What if the Fed doesn’t matter?

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Central bank epiphenomenism

I asked a few weeks ago whether Jay Powell was lucky or good: whether the Fed’s smart policy caused, or merely coincided with, the rapid decline in inflation over the past two years. If you think Powell and the Fed were mostly lucky—and many economists think they were—one is tempted to push the skepticism further. What if central bank rate policy is always a meaningless or near-meaningless sideshow in economies and markets? What if policy rates are (to use the vocabulary of the pretentious philosophy graduate student I was 25 years ago) largely epiphenomenal—that is, they accompany important changes rather than cause them?

Today, “heretic” is almost exclusively an honorific people give to their own beliefs, to mean “unique and wonderful.” But on Wall Street the view that Fed policy is epiphenomenal is heretical in the old-fashioned sense. If true, much of what investors, analysts, and pundits say, do, and believe are just elaborate rituals honoring a deity that doesn’t exist.

Serious people have this point of view. New York University’s Aswath Damodaran (who will be familiar to Unhedged readers from our interview with him) recently updated his defense of Fed epiphenomenalism on his blog. He claims that:

• The federal funds rate, set by the Fed, is a single, short-term rate that in no way determines the major interest rates—on mortgages, auto loans, credit cards, corporate bonds or business loans, and so on.

• While both the federal funds rate and major interest rates follow the same long-term trends, over shorter (but still significant) periods, the relationship between changes in the federal funds rate and “real world” rates is all over the place. Sometimes one rises and then the other falls, or vice versa, or there seems to be no relationship at all. Consider the federal funds rate and triple B bond yields, for example. Between the spring of 2004 and the summer of 2006, the Fed rate increased by more than 4 percentage points. Triple Bs moved less than 1%. The market has largely ignored a very aggressive Fed.

• There may be occasional strength in the Fed’s signaling: markets may include the belief that the Fed knows something about the economy that others do not, or that the Fed can somehow control interest rates. But outside of crisis situations, these effects are mild.

• In conclusion, “The Fed acts in response to changes in the markets rather than leading those actions, and is therefore more of a follower than a leader.” Nominal interest rates have two underlying factors, neither of which are under central bank control: real rates (which vary with expected economic growth) and expected inflation. For example, rates were so low in the pre-pandemic decade not because the Fed suppressed them, but because growth was weak and there was no inflation in sight.

Damodaran is not alone. Last year, Martin Sandbu of the Financial Times, in an article titled “What if Central Banks Can’t Do About Inflation?” argued that

() Here is a robust analysis that can explain virtually all of the behavior of both US and Eurozone inflation, exactly as the temporary cross-sector spillovers of a series of large supply shocks would look. . . (If) this is actually the true explanation of events. . . monetary policy could have done nothing to prevent the bursts of inflation of the past two years, and that current monetary policy is doing nothing to lower inflation.

Sandbu does not go as far as political epiphenomenalism. He believes that rate policy can have effects, but that this time they will be “exclusively harmful” because they will weaken the economy when inflation is already dead. But it is easy to see how his argument could be extended to other inflationary incidents that followed supply shocks, and perhaps beyond.

In The Wall Street Journal, my former colleague Spencer Jakab makes a similar point in the context of the stock market, comparing the Powell chair to the Wizard of Oz:

The big, powerful man behind the central bank curtain, Jay Powell, really can’t do as much as people think to keep their portfolios from going haywire if the wheels are already starting to come off the economy.

He uses the example of the 2007 rate cut, which initially sparked a rally in stock prices, but was unable – even when bolstered by many subsequent cuts – to stop a recession from starting a few months later. Even at less extreme times, Jakab argues (citing the work of David Kostin, chief U.S. equity strategist), economic momentum, not Fed policy, has been decisive for markets during rate-cutting cycles. Jakab does not go as far as Damodaran, who argues that rate policy pulls a lever that is not tied to anything. But his argument points very clearly in this direction.

There is a longer argument to be had about whether central bank epiphenomenism is true. To prove the case, he would have to describe and disprove the standard theory of how monetary policy rates control other interest rates. But suppose epiphenomenalism is a possibility. The interesting question for investors is: What would you do differently if you knew the Fed followed, rather than led, the markets and the real economy?

First, you’d be much less worried about “Fed mistakes” – especially excessive Fed tightening that leads to recession. Remember that many people, including Unhedged, were very concerned about this in 2022 and were probably under-exposed going into the glorious year of 2023 as a result. But if investors had ignored the Fed’s tightening and instead looked only at the company’s economic fundamentals and cash flows, could they have remained bullish?

A good read

On the US balance of payments.

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