Category: zerohedge

Authored by James Rickards via DailyReckoning.com,

In recent decades, the Fed has engaged in a series of policy interventions and market manipulations that have paradoxically left it more powerful even as those interventions left a trail of crashes, collapses and calamities.

This contradiction between Fed omnipotence and Fed incompetence is coming to a head. The economy has been trapped in a prolonged period of subtrend growth. I’ve referred to it in the past as the “new depression.” And the Fed has been powerless to lift the economy out of it.

You may think of depression as a continuous decline in GDP. The standard definition of a recession is two or more consecutive quarters of declining GDP and rising unemployment. Since a depression is understood to be something worse then a recession, investors think it must mean an extra-long period of decline. But that is not the definition of depression.

The best definition ever offered came from John Maynard Keynes in his 1936 classic, The General Theory of Employment, Interest and Money. Keynes said a depression is, “a chronic condition of subnormal activity for a considerable period without any marked tendency towards recovery or towards complete collapse.”

Keynes did not refer to declining GDP; he talked about “subnormal” activity. In other words, it’s entirely possible to have growth in a depression. The problem is that the growth is below trend. It is weak growth that does not do the job of providing enough jobs or staying ahead of the national debt. That is exactly what the U.S. is experiencing today.

Long-term growth is about 3%. From 1994 to 2000, the heart of the Clinton boom, growth in the U.S. economy averaged over 4% per year.

For a three-year stretch from 1983 to 1985 during the heart of the Reagan boom, growth in the U.S. economy averaged over 5.5% per year. These two periods were unusually strong, but they show what the U.S. economy can do with the right policies. By contrast, growth in the U.S. from 2007 through today has averaged something like 2% per year.

That is the meaning of depression. It is not negative growth, but it is below-trend growth.  And growth under Trump has been no greater than it was under Obama.

The bigger problem is there’s no way out, as I said. One manipulation leads to another. My greatest fear is that the U.S. is becoming like Japan, which has used every trick in the book to no avail.

In my 2014 book, The Death of Money, I wrote, “The United States is Japan on a larger scale.” That was six years ago now.

Japan started its “lost decade” in the 1990s. Now their lost decade has dragged into three lost decades. The U.S. began its first lost decade in 2009 and is now entering its second lost decade with no real end in sight.

What I referred to in 2014 was that central bank policy in both countries has been completely ineffective at restoring long-term trend growth or solving the steady accumulation of unsustainable debt.

In Japan this problem began in the 1990s, and in the U.S. the problem began in 2009, but it’s the same problem with no clear solution.

Now in 2020, central banks have been cutting rates again, as the trade war and slowing global growth have policymakers considering the implications of a new recession without the firepower they need. As things stand, the next recession may be impossible to get out of. And the odds of avoiding a recession are low.

The only way out is for the Fed to guarantee inflation “whatever it takes.” Nothing else has worked. So why not try a more active fiscal policy? Why not load the helicopters with cash and dump it out over Main Street?

First, we need to understand what helicopter money is, and what it isn’t.

The image of the Fed printing paper money, and dumping it from helicopters to consumers waiting below who scoop it up and start spending is a popular, but not very informative way to describe helicopter money.

In reality, helicopter money is the coordination of fiscal policy and monetary policy in a way designed to provide stimulus to a weak economy and to fight deflation.

Helicopter money starts with larger deficits caused by higher government spending. This spending is considered to have a multiplier effect. For each dollar of spending, perhaps $1.50 of additional GDP is created since the recipients of the government spending turn around and spend that same money on additional goods and services. The U.S. Treasury finances these larger deficits by borrowing the money in the government bond market.

Normally this added borrowing might raise interest rates. The economic drag from higher rates could cancel out the stimulus of higher spending and render the entire program pointless.

This is where the Fed steps in. The Fed can buy the additional debt from the Treasury with freshly printed money. The Fed also promises to hold these newly purchased Treasury bonds on its balance sheet until maturity.

By printing money to neutralize the impact of more borrowing, the economy gets the benefit of higher spending, without the headwinds of higher interest rates. The result is mildly inflationary offsetting the feared deflation that would trigger helicopter money in the first place.

It’s a neat theory, but it’s full of holes.

The first problem is there’s not much of a multiplier at this stage of the U.S. expansion. The current expansion is already the longest in U.S. history. It’s also been the weakest expansion in history, but an expansion nonetheless. The multiplier effect of government spending is strongest at the beginning of an expansion when the economy has more spare capacity in labor and capital.

At this point, the actual multiplier is probably less than one. For every dollar of government spending, the economy might only get $0.90 of added GDP; not the best use of borrowed money.

The second problem with helicopter money is there is no assurance that citizens will actually spend the money the government is pushing into the economy. They are just as likely to pay down debt or save any additional income. This is the classic “liquidity trap.” This propensity to save rather than spend is a behavioral issue not easily affected by monetary or fiscal policy.

Finally, there is an invisible but real confidence boundary on the Fed’s balance sheet. After printing $4 trillion in response to the last financial crisis, how much more can the Fed print without risking confidence in the dollar itself?

Quantitative tightening brought the balance sheet back down to $3.8 trillion. But now it’s over $4 trillion again, as the Fed has added hundreds of billions to its balance sheet since September, when it starting shoring up short-term money markets. It’s basically been “QE-lite.”

Modern monetary theorists and neo-Keynesians say there is no limit on Fed printing, yet history says otherwise.

Importantly, with so much U.S. government debt in foreign hands, a simple decision by foreign countries to become net sellers of U.S. Treasuries is enough to cause interest rates to rise thus slowing economic growth and increasing U.S. deficits at the same time.

If such net selling accelerates, it could lead to a debt-deficit death spiral and a U.S. sovereign debt crisis of the type that hit Greece and the Eurozone periphery in recent years.

In short, helicopter money could have far less potency and far greater unintended negative consequences than its supporters expect.

As US stocks swing between slight gains and losses, investors are waiting with baited breath for President Trump and Chinese Vice Premier Liu He to sign the ‘Phase 1’ trade deal, the first sign of comity in what has been an acrimonious two-year trade battle between the world’s two largest economies.

Earlier, we delved into the details of the agreement, the text of which is expected to be released on Wednesday. The basic takeaway is this: While it should narrow the US trade deficit with China, the agreement does nothing to curb China’s illegal state subsidies and rampant cyber theft, some of the biggest concerns of China hawks.

The US will scale back some tariffs, but the trade war tariffs will remain in place until after the election, a mechanism to help ensure Chinese compliance with the trade deal.

While markets remain largely optimistic, China’s Global Times posted an editorial earlier complaining about the deal, and claiming that the negotiations for ‘Phase 2’ might not start for a while.

But in the short term, the deal should boost US exports to China by $200 billion over two years, which will help reverse the trade war-inspired drop.

You will find more infographics at Statista

But as the two sides gear up for the next round of negotiations, will the trade detente last? That, of course, remains to be seen.

A day after European signatories to the Iran nuclear deal took took the drastic step of triggering the agreement’s dispute resolution mechanism regulating conformity to the deal by formally notifying the EU Iran is in breach, seen as the harshest measure taken thus far given it means EU sanctions are possible, President Hassan Rouhani has responded with his own ominous warning. 

On Wednesday Rouhani in televised remarks demanded that foreign powers immediately withdraw their forces from the Middle East or face “danger”. 

“Today, the American soldier is in danger, tomorrow the European soldier could be in danger,” he said in reference to the Western allies. 

Ironically, the countries of Britain, France, and Germany said they were acting in order to de-escalate soaring tensions following a Jan 6 declaration of Tehran leadership to no longer be beholden to uranium enrichment limits. This itself was in response to Washington dramatically raising the stakes with the assassination of Qasem Soleimani.

The European JCPOA signatories underscored they are “acting to avoid a crisis over nuclear proliferation” Reuters reported of the prior joint statement. Iranian FM Zarif charged that the EU investigation into Iran’s alleged non-compliance meant Europe is allowing itself to be bulled by the United States. He told reporters Wednesday:

“They say ‘We are not responsible for what the United States did.’ OK, but you are independent countries. Europe, EU, is the largest global economy. So why do you allow the United States to bully you around?”

As for Rouhani’s newest threat against US and Europe troops in the region, there have already been at least two separate rocket attacks this week against bases in Iraq which house American troops and contractors, in a slow and steady escalation expected to continue. Washington has pointed the finger at Iran-backed Shia militia groups despite no group claiming responsibility for these latest. 

You will find more infographics at Statista

And as for the apparent breakdown in Iran-Europe relations, given it looks like EU capitals now look more ready to reluctantly conform to Trump’s “maximum pressure” campaign (despite explicit denials that this is what the ‘dispute mechanism’ triggering is all about), it’s perhaps confirmation for Tehran of its prior charge that the Europeans are ‘too little too late’ with half-hearted measures to provide relief to Iran’s economy decimated by US sanctions, such as the ‘SWIFT-alternative’ special purpose financial vehicle INSTEX.

Meanwhile, seizing on the nuclear’s deal’s apparent unraveling in progress, British Prime Minister Boris Johnson said something else that certainly won’t be taken warmly in Tehran: “If we’re going to get rid of it, let’s replace it and let’s replace it with the Trump deal.”

Prime Minister of the United Kingdom, @BorisJohnson, stated, “We should replace the Iran deal with the Trump deal.” I agree!

— Donald J. Trump (@realDonaldTrump) January 15, 2020

Though of course there was at least one leader thrilled to hear this.

Authored by Richard Breslow via Bloomberg,

It certainly doesn’t make you a cynic to poke holes in the idea that the trade dispute between the U.S. and China is coming to an end, courtesy of the phase-one deal being signed today. There’s an awful lot of questions left unanswered and a lot that can go wrong. Just read the Chinese media and you will get the point. And we all can acknowledge that any phase-two agreement is a long way off. On the other hand, putting this very public dispute in abeyance is a lot better than nothing.

Kicking the can down the road is a time-honored tradition in politics and, in most cases, financial markets are willing to go along with the practice if it lessens headline risk and lets us get on with looking for securities to buy.

Make no mistake, however, the two countries may be doing business with each other, but it doesn’t make their rivalry and level of distrust any less real.

The deal suits the needs of the principals involved on both sides and, at the least, may be a welcome distraction from the tawdry events and sniping back and forth that will be taking place on Capitol Hill.

In any case, we’ll see how this plays out over the coming months. And need to keep in mind the relationship between the two countries remains very much a campaign issue which will likely cause periodic lurches between extolling the virtues of progress made, and to come, with maintaining a hard line. Variations on the removal of the currency manipulation designation versus maintained tariffs through the election theme.

Having said that, one of the defining characteristics of markets has been the rapid appreciation of the yuan. Likely very much a part of the negotiating process. The move through 7 versus the dollar has been seen as an important signal for optimism about the global economy. Just as the reverse was true when it weakened through that level last August. It’s an understatement to say a lot of assets have moved in response. Quantitative, as well as discretionary, traders have taken notice. And as each day has passed featuring continued yuan strength, the forecasts for how far it could go have become more stretched. Why pass on a good opportunity to extrapolate?

Yesterday’s low in USD/CNY at 6.8670, however, brought the currency pair right into a potentially formidable band of support. And this needs to be watched carefully if the continuation of this move is the basis for your investing thesis. Getting through here opens up a look at 6.83, rather than simply clear sailing toward some of the more extreme predictions. The currency is most definitely in play. That doesn’t mean it will continue to be an easy one-way trade. This isn’t your typical free-floating currency and the Chinese will have a lot to say about how far it will be allowed to roam. They practice signaling on a regular basis.

Another development that definitely merits watching is the seeming failure of global bond markets to build on any momentum toward higher yields. It hasn’t been a dramatic turn around, and there are technical levels galore, but it definitely looks deflating when looking at the charts, if that was your view. Trade news is encouraging. Economic numbers less so. Treasury bears are unlikely to get much help from today’s slate of Fed speakers.

Ten-year Treasuries and bunds look like they are moving in lock-step and which direction the spread moves off of the circa 200-basis points wide level will be telling. There has been a lot of interest in trading these two bonds against each other. And it doesn’t look like bunds are going back to a zero yield in a hurry.

It may be grossly premature, but it is January and, therefor, always prudent, if nothing else, to question the moves that look like they will define the trends setting the tone for the year. You might want to start with the dollar. It has been confounding a lot of analysts and stopping out traders along the way.

The simplest way to follow developments may just be to see which end of the Bloomberg Dollar Index’s December 27 range ends up giving way.

Oil prices are extending losses after last night’s surprise crude build reported by API, with WTI trading below $58 following OPEC’s latest forecasts suggesting a weaker outlook for global oil markets this year as surging supplies from competitors from Norway to Guyana threaten the group’s efforts to defend crude prices.

API

• Crude +1.1mm (-1.1mm exp)

• Cushing -69k (-1.0mm exp)

• Gasoline +3.2mm  (+3.4mm exp)

• Distillates +6.78mm (+1.1mm exp)

DOE

• Crude -2.55mm (-1.1mm exp)

• Cushing +342k (-1.0mm exp)

• Gasoline +6.678mm (+3.4mm exp)

• Distillates +8.171mm (+1.1mm exp)

The prior week was dominated by a surprise crude build and huge product inventory builds. This week saw crude inventories drop modestly (-2.55mm) but gasoline and distillates inventories soar (and the first Cushing build in 9 weeks)

Source: Bloomberg

US Crude production pushed higher, hitting 13mm b/d for the first time…

Source: Bloomberg

WTI traded sub-$58 ahead of the API print, and dropped notably after the huge buiulds in products

WTI trading $57.50 is the lowest in 5 weeks…

 

After waiting four weeks, House Speaker Nancy Pelosi announced that the House will finally transmit the two articles of impeachment against President Trump to the Senate, and that they have chosen seven impeachment managers to prosecute the case during the upcoming trial.

Of note, Sen. Roy Blunt (R-MO) told reporters on Monday that there aren’t enough GOP Senators to dismiss the articles of impeachment without a trial. “I think our members generally are not interested in a motion to dismiss. … Certainly there aren’t 51 votes for a motion to dismiss,” said Blunt.

The full list of impeachment managers are; Reps. Schiff (CA), Nadler (NY), Demings (FL), Jeffries (NY), Lofgren (CA), Crow (CO) and Garcia (TX).

The announcement comes one day before the House votes on a resolution to send the impeachment articles to the Senate accusing Trump of abusing his office and obstruction of Congress.

Why did you rush to have a vote, then wait for two weeks – Pelosi said “we had a strong case for impeachment of the president and removal of the president,” adding “Time has been our friend in all of this,” noting that Democrats have “uncovered” new evidence during the delay – likely referring to a trove of communications given to the House by former Rudy Giuliani associate Lev Parnas.

Shortly after Charlie Gasparino tweeted that the Trump admin is “mulling an election-year fiscal stimulus as part of budget proposal” and which may “include a payroll tax reduction, and increase in earned income tax credit”…

SCOOP via @LJMoynihan — Congressional sources say @WhiteHouse is mulling an election-year fiscal stimulus as part of budget proposal; sources say ideas on the table include a payroll tax reduction, and increase in earned income tax credit. more as we get it @FoxBusiness

— Charles Gasparino (@CGasparino) January 15, 2020

… Larry Kudlow spoke on CNBC confirming that the White House indeed plans to unveil a plan for additional tax cuts later in 2020.

“I am still running a process of Tax Cuts 2.0. We’re many months away – it’ll come out something later during the campaign,” Kudlow told CNBC. “Tax Cuts 2.0 to help middle-class economic growth: That’s still our goal.”

“I had a tremendous meeting with my friend Kevin Brady, who will undoubtedly be the new chairman of the House Ways and Means Committee,” he added. “But we will unveil this perhaps sometimes later in the summer.”

What this means is that after the $1.1-$1.2 trillion budget deficit in 2020, the US is staring at an even wider deficit next year, which of course will be funded by debt, and since foreign buyers have been increasingly less excited to buy US debt, will force the Fed to expand its QE4 to buy coupon bonds across the entire curve. It also means that the following chart projecting the trajectory of US debt is now the optimistic case.

Authored by Jonathan Turley,

CNN has long been criticized for what many view as overtly hostile coverage of Sen. Bernie Sanders that goes back to the 2016 election where the CNN openly seemed to favor Hillary Clinton in her bid for the nomination.

Yet, even for the most hardened critics of the network, yesterday’s debate in Des Moines was breathtaking in its unrelentingly negative questions of Sanders followed up relative softballs to others like Sen. Amy Klobuchar. However the lowest moment of this or any debate this year occurred when CNN reporter Abby Phillips made Sanders repeat his outright denial of the allegation by Elizabeth Warren that he told her that no woman could be president and then immediately stated that Sanders did make the comment in her next question to Warren. In watching with a room filled with people who are not affiliated with Sanders, Phillips’ statement led to loud gasps and Sanders himself seemed dumbfounded on stage by the bias shown by the CNN reporter. Later, Warren pointedly refused to shake the hand of Sanders.

In the debate, Sanders repeatedly and unequivocally stated that he never made the statement. While some have built up the allegations as a type of political MeToo moment, many remain skeptical for the very reasons that Sanders stated. It seems entirely at odds with Sanders’ numerous statements and actions over the years, including his standing aside for Warren herself when she indicated that she wanted to run in 2016. Moreover, it would have been perfectly insane to go to a meeting where Warren just discussing her next run for president and make such a clearly untrue and self-destructive statement. Even if Sanders believed such sexist tripe, why would he make the comment to a possible opponent who was clearly going to run? It would also been moronic since, when he made the statement, Clinton had already beaten Trump in the popular votes by millions. Why would Sanders say something that was proven to be demonstrably untrue in the last election? The point is not that Sanders is telling the truth and Warren is lying. Rather the point is that there is no reason to just reject the position of Sanders as clearly false as Phillips appeared to do last night.

Even in her set up, Phillips seemed to reject Sanders’ earlier denials of the story:

“Senator Sanders, CNN reported yesterday, and Senator Warren confirmed in a statement, that in 2018, you told her that you did not believe that a woman could win the election. Why did you say that?”

While Sanders made these points and repeatedly denied the allegation, Phillips left many of us confused when, literally just after he again denied the story, she asked him again if he denied the story. Some in the audience laughed at the weird follow up but that was followed by gasps when Phillips then turned to Warren and said “Senator Warren, what did you think when Senator Sanders told you a woman could not win the election?”

CNN: “You’re saying that you never told Senator Warren that a woman couldn’t win the election?”

Bernie: “Correct.”

CNN: “Warren, what did you think when Sanders said a woman couldn’t win the election?”

Reminder: CNN helped rig the primary against Bernie in 2016. #DemDebate pic.twitter.com/xMxwI3Mq8h

— Alex Marlow (@AlexMarlow) January 15, 2020

Phillips then turned to Klobuchar and asked her how she felt about people making such comments to female candidates.

I am not personal friends with Sanders but I have had dealings with him for many years both in hearings and on the Hill. I have always admired him as a person and I have never had reason to question his veracity or integrity. I have also never heard anyone suggest that he was not entirely supportive of women’s rights.

The decision of Warren not to shake Sanders’ hand does not bode well for the next few weeks. The sudden raising of this allegation when Warren is struggling to break out of pack in Iowa was obviously a concern by neutral observers. While Warren says that she is shocked by the story, she did not previously raise it and still last night would shake the hand of Sanders.

Whatever the outcome of this conflict between Sanders and Warren, CNN may have the most to answer for after the debate. CNN has often voiced the view of the DNC and Democratic establishment, particularly in seemingly repeating talk points against Trump. Indeed, in 2016, a CNN figure, Donna Brazile, was found to have leaked questions to Hillary Clinton’s campaign and then denied the story by falsely alleging that her emails were hacked. In the last couple weeks, there have been stories of DNC figures and establishment figures moving (again) against Sanders to prevent him from securing the nomination. The only people who have raised bias as often as Trump supporters are Sanders supporters. Just this week, this bias was raised before the debate by Sanders people on the air. CNN responded with clearly biased questions and one moderator all but calling Sanders a liar.

If the other questions were equally heavy handed to the other candidates, this would just be a case of hard hitting questioning. However there was a notably slanted quality to the questions. Thus, Biden was asked about this vote on Iraq in a good question but was not confronted on his false statements that he opposed the war in Iraq. Likewise, CNN hit repeatedly at Sanders not giving hard figures for his health plan but did not press people like Warren on her clearly unsupported projections of revenue to support her plan.

While Warren refused to shake the hand of Sanders, she had every reason to shake the hand of CNN and Phillips. The debate left many of us with the feeling of another setup in the Democratic primary debates.

The problem is that the bias was so open and frankly gross that it could have the opposite effect in pushing people toward (not away) from Sanders.

And we note that Andrew Yang wasn’t even in the debate.

Germany’s economic growth rebounded slightly in the fourth quarter but slowed last year to its weakest level in nearly six years as trade tensions escalated, exports plunged, and a steep downturn in the automotive industry led Europe’s largest economy onto the brink of a recession, reported Bloomberg.

Official government statics show Wednesday morning that GDP growth rate in the last three months of 2019 was 0.6%, the lowest since 2013’s 0.4% expansion

Despite the economy continuing to decelerate, there was a small notable increase in GDP growth at the tail end of the year – with some optimism that the worst of the slump could be over.

A synchronized global downturn had plunged Germany into an economic decline since late 2017 when growth printed a high of 2.5% on the year. Then by 2018, growth plunged to 1.5%, and a year later, to 0.6% in 2019.

Germany narrowly avoided a recession late last year as GDP contracted in the second quarter and expanded by 0.1% in the third.

The economy is powered by industrials and exports, and with a global manufacturing recession still underway with a decelerating China – the hopes of a massive rebound in the European country are limited in 2020.

At the center of the global industrial slowdown is the auto manufacturing industry. Germany has yet to diversify from building cars and is still heavily exposed to global crosscurrents that persist.

As a countercyclical buffer, the German government deployed increased government spending to counter declines in equipment investment and exports.

“After a dynamic start to the year, and a decline in the second quarter, there were signs of a slight recovery in the second half,” said Albert Braakmann, head of the Federal Statistical Office of Germany.

Bloomberg economist Jamie Rush says the 2020 outlook for Germany is comparable to last year: sluggish. 2019 forecasts are 0.70%, which is barely any growth:

“Germany’s economy saw a slight recovery in growth in 4Q, according to the statistics office — that’s consistent with our slightly above-consensus expectation for an expansion of 0.2% to be recorded. Leading indicators have turned up into 2020, and we see the worst as being over for the German economy. Renewed trade tensions are the biggest risk to that view,” Rush said.

Authored by Michazel Lebowitz and Jack Scott via RealInvestmentAdvice.com,

Yeah… Barry Bonds, a Major League Baseball (MLB) player, put up some amazing stats in his career. What sets him apart from other players is that he got better in the later years of his career, a time when most players see their production rapidly decline.

Before the age of 30, Bonds hit a home run every 5.9% of the time he was at bat. After his 30th birthday, that rate almost doubled to over 10%. From age 36 to 39, he hit an astounding .351, well above his lifetime .298 batting average. Of all Major League baseball players over the age of 35, Bonds leads in home runs, slugging percentage, runs created, extra-base hits, and home runs per at bat. We would be remiss if we neglected to mention that Barry Bonds hit a record 762 homeruns in his MLB career and he also holds the MLB record for most home runs in a season with 73.

But… as we found out after those records were broken, Bond’s extraordinary statistics were not because of practice, a new batting stance, maturity, or other organic factors. It was his use of steroids. The same steroids that allowed Bonds to get stronger, heal quicker, and produce Hall of Fame statistics will also take a toll on his health in the years ahead.  

Turn on CNBC or Bloomberg News, and you will inevitably hear the hosts and interviewees rave on and on about the booming markets, low unemployment, and the record economic expansion. To that, we say Yeah… As in the Barry Bonds story, there is also a “But…” that tells the whole story.

As we will discuss, the economy is not all roses when one considers the massive amount of monetary steroids stimulating growth. Further, as Bonds too will likely find out at some point in his future, there will be consequences for these performance-enhancing policies.

Wicksell’s Wisdom

Before a discussion of the abnormal fiscal and monetary policies responsible for surging financial asset prices and the record-long economic expansion, it is important to impart the wisdom of Knut Wicksell and a few paragraphs from a prior article we published entitled Wicksell’s Elegant Model.

“According to Wicksell, when the market rate (of interest) is below the natural rate, there is an incentive to borrow and reinvest in an economy at the higher natural rate. This normally leads to an economic boom until demand drives up the market rate and eventually chokes off demand. When the market rate exceeds the natural rate, borrowing slows along with economic activity eventually leading to a recession, and the market rate again falls back below the natural rate. Wicksell viewed the divergences between the natural rate and the market rate as the mechanism by which the economic cycle is determined. If a divergence between the natural rate and the market rate is abnormally sustained, it causes a severe misallocation of capital.

Per Wicksell, optimal policy should aim at keeping the natural rate and the market rate as closely aligned as possible to prevent misallocation. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow driven investments with riskier prospects languish. The bottom line: existing assets rise in value but few new assets are added to the capital stock, which is decidedly bad for productivity and the structural growth of the economy.”

Essentially, Wicksell warns that when interest rates are lower than they should be, speculation in financial assets is spurred and investment into the real economy suffers. The result is a boom in financial asset prices at the expense of future economic activity. Sound familiar? 

But… Monetary Policy

The Fed’s primary tool to manage economic growth and inflation is the Fed Funds rate. Fed Funds is the rate of interest that banks charge each other to borrow on an overnight basis. As the graph below shows, the Fed Funds rate has been pinned at least 2% below the rate of economic growth since the financial crisis. Such a low relative rate spanning such a long period is simply unprecedented, and in the words of Wicksell not “optimal policy.” 

Until the financial crisis, managing the Fed Funds rate was the sole tool for setting monetary policy. As such, it was easy to assess how much, if any, stimulus the Fed was providing at any point in time. The advent of Quantitative Easing (QE) made this task less transparent at the same time the Fed was telling us they wanted to be more transparent.  

Between 2008 and 2014, through three installations of QE, the Fed bought nearly $3.2 trillion of government, mortgage-backed, and agency securities in exchange for excess banking reserves. These excess reserves allowed banks to extend more loans than would be otherwise possible. In doing so, not only was economic activity generated, but the money supply rose which had a positive effect on the economy and financial markets.

Trying to quantifying the amount of stimulus offered by QE is not easy. However, in 2011, Fed Chairman Bernanke provided a simple rule in Congressional testimony to allow us to transform a dollar amount of QE into an interest rate equivalent. Bernanke suggested that every additional $6.6 to $10 billion of excess reserves, the byproduct of QE, has the effect of lowering interest rates by 0.01%. Therefore, every trillion dollars’ worth of new excess reserves is equivalent to lowering interest rates by 1.00% to 1.50% in Bernanke’s opinion. In the ensuing discussion, we use Bernanke’s more conservative estimate of $10 billion to produce a .01% decline in interest rates.

The graph below aggregates the two forms of monetary stimulus (Fed Funds and QE) to gauge how much effective interest rates are below the rate of economic growth. The blue area uses the Fed Funds – GDP data from the first graph. The orange area representing QE is based on Bernanke’s formula. 

Since the financial crisis, the Fed has effectively kept interest rates 5.11% below the rate of economic growth on average. Looking back in time, one can see that the current policy prescription is vastly different from the prior three recessions and ensuing expansions. Following the three recessions before the financial crisis, the Fed kept interest rates lower than the GDP rate to help foster recovery. The stimulus was limited in duration and removed entirely during the expansion. Before comparing these periods to the current expansion, it is worth noting that the amount of stimulus increased during each expansion. This is a function of the growth of debt in the economy beyond the economy’s growth rate and the increasing reliance on debt to generate economic growth. 

The current expansion is being promoted by significantly more stimulus and at much more consistent levels. Effectively the Fed is keeping rates 5.11% below normal, which is about five times the stimulus applied to the average of the prior three recessions. 

Simply the Fed has gone from periodic use of stimulus to heal the economy following recessions to a constant intravenous drip of stimulus to support the economy.

Moar

Starting in late 2015, the Fed tried to wean the economy from the stimulus. Between December of 2015 and December of 2018, the Fed increased the Fed Funds rates by 2.50%. They stepped up those efforts in 2018 as they also reduced the size of their balance sheet (via Quantitative Tightening, “QT”) from $4.4 trillion to $3.7 trillion.

The Fed hoped the economic patient was finally healing from the crisis and they could remove the exorbitant amount of stimulus applied to the economy and the markets. What they discovered is their imprudent policies of the post-crisis era made the patient hopelessly addicted to monetary drugs.

Beginning in July 2019, the Fed cut the target for the Fed Funds rate three times by a cumulative 0.75%. A month after the first rate cut they abruptly halted QT and started increasing their balance sheet through a series of repo operations and QE. Since then, the Fed’s balance sheet has reversed much of the QT related decrease and is growing at a pace that rivals what we saw immediately following the crisis. It is now up almost a half a trillion dollars from the lows and only $200 billion from the high watermark. The Fed is scheduled to add $60 billion more per month to its balance sheet through April. Even more may be added if repo operations expand.

The economy was slowing, and markets were turbulent in late 2018. Despite the massive stimulus still in place, the removal of a relatively small amount of stimulus proved too volatility-inducing for the Fed and the markets to bear.

Summary

Wicksell warned that lower than normal rates lead to speculation in financial assets and less investment into the real economy. Is it any wonder that risk assets have zoomed higher over the last five years despite tepid economic growth and flat corporate earnings (NIPA data Bureau of Economic Analysis -BEA)? 

When someone tells you the economy is doing fine, remind them that Barry Bonds was a very good player but the statistics don’t tell the whole story.

To provide further context on the extremity of monetary policy in America and around the world, we present an incredible graph courtesy of Bianco Research. The graph shows the Bank of England’s balance sheet as a percentage of GDP since 1700. If we focus on the past 100 years, notice the only period comparable to today was during World War II. England was in a life or death battle at the time. What is the rationalization today? Central banker inconvenience?

While most major countries cannot produce similar data going back that far, they have all experienced the same unprecedented surge in their central bank’s balance sheet.

Assuming today’s environment is normal without considering the but…. is a big mistake. And like Barry Bonds, who will never know when the consequences of his actions will bring regret, neither do the central bankers or the markets.