Federal Reserve's Problems.
No, "A Penny for Your Thoughts" does not indicate this is an article about the demise of the penny. Instead, it is a blog that seeks your thoughts on the problems facing the Federal Reserve. In November, the Wall Street Journal ran an article entitled, “The Fed Is Increasingly Torn Over December Rate Cut.” This was an interesting read. However, the challenge is not what the Federal Reserve will do about rates this week, but over the next ten years. The challenge is whether or not the Federal Reserve model for ascertaining rate changes is functioning correctly. Is it robust? I believe there is a structural problem in the Federal Reserve’s system for dealing with its assigned tasks of maintaining maximum employment and stable prices.
Do Not Blame The Federal Reserve.
I must add that the problem is not the result of Chairman Powell’s actions or even the board's actions. This is not a political statement, but a factual one. Installing a new Federal Reserve chair will not solve the problems, although President Trump is convinced that a new chair should reduce interest rates, which, magically, will solve all problems. He could be correct, but I think not.
Federal Reserve Regulatory Metrics.
Consumer Price Index. To understand the problems the Federal Reserve faces, it is essential to examine some of the metrics the Fed uses to set interest rates. First and foremost, we all know the Federal Reserve watches the Consumer Price Index (CPI). If the CPI goes up too much, the Federal Reserve, in theory, wants to raise rates to slow growth and thus inflationary pressures. If the CPI falls too much, the Federal Reserve wants to lower interest rates to stimulate growth.
Unfortunately, the CPI metric is being buffeted by problems that make the current model financially awkward, if not untenable. There are two driving forces. One is AI, which, in theory, reduces costs and drives prices down. The impact of AI will only grow greater over the next ten years. The second force is the tariffs President Trump has imposed, which can increase costs. For the time being, this is like two tsunamis crashing headlong into each other, partially canceling out each other's force. When economists marvel that prices have not gone up more because of the tariffs, they fail to consider the countervailing force. Sooner or later, one of the waves will ebb, making it even harder for the Federal Reserve to know how to maneuver.
For the Federal Reserve, making decisions in this environment is like drawing one card to an inside straight, i.e., about a one-in-twelve chance of getting it right. This is not the kind of odds that I want the Federal Reserve to have. (It should be noted that the Federal Reserve board members, when predicting future interest rates, rarely get it right even when there are no dramatic forces at work.)
Labor Market. The second metric that is difficult to evaluate is the labor market. The Federal Reserve always looks at the unemployment rate. Good metric. However, the critical question is, “What is now driving employment?” A slowing economy can lead to higher unemployment. But what if the increase in unemployment is a result, at least in part, of the increased use of AI? The problem for the Federal Reserve then becomes one of dealing with increased unemployment, which may not require lower rates if the increase is due to AI implementation. In fact, you can have a robust economy and yet a higher unemployment rate. How do you maneuver this challenge?
Beige Book. The final factor is the Beige Book. The Beige Book is a report
….published eight times per year. Each Federal Reserve Bank gathers anecdotal information on current economic conditions in its District through reports from Bank and Branch directors and interviews with key business contacts, economists, market experts, and other sources. The Beige Book summarizes this information by District and sector. An overall summary of the twelve district reports is prepared by a designated Federal Reserve Bank on a rotating basis.
The Beige Book is supposed to provide the Federal Reserve with insightful information, but its relevance may be declining. Over the last decade, information has become more readily available in the public arena, and the probative value of anecdotal details may be lower.
The Inevitable.
The last problem has nothing to do with the Federal Reserve’s modeling or data gathering, but the inevitable. In one of my finance classes in graduate school, the professor said markets go up, and markets go down. All the graduate students in the class rolled their eyes and groaned — a loud, mocking groan. What a stupid thing to say; it is a statement of the obvious. Yet the Federal Reserve faces the possibility that the AI bubble will burst. Then none of the plans it has put in place will succeed — but like a set of dominoes, the economy could fall.
Having served on the Charlotte Federal Reserve branch of the Richmond Federal Reserve, I have a great appreciation for the board members' and the chairman's efforts. However, the economic environment has and is changing so rapidly that the Federal Reserve's tools may not be adequate. The Fed may have to rely more on AI and less on its own judgment when making decisions. This prospect does not make me feel comfortable.
Please let me know what you think: "A Penny for Your Thoughts."
If you haven't read the initial blog describing the "However View," click here.
