Monetary Policy: Neutral or Normal?

Dr. Craig Callahan, ICON Advisers – Founder & President

March 8, 2019

T-Bills are generally considered to be risk-free investments. An investor knows what the return will be over the short holding period, and the bills are backed by the full taxation power of the U.S. Federal Government. From the perspective of financial theory, a person taking no risk should not gain on inflation but should just hold even, suggesting the yield on the short-term T-Bills should equal the rate of inflation. Based on Ibbotson data, such a relationship did exist from 1926 through 1981, as the average yield on T-Bills and the average annual change in CPI were both near 3.1%. Positive real returns, or additional return in excess of the inflation rate, had been available to risk free investing for a period after1981, as investors incorrectly kept expecting inflation to increase, but it did not. As those fears gradually and stubbornly subsided, the real return for risk-free investing diminished.

As 2019 begins, it appears the Fed is implementing a neutral monetary policy. 13-week T-Bills are yielding about 2.5%. CPI was up 2.2% Y-O-Y through November 2018 and only 1.9% Y-O-Y through December 2018. A survey of economists by Bloomberg is calling for CPI of 2.2% in 2019 and 2020. With predicted inflation at 2.2% and T-Bills at 2.5%, any moves to 2.75%, 3.00%, or even 3.25%, could only be viewed as tight monetary policy in our opinion, and clearly beyond neutral. With the potential for more rate increases by the Federal Reserve, we believe it is easy to see why the Administration is complaining and why investors reacted negatively in the fourth quarter of 2018.

So, what is “normal” monetary policy? We can only guess that it means using some historic average, which, going back to 1926, puts T-Bills in the high 3% range. It is difficult to imagine what would drive a Federal Reserve (FED) official to feel the need to get interest rates up to that historic average when we believe we are clearly in a low-inflation environment. As we correctly wrote in 2015, “We are on a very friendly Phillips Curve,”¹ based on land, labor, capital and the demand for goods and services. The current economic setting, in our view, remains accommodative for low unemployment with low inflation. We think taking risk-free interest rates to 3.0% and beyond based solely on an historic average would be ridiculous.

Besides an interest rate level, we believe there are two other aspects of “normal” monetary policy currently under the Fed’s control. Today, the FED is holding bonds purchased as part of its “quantitative easing” actions. We believe those bonds are doing nothing toward achieving the two goals of the FED; full employment and price stability. Why not just sell them? Take a month and dump them on the market? These actions might even steepen the yield curve, which would be welcomed by many observers.

Another aspect of “normal” policy involves interest on reserve deposits. Historically the FED did not pay interest on reserve deposits, however, currently it is paying interest. The FED claims this helps implement monetary policy, but that seems doubtful to us. We believe the FED has all the tools it needs through open market operations, where it can add or reduce reserves.

We can only guess that there is a high level of pride within the FED. Over the last 38 years they have successfully engineered disinflation, and now they have added low unemployment to go with low inflation. Mandates accomplished! Yet, post financial crisis, there seems to be a lack of trust in the Fed on Wall Street, as shown last fall with the market’s decline. We believe one scoop of neutral on interest rates and two scoops of normal on bonds and interest on reserve deposits would go a long way toward restoring trust.

Past performance does not guarantee future results.

Opinions and forecasts are subject to change at any time, based on market and other conditions, and should not be construed as a recommendation of any specific security, industry, or sector.

Investing in securities involves risks, including the risk that you can lose the value of your investment. There is no assurance that the investment process will consistently lead to successful results.

The Consumer Price Index (CPI) is a measure of the average change in prices over time of goods and services purchased by households. The CPIs are based on prices of food, clothing, shelter, fuels, transportation fares, charges for doctors’ and dentists’ services, drugs, and other goods and services that people buy for day-to-day living.

A Treasury bill (T-Bill) is a short-term debt obligation backed by the Treasury Dept. of the U.S. government with a maturity of less than one year.

The Phillips curve, first presented in 1958 by A. W. H. Phillips, represents the avail-able tradeoff between inflation and unemployment at a given point in time.

¹”Relax. We Are On A Good Phillips Curve”, Craig Callahan, April 27, 2015, https://iconadvisers.com/relax-we-are-on-a-good-phillips-curve/

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