The Federal Reserve may or may not elect to raise its target on the federal funds rate when it meets on Thursday. Yet either way, the much-anticipated decision is unlikely to have nearly as great an impact on the economy as it might have 30 years ago.
Such is the argument in a recently released paper from the Kansas City Fed, which posits that changes in financial markets and the American economy have reduced the import of changes to the interbank lending rate.
Before 1985, an unexpected 25 basis point cut in the federal funds rate would have led to a 0.2 percent increase in employment over the next two years, the study noted. But in the post-1994 period, the effect on employment is statistically insignificant, find Jonathan Willis and Guangye Cao of the Kansas City Fed.
This is obviously problematic, given that the Fed describes its ultra-low interest rate target as intended to "support continued progress toward maximum employment." If the impact of a shifting fed funds rate target on employment is indeed nil, then this strategy makes little sense.
Perhaps even more troubling, it means that the Fed's primary tool for helping the economy has been, at best, severely blunted.
As the economists noted in the study: "Slow recoveries followed recessions in 1990-91, 2001, and 2007-2009, a contrast to the much more rapid recoveries that followed pre-1990 recessions. These slow recoveries occurred despite sizable monetary accommodation from the Federal Reserve, primarily through reductions in short-term interest rates."
So what led to this unfortunate situation? Willis and Cao posit that a shift in the U.S. economy has made the country less interest-rate sensitive.
For starters, the economists show that durable goods manufacturing and construction are more interest-rate sensitive than industries like health-care services and education, as the data on job gains in those industries post-Fed-move show.
This makes sense, as business decisions in service industries like health care are not as dependent upon the cost of capital as are business decisions in manufacturing industries, where expensive property or equipment often needs to be purchased before workers are hired.
Over the past few decades, the relative size of these more interest-rate-sensitive sectors has declined, as the U.S. has transitioned from a manufacturing economy to a service economy. Unsurprisingly, this appears to have diminished the nation's overall interest-rate sensitivity.
But that's not the only factor that has diminished the import of the fed funds rate. The connection between short-term rates and long-term yields appears to have diminished, with the 10-year yield now tending to initially rise in response to a decline in the federal funds rate, and any slide in longer-term yields occurring with a "longer lag in the post-1984 period."
But again, since the U.S. economy has become less interest-rate sensitive, the connection between employment and long-term rates is also not as strong as it used to be.
This is somewhat in line with a paper written by St. Louis Fed economist Stephen Williamson, who noted that "there is no work, to my knowledge, that establishes a link from QE (quantitative easing) to the ultimate goals of the Fed—inflation and real economic activity. "
Willis and Cao go on argue that changes in monetary policy "do not appear to be responsible for the shift in interest sensitivity."
But some believe that Willis and Cao let the Fed off the hook a bit too easily.
Economist Scott Sumner retorts in a recent blog post that "Monetary policy has clearly been less expansionary during recent recessions, and that's why the recoveries have been slower."
Sumner doesn't mean that the Fed's nominal rates have been higher, but that they have been higher with respect to the economy's equilibrium interest rate. That is the threshold at which money would naturally be lent to borrowers.
Sumner, like many economists, says this rate has fallen dramatically since 1985—which means the Fed's policies have been far less expansionary than they think. Sumner's optimal Fed would pursue a more aggressive stimulative policy.
The one point most hawks and doves can agree on, then, is that the Fed's recent policies appear to have done little to spur employment—or inflation, for that matter. Whether that's the fault of policymakers or systemic changes, however, remains the hot question.
Meanwhile, the Kansas City Fed economists conclude their paper with a simple plea: "Future research should investigate whether and how monetary policy should adapt in response to these changes" in interest rate sensitivity.