Recently, many economic and FED commentators point out that if we have a recession we will need a tighter FED balance sheet and higher interest rates in order to fight the recession using stimulative monetary policy. At the same time, others have pointed out that if interest rates get to high it will cause a recession. This leaves us with a logical conflict. If the FED actively manages the economy to have higher short-term interest rates and thereby be in position to fight a recession by lowering interest rates substantially, it will cause a recession to happen.
Bond sector money flows are one way to see how this might happen. As the FED sells bonds to reduce its balance sheet and increase short-term interest rates, the value of unmatured bonds will decrease. This is because the value of a bond varies inversely with the market interest rate for those bonds. Moreover, either the interest rate can change and cause the value of bonds to change in the opposite direction of the interest rate change or the value of the bond can change and cause interest rates to change in the opposite direction..
An example of an interest rate change that causes an inverse change in bond values is as follows. If you have a $1000 bond that never matures and pays a stated or fixed return of $50 per year, the corresponding market interest rate must equal 5%. This gives $50/.05 = $1000. Only the stated return of $50 is a constant value. Both the $1000 bond value and the market interest rate of 5% are inversely related variables. By contrast, if the market interest rate climbed to 10%, this same unmatured bond would now be worth $50/.10 = $500 in the open market.
This process is underway at the FED. Specifically, as the FED sells bonds to decrease their value and thereby drive up interest rates we can expect people to sell unmatured bonds to avoid the expected capital losses. The bond market is huge in that it is about twice the size of the market for stocks. Cash from bond sales must go somewhere and most of it will go into stocks and drive the price of stocks higher. At some point, on the other hand, those holding stocks will see higher rates on less risky bonds as a better alternative and the money that flowed into stocks will reverse and flow back into the now higher yielding bonds. This will look like what happened during the stock market crash in 1987. The crash may cause a sudden V-shaped sell-off as in 1987 in which stock buying followed the sell-off. On the other hand, it may cause a recession so that the stock market has a flat, bear market bottom.
One way to prevent the FED from causing a sudden and severe stock market sell-off from its activist monetary policy is to require the FED to follow a monetary rule that will maintain a so-called “neutral” short-term interest rate. Such a rule might be related to the difference between a target inflation rate such as 2% and the actual inflation rate and the difference between a full employment GDP growth rate and the actual growth rate. This is the Taylor rule. If, for example, the actual inflation and GDP growth rates are above their respective target rates the FED would be required to sell bonds and cause an increase in short-term rates. If, on the other hand, actual inflation and GDP growth rates are below their target rates then the FED would buy bonds to increase their value and thereby decrease short-term interest rates. In both cases, it follows the monetary rule rather than to act with discretion. Having the FED follow a monetary rule means that the state of the economy determines FED actions. without the rule, FED actions tend to involve attempts to actively manage the economy based on the whims, fancies, assumptions, political influences, attitudes, or beliefs of the FED chief and board of governors.
As long we the economy is not characterized by stagflation in which the actual inflation rate is above target and the actual GDP growth rate is below target, the Taylor rule will work as guide to FED actions. In a period of stagflation any monetary or fiscal expenditure stimulus aimed exclusively at the expenditure or aggregate demand side of the economy will fail because only an increase in inflation will occur. Instead, policies with predominant effects on the supply or production side of the economy are effective because they increast the GDP growth rate and reduce inflation. Such policies may include tax cuts, but policies such as reducing regulations that, in turn, reduce production costs and incentives for greater private investment that increase productivity, which also lowers production costs,are effective.
Fiscal expenditures on public infrastructure investment also increase productivity and lower production costs. While the short-run effects on aggregate demand are inflationary, the longer-run effects are on the supply-side of the economy through increased productivity and lowered production costs put downward pressure on inflation while simultaneously stimulating production and GDP growth.
