The Burnt Man in the Shower

I once spent the night at a resort in Estes Park, Colorado.  Our bank was looking at financing a purchase on the resort.  After my morning workout, I retired to my room for a shower in the short window of time I had before a morning meeting. 

The problem I encountered was the water never warmed up.  Even though I turned up the water as hot as it could go, the shower did not get much warmer than the Fall River was outside on this January morning!  Judging that I had to take a shower before the meeting, I proceeded to jump in for what seemed an eternity of time that was punctuated by my constant swearing, “Oh Lord”, and “you gotta be kidding” until the end of the most painful event.  The walls were thin and the other gent I was travelling with in the other room said he got the best laugh that he had in years.

Have you ever been in a shower that was not warming up as quick as you desire so you blast the hot water?  In some of these, the water heat is building up slow and finally comes in a scalding batch that suddenly burns the person in the shower.  OK, so next time, you would hope to remember what happened and turn up the hot water more slowly or just wait until the water gets warmed up.  The problem with the burnt man in the shower scenario is that the man continues to do the same actions each time he gets in the shower with the same result—a burn from the hot water.

I once heard the Federal Reserve as compared to the burnt man in the shower.  The Fed tries to set monetary policy as a balance between full employment and price stability.  When Alan Greenspan was Fed chair, he once defined price stability as “the state in which expected changes in the general price level do not effectively alter business and household decisions.”  Greenspan kept a targeted inflation rate of 2%, though he insisted that no actual amount should ever be made public.  When Ben Bernake was chair, he formally announced in 2012 the targeted inflation rate was 2%.

Incidentally, this targeted rate came in 1988 from a TV interview with New Zealand Reserve Bank chair Roger Douglas, in seeking to dissuade New Zealanders from thinking the central bank would be content with high inflation.  He stated the bank was targeting an inflation rate between 0 and 1 percent.  In the next year, Don Brash, Reserve Bank Chair, and Finance Minister David Caygill set a targeted range of 0 to 2% to achieve price stability.  Inflation in the island country dropped from 7.6% in 1989 to 2% in 1991 after the enactment of this monetary policy shift.  As Brash shared his story with other central bankers at a conference in Jackson Hole, Wyoming, one by one other central bank heads began the 2% inflation target which has reigned as a norm in monetary policy for nearly 30 years now. 

A problem with monetary policy changes is often those who pull the levers are not patient to see what impact their changes accomplish prior to making the next move.  In 2018, we saw four—quarter point increases in the Fed Funds Rate.  At the end of the year we sit with a very flat yield curve.  As I write this the 2-year Treasury is only 17 basis points lower than the 10-year U.S. Treasury. 

Each recession since the 1970s has been marked with an inversion of the yield curve, a point where 2-year notes are at a higher rate from the 10-year notes.  This is out of the ordinary since a 10-year note would require a higher rate due to its duration risk.  We are very close to this going negative and one additional quarter point bump coupled with stable prices on 10-year notes will push the curve there. 

So, is the economy overheating?  Inflation in November ended at 2.2%, which was in the Fed’s target range.  Unemployment sat at 3.7% with more job openings than people searching for employment.  This was a little below the Fed’s long-term goal from 4 to 4.6%.  Things don’t seem that out of control and yet the Fed still chooses to increase rates. 

Some will argue that the Fed’s inflation target is arbitrarily too low and a rate of 3 or maybe even 4% is more normal.  If that were the case, we would not have seen the interest rate increases in the past year.  The question is if the Fed under Chairman Powell will act like Chairwoman Yellen.  Yellen followed a pattern of making a small change and then taking time to observe what was happening before the next move.  One may question if Powell will follow the same course.  Four rate increases in a year, even though they are small, causes one to wonder. 

Will the burnt man in the shower learn his lesson?  Or will we see hot increases in interest rates until the economy goes to into a recession, thus forcing a quick reversal in policy to get things going again?  Only time will tell.  If past history tells us anything, there is a good chance the burnt man will be burnt again.