The Fed Broke the Rules, Now We’re Paying the Price

Dear Reader,

Life is one long process of choice and consequence.

Some choices have immediate consequences and others are more of a slow burn.

Today, we’re living with the consequences of a choice that was made two decades ago.

We did not make this choice, but we did participate in the immediate gratification this choice gave us.

Our story starts in 1993 with Stanford University economist, John Taylor.

John Taylor developed a mathematical formula that became known as the ‘Taylor Rule’.

Taylor’s rule was designed to provide the US Federal Reserve and other central banks with guidance on the appropriate setting for short-term interest rates.

The rule incorporated a number of economic variables…inflation, economic growth and unemployment.

According to Federal Reserve Bank of San Francisco (one of the 12 districts that make up the US Federal Reserve) (emphasis added):

This [Taylor] rule is consistent with a policy regime in which the Fed attempts to control inflation in the long run and to smooth the amplitude of the business cycle in the short run. The arguments in the rule–inflation and the GDP gap–roughly correspond with goals legislated for U.S. monetary policy, namely, stable prices and full employment.

As stated on the Federal Reserve Bank of San Francisco’s website, the economic inputs for the Taylor Rule are:

    • where actual inflation is compared to the central bank’s targeted level
    • how far the level of economic growth is above or below the level of full employment


  • what interest rate would be consistent with fostering full employment.

With these inputs, the Fed (and other central banks) can approximate what the appropriate short-term (cash) rate is for the economy.

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Is the Taylor Rule any good?

The following is an extract from a working paper published by the Federal Reserve Bank of Kansas (another of the 12 districts that make up the Federal Reserve Bank).

The paper is titled ‘The Taylor Rule and the Practice of Central Banking’ (emphasis added):

The Taylor rule has revolutionized the way many policymakers at central banks think about monetary policy. It has framed the conduct of policy as a systematic response to incoming information about economic conditions, as opposed to a period-by-period optimization problem. It has emphasized the importance of adjusting policy rates more than one-for-one in response to an increase in inflation. And, various versions of the Taylor rule have been incorporated into macroeconomic models that are used at central banks to understand and forecast the economy.

The paper was published in 2010 when, up until then the Taylor Rule had (to a certain degree) ‘framed the conduct of policy as a systematic response’.

The Federal Reserve Bank of Atlanta (yet another of the 12 districts that make up the Federal Reserve Bank) recently published this chart on ‘Actual Fed Funds Rate (black line) and the original Taylor Rule Prescriptions (dotted blue line)’ and other interpretations (that adjust the inputs differently) of the Taylor Rule…

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Source: Federal Reserve Bank of Atlanta

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For the purpose of our story we’ll stick with the Original Taylor Rule (dotted blue line) and the Actual Rate (black line).

The Fed — under Greenspan — made the choice to break the Taylor Rule during the US recession in the early 2000s.

The Actual Rate (black line) was suppressed below the Taylor Rule for too long.

That two- to three-year window of low rates was all that was needed to inflate the US housing bubble.

Then the Fed hastily raised rates — as dictated by the Taylor Rule — but it was too late.

The credit bubble had formed.

The higher rates sealed the fate of sub-prime borrowers with adjustable rate mortgages (ARMs). When the ARM honeymoon rate periods expired (in 2007 and 2008), loans were adjusted up to the market rate…which was now 3–4% higher.

Boom became bust.

Greenspan’s choice to ignore the Rule had global consequences.

If the Taylor Rule had been followed, it’s highly unlikely the US housing bubble would have been blown…or, at least not to the extent it was.

The arrogance and conceit of the Fed (and other central banks) is clearly evident in what happens after 2008.

Guidance offered by the Taylor Rule is completely ignored

Did they not learn anything from the previous period?

In theory, the Fed should have been taking rates higher in 2010. Instead, the rates were suppressed for seven years.

Even the three other Taylor Rule interpretations — that apply different weightings to the inputs — had rates higher than the actual rate.

Why did the Fed choose to act with such arrogance?

Bottom line…the Fed was not the least bit interested in prudent governance of the economy, it was on a mission of ‘growth at all costs’.

Had the Fed followed the Taylor Rule and started raising rates in 2010, then we would have seen a vastly different recovery.

Investor enthusiasm for low-yield, high-risk junk debt offerings would have been tempered.

Corporate borrowers may have acted (even somewhat) in the long-term interest of shareholders, rather than engaging in all sorts of creative accounting (using borrowed funds) to put their executive share plans in the money.

Asset prices — fuelled by access to cheap loans — would have remained somewhat connected to long term valuation models.

Global debt levels would NOT have ballooned by a further US$120 trillion.

The choice to abandon the prescribed interest rate path provided the illusion of growth, but, as we are now seeing, there are consequences.

In 2008, we suffered the consequences of the US household sector participation in a lending free-for-all, this time it’s the US Corporate sector.

Since the GFC — and courtesy of the Fed’s wilful disregard of the Taylor Rule — US corporates have loaded up balance sheets with more than US$4 trillion in debt.

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Source: FRED

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In 2008, it was ‘zombie’ households — ones that could not afford to cover debt servicing costs from their income — that imploded the credit bubble.

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If we thought the sub-prime ‘zombies’ were a threat to the financial system, check out the level of zombie US corporates…

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Source: WSJ The Daily Shot

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Apply that percentage to the US Corporate debt load and we’re talking over US$2 trillion ($2,000 billion).

For a little context, subprime lending was around US$360 billion.

And readers wonder why I have so much contempt for central bankers.

They blatantly ignore the rules and yes, for a while they get away with it. But, eventually the consequences of their actions, in a very public way, become evident.

Yet, it’s not them who pay the price for their poor choices.

They’re given generous taxpayer funded pensions. Are feted by institutions. Offered sinecures with group-think tanks. Receive significant royalties for their ‘fictional’ memoirs.

It is us, those not on the inside, that have to live with the consequences.

Central banks are scurrying around desperately trying to provide unconventional solutions to a conventional problem of too much debt in the system.

Rather than accept the consequences of their misguided and irresponsible actions, they wheel out all manner of ‘rescue’ plans.

The only thing society really needs rescuing from is central bankers. Get rid of the lot of them, we can’t be any worse off than we are now.

They broke the rules, now they should pay the price. But they won’t.

The rules have been broken and there will be a price to pay.

Just how much or little we each pay will come down to the individual choices we make.


Vern Gowdie,
Editor, The Rum Rebellion

Vern has been involved in financial planning since 1986.

In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners.

His previous firm, Gowdie Financial Planning, was recognised in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top five financial planning firms in Australia.

In 2005, Vern commenced his writing career with the ‘Big Picture’ column for regional newspapers and was a commentator on financial matters for Prime Radio talkback.

In 2008, he sold his financial planning firm due to concerns about an impending economic downturn and the impact this would have on the investment industry.

In 2013, he joined Fat Tail Investment Research as editor of Gowdie Family Wealth. In 2015, his book The End of Australia sold over 20,000 copies and launched his second premium newsletter, The Gowdie Letter.

Vern has since published two other books, A Parents Gift of Knowledge, all about the passing of investing intelligence from father to daughter, and How Much Bull can Investors Bear, an expose on the investment industry’s smoke and mirrors.

His contrarian views often place him at odds with the financial planning profession today, but Vern’s sole motivation is to help investors like you to protect their own and their family’s wealth.

Vern is Founder and Chairman of The Gowdie Advisory and The Gowdie Letter advisory service.

The Rum Rebellion