The Fed Pill
What if everything you believe about monetary policy is wrong?
In the iconic scene from the 1999 film The Matrix, the protagonist Neo is presented with a choice between two pills - the red pill, which reveals true reality, or the blue pill, which allows him to remain in his mundane existence, unaware of the choice he has made. This metaphor has become a popular trope on social media over the past decade, with the term "pill" being used to describe a sudden realization or enlightenment. The term is often used in the context of learning or gaining knowledge, and it is meant to evoke the idea of a "magic pill" that can instantly change one's understanding or perspective on a subject.
Have you tried the Fed pill?
Since the 1980s, interest rates in many parts of the world have exhibited a downward trend. Economist and teflon prophet Larry Summers, who popularized the term "secular stagnation" to describe this phenomenon, is among those who have written about it. As recently as March 2020 he wrote that "investment failed to absorb savings" and that this therefore induced lower interest rates.
Note: this article is also available in Swedish
An increase in income inequality, which has been observed over the past 40 years, can for instance lead to a decrease in interest rates. This is due to the fact that the wealthy have a lower marginal propensity to consume, meaning that an increase in their income does not translate to an equivalent increase in spending. This can create a mismatch between savings and investments, leading to downward pressure on interest rates. In simpler terms, when a wealthy person like Warren Buffett sees more money in his bank account, he is less likely to skip to the nearest corner mart to buy more ice cream, compared to someone with a lower income.
An intriguing fact, however, is that interest rates have not fallen at all(!) since the early 1980s, at least not when excluding changes around monetary policy announcements by the Federal Reserve. Economist Sebastian Hillenbrand, who documented this several years ago, suggests that this may be due to the Fed's access to information about the long-term neutral rate, which is the interest rate level that neither slows down nor accelerates the economy.
The question arises, whether the Federal Reserve truly holds such particularly significant information?
The map precedes the territory
Jean Baudrillard, in his analysis of our postmodern societies, wrote that "the map precedes the territory." This means that the map, rather than reality itself, creates our perception of reality.
Economists at the Bank for International Settlements (BIS) found evidence of a feedback loop between the central bank and the private sector, resulting in significant and prolonged changes in perceptions of the neutral rate. According to their study, interest rate cuts by the central bank can cause fear among the private sector, leading to a decrease in demand and causing the central bank to conclude that the neutral rate has fallen, and subsequently draw the conclusion that interest rates should be cut further. They called this a "hall of mirrors" effect, and that this may be the reason for the decline in interest rates since the Great Financial Crisis of 2008. (BIS Working Papers No 974)
Perhaps Baudrillard's theory of the map preceding the territory applies to monetary policy? In the context of monetary policy, the central bank's actions and decisions shape the private sector's and public's perception of reality. Interestingly, the Wachowski Brothers' film, The Matrix, was inspired by Jean Baudrillard's book, Simulacra and Simulation. Despite this - or because of this? - Baudrillard himself came to disdain the film.
A funhouse of simulacra
It is common for central banks to use market interest rates as an indicator for monetary policy decisions. For instance, the Riksbank, Sweden's central bank, in 2019 wrote that that the neutral interest rate can be calculated as "(...) the average expected future real interest rate (...)". This sounds like a good idea, but is it really?
Over the past decade, economists at the International Monetary Fund (IMF) and other institutions have proposed that governments can stuff pension funds full with government bonds and regulate them to accept lower returns (IMF WP/13/266). Such a "tax on savings," which might be made "opaque to most voters" (IMF WP/15/7) is known as "financial repression" within the industry. The quantitative easing (QE) manipulation programs of the Federal Reserve, European Central Bank, and the Riksbank are but a few examples.
Perhaps it is possible that central banks, through their actions, have instilled fear in the private sector since the 1980s - depressing rates in the process. And it is true that regulators have compelled pension funds to purchase bonds at rates below market value (in an opaque way "to most voters"), as have central banks - further skewing bond market prices and pushing rates down. Astonishingly, the same bond market prices (interest rates) have then been utilized as a guide when implementing actual monetary policy such as interest rate cuts(!)
Indeed, central banks and monetary policy theorists all seem to be stuck in a funhouse of simulacra, to further borrow from Baudrillard. And this would be quite amusing, were it not that we are trapped in the same building.
And the building? Well, it seems to have caught fire.
Image source: Wikimedia Commons
"And this would be quite amusing, were it not that we are trapped in the same building." Haha, great ending. How do you prepare your portfolio for it to survive/prosper? (besides living under the orion sky:)