John Taylor wrote a very interesting article in the Wall Street Journal last week, "Fed Policy Is a Drag on the Economy," in which he argues that the Fed has been hurting the economy by keeping short-term interest rates extremely low, and promising to keep them extremely low for a long time. This of course runs directly counter to what we have been led to believe.
He describes a variety of problems created by super-easy monetary policy (e.g., encouraging people to take on too much risk, creating great uncertainty about the Fed's ability to reverse its QE efforts, making it easy for the federal government to fund its massive spending plans, and forcing other central banks to follow suit). More importantly, perhaps, he argues that very low interest rates create disincentives to save, and this limits the economy's ability to grow. "While borrowers might like a near-zero rate, there is little incentive for lenders to extend credit at that rate. ... lenders supply less credit at the lower rate. The decline in credit availability reduces aggregate demand, which tends to increase unemployment, a classic unintended consequence of the policy."
In other words, while everyone, including the Fed, thinks that ultra low interest rates provide an important source of stimulus to the economy, it's quite likely that they do just the opposite. The Law of Unintended Consequences strikes yet again.
Taylor had a somewhat-related blog post the other day in which he discusses the "strong inverse relationship between fixed investment and the unemployment rate." He accompanied the post with a chart that got my attention, because I saw a way to improve it.
The above chart uses the same data as Taylor's original chart, but includes data going back to 1960 (his only went back to 1990). The interpretation of the chart remains the same. There is a strong inverse relationship between fixed investment as a share of GDP (fixed investment includes private residential and nonresidential construction, and private investment in equipment and software) and the unemployment rate, which is a good proxy for the health of the economy. He is careful to note that while the correlation is strong, we cannot infer the direction of causality. But this does illustrate how a lack of investment could go a long way to explaining why the recovery has been so weak.
It then occurred to me to put his two ideas together, to see if the Fed's monetary policy was correlated with the amount of fixed investment. Where Taylor's WSJ article focuses on how artificially low interest rates limit lending and therefore aggregate demand, and his chart compares fixed investment to the unemployment rate, I wanted to see if there was a link between Fed policy and fixed investment.
As the chart above shows, Fed policy is indeed highly correlated to fixed investment (even more so than the unemployment rate is). This fits hand in glove with the first chart, which links fixed investment to the unemployment rate. The red line in the above chart is the real Federal funds rate (using the Core PCE deflator), since that is a good proxy for the degree to which monetary policy is "tight" or "easy."
This puts some meat on the bones of Taylor's WSJ article. The Fed's unusually accommodative monetary policy stance -- which promises extremely low interest rates (negative in real terms) for a long time to come -- does appear to be a factor in limiting the amount of funds available for investment, and in reducing aggregate demand. And that in turn helps to explain why the recovery has been so weak.
How else to explain the fact that fixed investment is almost always very strong when monetary policy is very tight, and weak when monetary policy is easy? How else to explain how a decade of extremely low interest rates have failed to stimulate Japan's economy?
Food for thought and controversy.