The Fed needs to stop raising interest rates

The writer is a philanthropist, co-founder of Pimco, and author of the 2022 memoirs I’m Still Standing, Bond King Bill Gross and Pimco Express.

“Love lifts us up where we belong,” the theme song from the 1982 movie rings out An officer and a gentleman. Replace “the Federal Reserve” with “love” and you have the theme for 2022-2023, with the global central bank leader, Jay Powell, doing the heavy lifting.

We need to re-settle the cost of money. Most of us would agree to this. But how high is it and for how long? Among economists, Larry Summers suggests up to 6 percent for the Fed’s target money rate, but Jeremy Siegel suggests that 3 to 4 percent is sufficient. As Chairman of the Federal Reserve, Powell strongly maintains that we will rise above the current target of 4.25 to 4.5 percent, but warns that peaks in rates and their duration will depend on the data in the coming months.

I propose several clues to this puzzle. First, apart from the critical focus on US employment, global growth and financial conditions, it is important to analyze the level and pace of real interest rates that have historically slowed economic growth in past cycles and resulted in acceptable inflation targets.

I stress real yields versus nominal yields because the outcome dreamed up by the Fed and other central banks is the infrequently mentioned “r-star” — the “neutral” level of overnight money rates net of inflation that corresponds to stable economic conditions.

This is probably too complex for broad general use and difficult to calculate based on future CPI assumptions. The 0 percent rate or less that we’ve seen in some recent years is also an anomaly given the trillions of dollars created under QE programs.

However, regardless of this period, historical statistics over the past several decades will show that, on average, 2 percent in the United States would be enough to level out growth and increase unemployment. Zero percent or less would be enough to accelerate inflation above the central bank’s targets.

It’s the 2 percent that forecasters seem to skip in their analyses. I would argue that with the federal inflation target of 2 percent and with the current target federal funds rate at 4.25 to 4.5 percent and rising in February, we’re already at the optimal r-star rate and likely to stay there for some time as it looks like — and a large percentage — That inflation is close to acceptable levels, even above 2 percent.

The risk of overshoot and the need for forward-looking monetary policy strongly argue for this. The Fed should now stop raising interest rates and wait to see if its punching pot has been sufficiently drained.

Secondly, though, I think it’s important to recognize the dangerous levels of debt recently approved by the Bank for International Settlements. “Off-balance sheet dollar debt,” they warned in a December 5 update, “may remain out of sight and out of mind, but only until the next time dollar financing liquidity is squeezed.”

They estimate that the hidden “shadow bank” debt could reach $65 trillion, more than twice the size of the entire treasury market, and that most of it is owed to banks. Shades of Minksy’s Past Moments!

Minsky’s famous theory is that stability leads to sudden periods of instability caused by excessive risk-taking that invite common sense caution. Check out the Ponzi schemes – cryptocurrencies, non-fungible tokens, etc. – that central banks have created in abundance under the cover of Covid.

Economist and journalist Walter Bagehot noted the pain point for savers in the old days in the UK: “John Paul can afford many things, but he can’t afford 2 percent!” So can Paul stand at 0 percent or less for the past few years?

The lowest global rates in history since 2020 have led to massive capital misallocations. Most of it is in hidden private equity that must eventually re-price sharply lower. It is also reflected in housing prices around the world which are similar to those of 2005-2008 and pose a risk to lenders as they were in the era before the global financial crisis. Having secured historically low mortgage rates, borrowers should not suffer the same default rates as then, but their ability to access equity-based loans in the future should be severely limited as home prices fall.

There could be a problem in the future if the nominal federal funds rate rises from 4.25 to 4.5 percent and 2 percent. A lot of hidden leverage, a lot of shadow debt behind closed doors. To paraphrase the Persian poet Omar Khayyam, the Fed must stop moving and then, after that, move forward.

Video: Divided Markets: The Great Threats to the Financial System

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