions and inverted curves were always preceded by large hikes in the Fed’s rate target. This gave the false impression that rate levels mattered.

Second, the change in short rates, rather than long rates, is what made the difference in the past. In my statistical analyses of how movements in short and long rates compete to explain growth, the long rate consistently loses. The long rate is statistically insignificant and can be safely ignored.

If the yield curve is irrelevant to economic growth, do any Fed rate actions influence the probability of a recession? They once did, but my research suggests the Fed no longer has that power. This may sound like a radical proposition. Yet there are numerous examples of significant economic relationships that work well for a time but eventually weaken and disappear.

In the 1960s growth in the money supply and the economy’s performance were strongly correlated. But banking regulation, governing such matters as the payment of interest on deposits, changed. Financial institutions adjusted their practices, and over the years the meaning of “money” shifted. The correlation weakened. Economics moved on.

When the price of crude oil quadrupled without warning in 1973, the U.S. economy nearly turned upside down. Markets were unprepared for such an unprecedented event, but they learned. Further spikes in the oil price followed with less recessionary effect. Today few believe that an oil crisis alone could trigger a recession. The economy has become less vulnerable to imported oil, and markets expect oil prices to be volatile and now can cope better.

The vulnerability of the economy to an interruption in the normal course of business arises from two sources, each related to market unpreparedness. One is the shock effect: the sudden, surprising nature of the triggering force. The more warning given, the less damage done. The other is the depth and resilience of markets—that is, their capacity to allow buyers and sellers to hedge.

The relationship between short-rate movements and economic growth resembles the oil story. The effect dissipated over time; in recent decades there has been little sign of a connection. The evidence of a slow decline can be summarized by dividing the past six decades into two 30-year periods. Between 1957 and 1987, I found the year-to-year correlation to be minus 0.73 and significant statistically at very high confidence. The subsequent 30 years produced an insignificant correlation, minus 0.02.

What could cause the disappearance of such a long-established connection between short-term rate increases and recessions? In the past the Fed not only relied on the shock value of its rate actions; it imposed them on financial markets that were far less sophisticated and resilient. The Fed’s interest-rate actions are now gradual and telegraphed well in advance, and there are many more ways for investors to cope with interest-rate risk. Rate increases may or may not be desirable, but markets can take them in their stride.

Mr. Ranson is head of research at HCWE & Co. in Portland, Ore.



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