The timing is perfect to ask the three questions. Inflation is high, the economy is good, unemployment is low – and the Fed is ready to raise interest rates.
So, here goes…
The first question:
“With the economy doing well, the unemployment rate low, Covid-19 concerns receding and inflation well above 2%, where would short-term rates (say, the 3-month US Treasury Bill rate) be now if they were determined by the capital markets?”
This question is key because it moves the discussion from what the Fed’s plans are to what the destination is. And that goal should be capital market-based interest rates.
So, how high should it be?
The 3-month US Treasury Bill rate is widely used as the safe short-term yield. Its level is typically expected to be near the inflation rate to compensate for the dollar’s loss of purchasing power. In other words, a “real” (inflation-adjusted) yield of 0%. In times of growth and tight money, that yield can rise higher than inflation.
We know the current inflation rate contains some extreme issues, so let’s assume the base rate now is about 4%. That, then, would be the expected 3-month T-Bill rate – perhaps higher if inflation was expected to be higher during the 3-month period.
Powell has a capital markets background, so he should answer with such a final rate.
Now it’s time to ask the second question:
“Many of our constituents, organizations and government bodies depend on safe interest income. They are not able or willing to take on risk. So, for the past fourteen years, they have earned interest well below inflation, meaning their capital’s purchasing power has fallen. You have said they could be earning a much higher yield now if the capital markets were setting the rates instead of the Federal Reserve. So, why not just step back and let capitalism work?”
We can guess the answer will be mayhem and turmoil.
That, then should bring up the third question:
“So, you are saying that you have put us in a box, and the only way out is slow, incremental steps. So, what do we tell the constituents and others who continue to suffer from the interest income shortfall you have created?”
The answer can come from many directions. Most likely it will be a version of “for the good of the country.”
The tough-minded conclusion
Senate confirmation is on the table for Powell and President Biden’s board replacements. So, what to do?
Since Powell is the last leg of the Bernanke-Yellen-Powell trio, he feels boxed in and cannot effectively lead a redo of the situation. Therefore, why not identify someone else who can step in, rework the process, explain the steps and benefits to produce understanding, with year-end 2022 being the endpoint? It’s the perfect time to do so.
The bottom line: A group of people cannot set prices better than the capital markets
Just because they are well-intentioned, the results nevertheless will be lackluster and flawed. Certainly, the Federal Reserve’s “lender of last resort” role is vital in times of extreme turmoil. However, at all other times, remaining at the ready with hands off of the controls is the best strategy.