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Monetary policy update

With today's release of the Core PCE deflator (the Fed's preferred measure of inflation), I thought I would update some monetary policy charts. Core inflation is relatively benign at 1.6% over the past year, but it is substantially higher than the short-term rates the Fed is targeting, and that results in negative real borrowing costs. Real short-term borrowing costs are the best way to measure how "easy" or "tight" monetary policy is. By this measure, the Fed has never been so easy for so long.

The chart above shows the real Fed funds rate, calculated by using the Core PCE deflator. There are several things to note, most important being the see-saw nature of Fed policy. Fed tightening was likely the proximate cause of every recession in modern times, and it was almost always done in response to rising inflation. The Fed typically starts easing as recessionary conditions develop, and stays easy for the first few years of a recovery. But after being easy for several years, inflation typically picks back up, to be followed a few years later by Fed efforts to tighten once again. We are currently in the longest period of negative real borrowing costs. It would not be surprising to see inflation start to pick up in the next few years, to be followed by a recession a few years later.

This next chart overlays the slope of the yield curve on the first chart. Note that the yield curve slope tends to move inversely with monetary tightenings and easings. Recessions typically follow the point at which the Fed tightens policy by enough to invert the yield curve.

If there is one comforting message here, it is that monetary policy does not pose any threat to the economy. Indeed, policy is quite easy, as it almost always is during the early stages of a business expansion. Put another way, if we experience a recession in the next year or so, it will not be because the Fed has tightened too much. There is absolutely no shortage of money in the system these days.

What the Fed is doing is to actively encourage people to borrow money. Borrowing money at or near the funds rate to buy anything that is likely to rise in price even just a few percentage points a year is likely to be a profitable speculation. Leveraged investments, in other words, are almost a license to print money in this environment, and the Fed is all but guaranteeing that this will be the case for the next several years.

The good news is that investors can benefit from leveraged investments. The bad news is that this diverts capital from other areas of the economy that might be more promising. The Fed is promoting speculation, not long-term investment with this policy. Similarly, Fed policy is punishing savers in order to reward borrowers. This does not help the economy grow, and it likely is one of the reasons that growth has been disappointingly slow in recent years.

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