It seems that everyone wants to know the future course of interest rates. For a variety of reasons, it is less predictable than in “normal” times. But a quick look at a few numbers places the recent history of Fed policies in stark relief, possibly presaging what is to come.
Consider the following quantitative measure that we call the Fed Accommodation Index. In our view, it approximates the degree to which the Fed’s monetary policy has been “accommodative” over the years. The index is the sum of two components. The first is the difference between the rate at which M2 (the broad measure of money) grows and the growth rate of GDP; our rationale being that money growth exceeding economic growth should be indicative of “loose money.” The other component is the difference between the inflation rate (as proxied by the CPI growth) and the Fed funds rate. If the latter, the Fed’s main policy lever, is lower than the rate of inflation, it would suggest insufficient tightening.
Since the Accommodation Index is simply the sum of the two components, a positive index value would imply that the Fed is being accommodative, while a negative value implies the opposite.Figure 1 shows changes in the value of our index for a bit more than 60 years. The pattern is revealing. From 1959 to the late 1970s, the index mostly hovers between +7 and -10. But for the 20-year period immediately following it is nearly always negative, even dropping as far as -15.
By this account, in other words, the Fed had its foot on the brake – often vigorously – from about 1980 to 2000. The simple explanation is that it responded emphatically to the double-digit inflation of the 1970s, even contracting the economy and provoking a recession in the early 1980s. The historically low inflation that ensued is mostly responsible for keeping the index in negative territory for two decades.
After 2000, however, a starkly different picture emerges. The Fed Accommodation Index moves into positive territory and, except in rare instances, remains there in the decade or so following the financial crisis. Moreover, it hits peaks of 25, and then again 18, far higher than at any time in the last six decades. What is most remarkable is that the index remains relatively high throughout despite historically low inflation.
What happened? As is well known, much of the preceding two decades were characterized by relatively rapid money creation and rock-bottom interest rates. In other words, loose money.
Persistently low interest rates generally signify an excess of available capital – i.e., more lenders than borrowers. It suggests, in turn, that economic expectations and growth prospects are relatively modest. The macroeconomic data certainly bear this out; after growing at an annualized rate of over 3.5 percent from 1947 to 2000, inflation-adjusted US GDP grew only two percent per annum from 2000 to 2020.
One possible explanation is that the normalization of federal budget deficits starting around 1980 proved insufficient to lift a secularly stagnant economy: hence the need for additional stimulus on the monetary side. Yet the monetary stimulus in turn relates to another potential explanation: the unabated Fed purchase of Treasury debt, along with an aggressive policy of keeping interest rates at near zero levels, distorted investment incentives and fueled excess debt creation at the expense of productive projects.
Notice now what Figure 1 shows for the three most recent years – unprecedented volatility. Is something new afoot? It would be easy to attribute it to the emergency measures prompted by the Covid-induced economic collapse. Sharply negative GDP growth in the second quarter of 2020 raised the index to an anomalously high level, while the ensuing “correction” did the same in the opposite direction. But now that the acute economic crisis appears behind us, notice the sharp fall in the index over the past 18 months from about +7 to -12; it is mostly due to the recent bout of inflation and the resulting monetary tightening.
What the graph cannot tell us is what to expect in the medium to long term future in terms of growth, inflation, and interest rates. Is the drop in our index over the past 18 months a mere blip, to be reversed once we re-enter the accommodative regime of persistently low rates? Or does it perhaps signify entry into a new policy regime of high rates?
It is the question that either is or should be on everyone’s mind. Unlike some of our colleagues, we believe that “real” factors like demographic changes and game-changing scientific discovery (or, more likely, its lack) will bear adversely on long-run growth prospects. Add to this a greater debt burden and an apparent retreat from globalization, and it seems that the Fed’s ability to continue financing deficit spending will be seriously hampered. It points to significantly higher interest rates; if not in the short- to medium-term, almost certainly a decade or more out.