The Fed Still Hasn't Learned Its Lesson on Interest Rates

Just a few hours ago, the US Federal Reserve announced they're raising interest rates for the first time in one decade. In this gust post written just one day prior, Troy Vincent warns that since all the advice and commentary about raising comes through a Keynesian lens, it leads to a diagnosis that is superficial and a prescription that reflects a deep misunderstanding of the business cycle.

Today, just one day prior to the announcement of the FED’s decision as to whether or not they will raise rates [which they did this morning, NZ time], the financial headlines are awash with dire warnings to the FOMC by both economists and columnists alike.  Although these articles point out legitimate concerns and data that should cause us to pause if we think that the economy is functioning like a well-oiled machine, they all miss the mark for the same consistent reason – they’re viewing the economy through the Keynesian lens.  This leads to a diagnosis that is superficial and a prescription that reflects a deep misunderstanding of the business cycle. Oddly enough, the Fed has now waited so long to raise rates that those with the incorrect diagnosis and prescriptions could soon once again be hailed as the great prognosticators.

Mark Gilbert over at BloombergView, for example, rightly points out one of the most important damning factors of the Fed’s near decade-long misadventure of zero interest rate policies.  Quantitative easing has effectively destroyed the price discovery or valuation mechanisms for (government) debt.  He recognises that prices and yields lose their information value when central banks are buying up debt as fast as they can, but somehow fails to recognise that the Fed’s key role is to do just this – distort the most important price in the economy – interest rates.  

He continues the logical misstep, as he uses the fact that Mario Draghi and the ECB are doubling down on their zero rate policy as a reason for the Federal Reserve to continue this folly.

Mark points to the ECB’s “errors” of raising rates in 2011, which they later reversed in an effort to compete in a world of competitive monetary devaluation, as a series of events that the Federal Reserve should want to avoid. 

Former U.S. Treasury Secretary Lawrence Summers and economist Nouriel Roubini are also weighing in with their warnings of a premature rate hike.  “A decision to delay rates runs risks that are easily reversed by subsequently raising rates, whereas a decision to raise rates, if it proves to have been the wrong decision, is a much more difficult decision to correct,” Summers said. Roubini agreed, echoing the sentiment that it easier to raise rates in an overheating economy than it is for the Fed to reverse course and lower rates after hiking them, which might damage the central bank’s credibility.  Sadly, although these individuals are overlooking the root cause of this madness and suggesting policies that will only prolong the inevitable, the rate hike has been delayed for so long already that the outcomes they foresee will likely come true.  Meaning, high-yield bond markets and funds will experience massive pain, both company and government budgets will be further stressed, and the Fed will eventually have to renege and lower rates once again.

But this is not a result of raising rates too soon, this is because the Fed has kept rates low for so long that it is now preparing to raise rates as we near the end of a credit cycle.

So what is the insight that could stop this endless cycle of global currency wars and markets obsessing over every word uttered by central banks? Why, the Austrian theory of the business cycle of course.  It is the fundamentally Austrian insight that it is the boom that is to be feared, not the bust—specifically, the “boom” of economic growth and asset price inflation associated with central bank suppressed interest rates. As Mises identified,

Credit expansion can bring about a temporary boom. But such a fictitious prosperity must end in a general depression of trade, a slump.

The bust, or the depreciation of asset values and economic contraction associated with recessions and depressions, are actually the healthy part of the business cycle.  The recovery part. This gives the market an opportunity to rid itself of any malinvestment or misallocation of resources that took place in the boom and arrive at market clearing prices, or a foundation upon which the economy can soundly begin to rebuild. Squelch that recovery part however by propping up bad positions, and the necessary reallocation of resources may never successfully happen.

Until economists begin to look for the root cause of the business cycle (and read Mises), instead of attributing it to animal spirits and market and regulatory failures, we should expect for this repetitive cycle of central bank inspired booms and busts to continue. As long as it is the prevailing wisdom that interest rates must be controlled and manipulated in order for the economy to grow soundly we will have the predictable consequences of price controls. 

On the day before [now just hours after] this hyped announcement, let us remember that manipulating the supply and demand of money will not bring us prosperity. As Mises said,

What is needed for a sound expansion of production is additional capital goods, not money or fiduciary media. The credit boom is built on the sands of banknotes and deposits. It must collapse.

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Troy Vincent is a 2011 graduate of Mises University and has a BS in economics and public policy from Indiana University. He has worked for three years in energy economics and is currently a market analyst for an energy procurement and consulting firm.
This post appeared previously at the Mises Wire.

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