Should Congress Legislate Rules for the Central Bank?


If the Taylor rule (which will force the Federal Reserve to raise interest rates to more traditional levels) is implemented by Congress (which is unlikely) then short term rates would rise 1.25%. Ironically this would help long term bond prices. See the article in FT about Taylor rule. It would hurt stocks and speculative leveraged ventures causing stock prices to go down and creating a less robust, more depressed economy thus reducing the risk of inflation which would help the value of long term bonds.

Trying to fix a mandate for the Taylor rule is a bad idea because the Fed needs flexibility as some unknown, unknown may occur which would require the fed to react in new ways in an emergency. Since Congress can be paralyzed over ruthless budget deficit fights then presumably similar problems could occur if there was ever an emergency need to end the proposed legislation.

Ironically cutting rates to ultra-low levels has an analogy with supply-side economics policy of cutting taxes to encourage more economic activity which in turn allegedly results in more taxable income and thus no loss of tax revenue. In the case of deep interest rate cuts in theory these could result in more activity than if the cuts had not occurred which would then help to push up asset prices, economic growth, employment and thus move people away from being eligible for welfare benefits, etc. and towards becoming a fully employed worker who pays taxes. As a result of a reduction in bad economic statistics because of the use of rate cuts the system was saved from a more savage recession that would have led to the election of politicians who would have advocated more leftist confiscatory policies. So ironically letting the Fed “confiscate” part of one’s expected real interest income may have been less worse than ending up with a deep depression and a leftist Congress that confiscated other forms of wealth.

The rate cuts may have failed to create jobs but if the cuts had not occurred then surely the economy would have received less stimulus than it did and thus languished in a deeper recession for a longer time.

Economists must be careful not to assume the current recovery will eventually be the same as a typical recovery. Instead it is far different than previous recoveries because of the massive debt burden acquired in the past 25 years and the massive qualitative degradation of middle income workers’ pay. Workers get a much greater proportion of income through unreliable arrangements such as part time, temporary, independent contractor, and commissions, etc. than decades ago. This makes it harder to take on more debt to buy more things and thus the economy will continue to grow slowly.

The Taylor rule may seem fair in the sense that its supporters look at the mistakes of the Federal Reserve in 2002 when rates were too low, however, the current “recovery” from the great recession of 2009 is uniquely burdened with a new set of problems for which the Taylor rule hasn’t been designed to take into consideration. These are the twin problems of qualitative degradation of worker pay and excessive debt burdens. These two when combined create serious negative synergy for the economy. At no time is U.S. history did we have both declining real wages and excessive debt. By “excessive debt” I mean the total debt from all sources which for a long time ranged between 100% to 180% of GDP and 25 years ago went parabolic and is now 345%. I don’t recall any mechanism in the Taylor rule to adjust for the problem of excessive debt. Basically the reason a central bank raises rates is if the economy is overheated. But if taxes are raised or oil prices increase that can also cool down the economy thus negating the need for the Fed to raise rates. Now to the list of tax increases and oil increases a new reason not to raise rates is if principal repayments are excessive then that acts like a surrogate for a rate increase. Thus economists need to rethink the well intentioned Taylor rule. No one wants to have their savings confiscated by a Central Bank making real rates too low, so the Taylor rule is well intentioned, however new circumstances have developed.

Investors need independent financial advice about the risks debt bubbles leading to a stock bubble and crash. I wrote an article “Is a quadrillion too much debt?”




About the author

Don Martin, CFP®

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