Calafia Beach Pundit: Why Fed policy is hurting the economy

http://scottgrannis.blogspot.com/2013/02/why-fed-policy-is-hurting-economy.html

Why Fed policy is hurting the economy

In other words, while everyone, including the Fed, thinks that ultra low interest rates provide an important source of stimulus to the economy, it's quite likely that they do just the opposite. The Law of Unintended Consequences strikes yet again!

The above chart uses the same data as Taylor's original chart, but includes data going back to 1960 (his only went back to 1990). The interpretation of the chart remains the same. There is a strong inverse relationship between fixed investment as a share of GDP (fixed investment includes private residential and nonresidential construction, and private investment in equipment and software) and the unemployment rate, which is a good proxy for the health of the economy. He is careful to note that while the correlation is strong, we cannot infer the direction of causality. But this does illustrate how a lack of investment could go a long way to explaining why the recovery has been so weak. 

It then occurred to me to put his two ideas together, to see if the Fed's monetary policy was correlated with the amount of fixed investment. Where Taylor's WSJ article focuses on how artificially low interest rates limit lending and therefore aggregate demand, and his chart compares fixed investment to the unemployment rate, I wanted to see if there was a link between Fed policy and fixed investment.

As the chart above shows, Fed policy is indeed highly correlated to fixed investment (even more so than the unemployment rate is). This fits hand and glove with the first chart, which links fixed investment to the unemployment rate. The red line in the above chart is the real Federal funds rate (using the Core PCE deflator), since that is a good proxy for the degree to which monetary policy is "tight" or "easy."

This puts some meat on the bones of Taylor's WSJ article. The Fed's unusually accommodative monetary policy stance, which promises extremely low interest rates (negative in real terms) for a long time to come, does appear to be a factor in limiting the amount of funds available for investment, and in reducing aggregate demand, and that in turn helps to explain why the recovery has been so weak.

How else to explain the fact that fixed investment is almost always very strong when monetary policy is very tight, and weak when monetary policy is easy? How else to explain how a decade of extremely low interest rates have failed to stimulate Japan's economy?

Food for thought and controversy...

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