How The Fed Sets Interest Rates - Rich In Tradition But Slow As Molasses

This week, we were treated to one of the great traditions of the Western World: the Federal Reserve's biannual report to Congress. This duty was always delivered by the Fed's Chairman this year, as that duty fell to Jerome Powell for many years in the past.

By all accounts, Powell performed most masterfully. A lawyer by training, Powell transitioned easily among the Fed's favorite measures of GDP, Inflation, and monetary policy. Cognizant of his historic role, Powell reminds the Congressmen and Senators, in his very first sentence, that:

"The Federal Reserve remains squarely focused on our dual mandate to promote maximum employment and stable prices for the benefit of the American people."

It sounds idyllic. Maximum employment and stable prices are a couple of economic conditions that everyone can agree on. We all would like to see as many people employed as possible, and stable prices would be a relief from the current bout of inflation.

But have you ever wondered where the twin mandate came from? Or why were these two economic principles, and not some other verity, chosen? We must travel back nearly half a century to 1978 to find the answer to these questions. Jimmy Carter was President, and the country had not yet emerged from what would become the most extended recession of the post-World War II era.

Many economists consider the 1970s to be the "lost decade." This time of high unemployment, low economic growth, and inflation led to the invention of the term "Stagflation," which describes the dismal economy of this time.

That year, one of the canniest politicians of all time, Hubert Horatio Humphrey, was in the US Senate. For 29 years, Humphrey has roamed the Halls of Washington, having served as first a Congressman, then a Senator, later Vice President of the United States, and now, in 1978, senator from Minnesota.

Humphrey had a long record as a classic political liberal and a defender of the working men and women of the country. 1978 would be Humphrey's last year in Washington, and he was anxious to enhance his legacy. Before him were two institutional mandates: the mandate of the Federal Reserve to set short-term interest rates. The second mandate (from the Employment Act of 1946) is for the Federal Government to pursue "maximum employment." Something that the Federal Government was not achieving. From 1970 until 1978, the unemployment rate in the country ranged from 5.5% to 9%, well above what the public saw as acceptable.

Humphrey saw an opportunity to offload the Federal Government's responsibility for employment and put it on the Federal Reserve. Killing two birds with one stone, as they say, enhanced Humphrey's reputation as a pro-labor politician while relieving the Congress and President of a task they proved to be woefully inadequate.

Congress, both Senate and House, would be all for this new legislation. So, with the help of fellow Democrat and labor advocate Augustus Hawkins, the Humphrey-Hawkins law was created. The Federal Reserve would then report to Congress on its twin mandate, "full employment and stable prices."

It's been 46 years since the Humphrey-Hawkins Law was enacted. This week, the Chairman of the Federal Reserve reported for the 91st time on the twin mandate, indicating that the Fed is doing all it can to uphold those two economic realities.

It's a Tradition!

Like changing the guard at Buckingham Palace or laying a wreath at the Tomb of the Unknown Soldier, the Fed's Report to Congress is a long-standing tradition.

But it is a tradition, I fear, that yields little in providing a timely, informative look at the current state of our economy. Timeliness is at the root of nearly all the issues with Fed Monetary Policy. You see, our economy moves at the speed of the internet. The lightning-fast propagation of data moves markets, informs analysts, and impacts our lives.

But in Washington, the Committee Calendar sets the pace. So, when Jerome Powell testified before the House and Senate on Tuesday and Wednesday, he relayed the decisions made by the Federal Reserve Open Market Committee on June 11 and 12 a month ago—all based on last month's data—which in today's financial world is surely antiquated.

As Powell pulls up his chair and sits before the assembled press and various Representatives, he must present last month's policy decision and underlying data as if it were news, somehow making June's FOMC Meeting Results relevant in mid-July.

Now we know why "stand pat" is the most oft-heard refrain from the Chairman of the Federal Reserve. He is under complete restraint. The Fed's Interest Rate Policy has been set for a month now; Powell cannot change that. The Fed was frozen from the moment the FOMC Meeting ended on June 12 until Powell reported those results a month later on July 9th and 10th.

All policies are frozen for two months each year, the month before the Fed's March and July testimony before Congress. They cannot change lest the Fed's carefully crafted economic scenarios unwind. While it is true that the Chairman could schedule a "special" FOMC Meeting and change policy mid-month, imagine the "PR" nightmare that would create.

No, Powell would rather remain too restrictive than risk any perceived sudden change in policy.

Even though unemployment has risen all year, from 3.7% to 4.1%, and inflation (CPI)has fallen all year, from January's annualized 3.66% to June's -0.67, Powell refused to budge: the Fed's policy will remain restrictive. He knows that once your "message" is set, it's best to wait until all the Committees have met before making any change.

It's sad, but I fear an authentic commentary on how the United States implements its 1970s Monetary Policy today, in the 21st century.

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