6% Fed Funds Rate – “Monetary Policy Nirvana”

From the Wall Street Journal:

Economic Rehab

“The stock, bond, currency and commodity markets are bouncing around wildly. While there are many crosscurrents, monetary policy and economic data are front and center in day-to-day market volatility. As a result, some market observers are trash-talking the new Federal Reserve Board chairman, Ben Bernanke, and blaming him for all sorts of perceived missteps.”

“This is unfair. Mr. Bernanke is doing a fine job. The inflationary pressures he is fighting today were baked in the cake before he arrived. Monetary policy was overly accommodative for too long, and even after 16 rate hikes the Fed has not yet reached neutral. Weaning investors, home builders, hedge funds and proprietary trading desks from 50-year low interest rates is like forcing them to quit smoking: It’s good for the health of the economy, but it hurts and they are complaining loudly.”

“Historically, housing has been a solid leading indicator of business cycles, but the special circumstances of recent years suggest that this time it is sending a misleading signal. And while some believe that a slowdown in housing will undermine consumer spending, this fear is overblown. Cash-out financing (or mortgage equity withdrawal) may have increased spending for those who took advantage of low interest rates to refinance, but every dollar of borrowing was funded with someone else’s savings.”

“In other words, there is little evidence that rates have reached a level that is detrimental to the economy. The Fed is not tight; it is just less loose. This can be seen in real time by watching market-based indicators. Commodity prices remain elevated and the dollar continues to weaken; both suggest excess money creation. Moreover, the economy has not experienced a recession in over 45 years without the federal funds rate rising above nominal GDP growth. In the past year nominal GDP growth has been 6.9%, so with the federal funds rate at 5%, monetary policy is still accommodative.”

“Nonetheless, the Fed is very close to a neutral monetary policy. Using nominal GDP as a target, and looking back historically, a neutral rate is likely close to 6%. If the Fed could get rates to this level soon, the economy could continue to grow based on underlying entrepreneurial activity and productivity — a rate estimated to be 3.5% or 4% per year. A neutral rate would also put a lid on inflation, stabilize the dollar and cap commodity prices, including oil. A 6% federal funds rate would be monetary policy nirvana.”

-Hat tip to ChicagoFinance for this piece.