The Fed's Day of Reckoning Nears
The Fed may soon reap what it sows.
The minimum takeoff or “vertical rotation” speed (Vr) of a fully loaded Boeing 777 airliner is about 155 knots (175 mph) at sea level. If the pilot attempts to pull back on the stick and lift off the runway before reaching Vr speed, then the plane is likely to smash its tail into the tarmac and possibly even crash.
This aeronautical example is also applicable to monetary policy.
For more than a year now, economists have been predicting that the Federal Open Market Committee would soon increase interest rates—this after seven years of near-zero short-term money rates. Investors and economists alike greatly desire to see a Fed rate increase as a sign that the U.S. economy has recovered from the 2008 market collapse. But because economic consumption and demand for credit remain anemic, and debt levels in the industrialized nations have actually increased since 2008, any attempt by the Fed to achieve “lift off” in terms of raising interest rates is likely to result in an economic stumble.
The current debate about the direction of monetary policy is proceeding as though the U.S. economy were actually recovered. Some FOMC members and market observers want to see a rate hike to forestall increased inflation, an ancient fear that seems to be ill-considered. The global economy is still confronted by excessive debt and secular deflation, perhaps not in terms of prices for financial assets, but certainly when we look at wages, employment and commodity prices. Indeed, despite the efforts by the Fed to reflate the global economy, the United States seems to be suffering from a prolonged period of slack demand, low investment and weak prices for key industrial inputs.
For the past several years, the FOMC has maintained a target of 2 percent inflation as one of the indicators it wishes to achieve before changing policy, yet today that goal seems further away than when the target was first adopted. Indeed, consumption seems to be falling around the world, along with global commodity prices. Even the rulers of communist China have embarked upon a program to boost economic activity. Yet, ironically, the inflation hawks in and around the FOMC continue to warn of future price increases.
Grant’s Interest Rate Observer reminds us that periods of secular deflation are often followed by steep increases in inflation:
Inflation may be hibernating, but it would be rash to count it out. Our five-year forward inflation swaps-rate gamble? On a hunch, we will say that the average rate will prove to be meaningfully higher than the 1½ to 2% now implicit in various markets.
Federal Reserve Bank of Richmond President Jeffrey Lacker said last week that despite weak job numbers and other bearish indicators, a good argument can still be made to raise rates at the U.S. central bank’s mid-June policy meeting.
“I think a strong case can be made that short term interest rates should be higher right now,” Mr. Lacker said in response to a question following a speech. He added that even with some signs economic activity might have softened over the start of the year, “I think the case is likely to remain strong” that rates should move up off of near zero levels by the June FOMC meeting.
Many investors and economists clearly are pressing for the FOMC to raise rates, but even if the Fed does act it is unlikely to move key rate benchmarks very much. Such is the level of fear of deflation within the Fed’s key monetary policy body that a quarter-point rate hike in June might be the only policy change during 2015. Moreover, if a rate hike were followed by continued indications of economic slack, then the FOMC might be forced to reverse direction, an eventuality that could hurt market confidence more than no action at all.
Many observers including this writer (See “Dangers Lurk in Fed's Zero Rate Policy”) believe that the Fed’s policy of subsidizing debtors at the expense of savers via zero interest rates— known as “financial repression”—is actually accelerating deflation. Low interest rates also damage banks, pension funds and other financial institutions, which survive based upon the earnings from their investments. Indeed, the chief beneficiaries of low interest rates are heavily indebted corporations and governments such as Greece and Japan.
Bond investor Bill Gross criticized ultra-low interest rates, saying that financial repression could harm global growth instead of boosting it in the way that many central banks intend. "Low interest rates globally destroy financial business models that are critical to the functioning of modern day economies," Gross, who oversees the Janus Global Unconstrained Bond Fund, wrote in his monthly investment commentary. "Negative/zero bound interest rates may exacerbate, instead of stimulate, low growth rates… by raising savings and deferring consumption," he wrote, adding that pensions funds and insurance companies were particularly "threatened by low to negative interest rates."
The FOMC seems to be caught up in the horns of a dilemma of historic proportions. On the one hand, economic activity measured by employment and consumer spending is insufficient to justify higher interest rates. On the other, low interest rates, which are taking trillions of dollars per year in income out of the hands of consumers and financial institutions, are arguably impeding growth and driving deflation. Zero interest rates have boosted prices for stocks, bonds and assets such as real estate, but without the validation of increased income, prices for these assets will likely decline sharply as and when the FOMC does change policy.
For the past several decades, the FOMC has used progressively lower interest rates to maintain nominal growth measured by GDP and job creation, but structural issues are making it increasingly difficult for the Fed and other central banks to keep the growth game going with cheap money. By no coincidence, former Treasury Secretary Lawrence Summers has suggested that the world faces a period of “secular stagnation,” but such views are mistaken.
“Supporters of the secular-stagnation hypothesis, it seems, have identified the wrong problem,” argues Arvind Subramanian, Chief Economic Adviser at India’s Finance Ministry. “From a truly secular and global perspective, the difficulty lies in explaining the pre-crisis boom. More precisely, it lies in explaining the conjunction of three major global developments: a surge in growth (not stagnation), a decline in inflation, and a reduction in real (inflation-adjusted) interest rates. Any persuasive explanation of these three developments must de-emphasize a pure aggregate-demand framework and focus on the rise of emerging markets, especially China.”
Low population growth rates and other long-term structural factors suggest that the industrial nations do indeed face a period of lower growth, but this is due to a lack of focus on encouraging private sector investment and productivity growth in the industrial nations. Investment flows from emerging nations such as China, fueled by debt creation in the United States and EU, were the ultimate cause of the 2008 financial crisis.
Looking at recent weakness in prices for both stocks and bonds, financial markets are aware that the era of financial repression is nearing an end and that policymakers in the major industrial nations will soon be compelled to address the issues of low growth and excessive debt. If policymakers in the United States and EU want to address the twin issues of debt and growth, and avoid another economic calamity, then we must make the proverbial Boeing 777 go faster.
Christopher Whalen is senior managing director and head of research at Kroll Bond Rating Agency. He is the author of Inflated: How Money and Debt Built the American Dream (Wiley, 2010) and the coauthor, with Frederick Feldkamp, of Financial Stability: Fraud, Confidence, and the Wealth of Nations (Wiley, 2014).
Image: Flickr/ Ervins Strauhmanis