Figuring Out The Fed

Since 2008, the Federal Reserve has been trying one program after the other in order to kick-start the US economy. It culminated in currently buying around $1 trillion of bonds a year. But economic growth remains weak. Why does the Fed continue its ultra-lax monetary policy despite evidence it doesn’t help much? The people at the Fed are not stupid, so there must be a rational explanation. This is an attempt to figure out their ‘game plan’.

Via Lighthouse Investment Management’s Alex Gloy,

In a debt-based economy (like ours), GDP grows only if the overall pile of debt is growing. As long debt doesn’t grow faster than GDP, the system is stable. You may grow debt faster than GDP for a while (depending on your starting point), but eventually you reach a point where the whole thing becomes unstable. There is no magic number, but anything north of 100% debt-to-GDP probably makes you prone to mayhem. The US is at 100%.

Here’s how debt and GDP have been growing over past periods.

From 1950-2000, GDP grew slightly faster than debt, so smooth sailing. In the 13 years since the millennium, debt grew more than twice as fast than nominal GDP. And over the past six years, the fork opened even wider. It doesn’t take a genius to see the problem with the current situation.

Two elements make up nominal GDP growth: real growth (volume, green bars) and inflation (price, red bars).

For debt purposes it doesn’t matter how the growth is achieved. If real growth is insufficient, you could, theoretically, make up the difference via inflation. We would currently ‘need’ around 10% inflation. Of course, in that case, yields on 10-year bonds wouldn’t remain at under 3%. Unless the Fed declares a ‘yield cap’. It could, for example, promise to buy any bonds yielding more than 3% (they have done so in the past). But that would imply a negative real return of 7% for holders of those bonds, and the Chinese and Japanese probably wouldn’t keep their trillions of bonds in that case. The Fed would simply have to purchase all outstanding Treasury bonds. So this plan would probably not work.

So…

The Fed tries and tries. It might seem as if it ran out of tricks, but there are a few cards up the sleeve…

Full Lighthouse letter below…

Lighthouse – Letter to investors – 2013-11.pdf by Alexander Gloy