The Illusion of Power

All hail the mighty Federal Reserve, the setter of interest rates and gatekeeper of the economy.

I don’t think anyone would go so far as to explicitly say that, but it seems to be the underlying tone I hear from many investors, as well as the subject of many op-ed pieces written by economists and investment advisors.

In this low interest rate world, everyone wants to blame the central bank. Asset prices in a bubble? Blame the Fed. No return for savers? Blame the Fed. Low economic growth? Blame the Fed.

Whatever the problem may be, it seems the Fed is a convenient and well-accepted scapegoat. But is that claim warranted? Are they truly the masters of our financial universe? Or are they more like the Wizard of Oz?

Just like the planets in our solar system revolve around the sun, assets prices and our economy typically revolve around interest rates, and particularly, risk-free rates.

If you believe that interest rates are set and controlled by the Fed, then the masters of the universe theory make sense. On the other hand, if you recognize that interest rates are set by the markets, based on fundamental aspects of our economy, then the Fed is more akin to a smoke and mirrors show.

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In a recent article, Aswath Damodaran, Professor of Finance at NYU, reminds us that longer-term interest rates (the ones that matter because they actually impact consumer and business borrowing) are set by economic fundamentals, not by central banks.

As Damodaran explains, the risk-free rate, or interest rate on a guaranteed investment, can be determined as follows:

Interest rate on a guaranteed investment = Expected inflation + Expected real interest rate

When you consider that the real interest rate has a strong relationship to economic growth (in the long-run you cannot have a real interest rate consistently higher or lower than an economy’s growth rate), then the relationship can be rewritten as follows:

Interest rate on a guaranteed investment = Expected inflation + Expected real growth rate.

Don’t worry if you're confused at this point, the next chart will help tie everything together.

This chart, courtesy of Damodaran, shows how the yield on the 10-year Treasury (risk-free rate) has tracked the sum of inflation and real GDP growth over the last 60 years.

The relationship is remarkably steady, and lends credence to the fact that rates at the longer end of the yield curve (again, the ones that directly influence our economy) are actually a result of our economy, not the machinations of the Federal Reserve.

The Fed does have complete and total control over the federal funds rate, the rate at which banks lend money to each other on an overnight basis, but it’s important to recognize that what the Fed does with overnight rates has very little impact on longer-term rates.

Even Milton Friedman, the twentieth century’s most prominent advocate of free markets, recognized this, saying, “After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."

The realization that longer-term interest rates are set by the broader economy, rather than monetary policy, leads to a somewhat stunning conclusion: absent the Federal Reserve, interest rates would still be very close to where they are now.

The low growth and low inflation (and consequently low-interest rates) that we are seeing are ultimately the results of a global economy that has grown exceptionally large. Strangely, many people don’t seem to recognize that our economy cannot experience exponential growth forever.

Consider this: If our economy was able to grow at 3% per year for the next 100 years, our economy in 2116 would be nearly 20 times the size of our current economy. In 200 years, our economy would be 370 times larger. That’s simply not possible, as sooner or later the mathematical concept of exponential growth runs into the limits of a finite world with limited resources.

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I think we’re already nearing that intersection. We’re seeing growth decelerate because our economy is so large that even 1 or 2% growth is a remarkable amount of actual growth. Our ability to grow the pie larger is being continually diminished, and that is going to lead to lower and lower growth rates moving forward.

And since we’ve now seen that interest rates are a function of economic growth and inflation, it seems rather clear why interest rates have been declining over the past few decades and are unlikely to move much higher in the future, regardless of what the Fed does.

Interestingly, even though the Fed’s power is surprisingly limited, our obsession with the Fed and other central banks may play an important psychological role for investors. The sense that central banks have control over the economy leads to a feeling of comfort in that at least “somebody” is in control.

It can be difficult to swallow the idea that gyrations in our economy are uncontrollable, even though that’s really how it is. The illusion of central bank control gives us something to talk about, someone to blame, and a sense of hope that if they do things right, maybe we can get back to the “normal” growth levels and policies of previous years.

Unfortunately, that power and control are merely an illusion.

The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

About the Author

Chief Investment Strategist
matt [at] modelinvesting [dot] com ()