In recent decades, the Federal Reserve 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.
The following is a survey of seven Federal Reserve tools in the Fed toolkit to stimulate the economy if recession or deflation gains the upper hand and why their toolkit is flawed.
The image of the Federal Reserve 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 Federal Reserve steps in. The Federal Reserve 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 may not be much of a multiplier at this stage of the U.S. expansion. The current expansion is 90 months old; quite long by historical standards. It has been a weak expansion, 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 multiplier could actually be less than one. For every dollar of government spending, the economy might only get $0.95 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? 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 have hit Greece and the Eurozone periphery in recent years.
In short, helicopter money, which both Trump and the Federal Reserve may desire, could have far less potency and far greater unintended negative consequences than either may expect.
Another form of stimulus in the Fed’s toolkit is negative real interest rate policy achieved through financial repression.
Negative real rates exist when nominal interest rates are lower than the rate of inflation. A simple example would be a 2.5% yield on ten-year Treasury notes and inflation of 3.0%. That would produce a negative real interest rate of -0.5% (2.5% – 3% = -0.5%).
A negative real rate is an encouragement to borrow and invest because the borrower can repay the lender in cheaper dollars. Negative real rates also cause a fall in the exchange value of the dollar since capital will flow to other currencies with positive real returns.
A lower dollar is inflationary in itself because it increases the costs of imported goods. The U.S. has a persistent trade deficit and is a net importer so such increased costs feed through supply chains and result in higher prices.
The Fed can achieve negative real rates by using financial repression, also called fiscal dominance. The Fed can encourage inflation by keeping nominal short-term rates low, while negating higher long-term rates with bond purchases.
Negative real rates and financial repression have been used in the past to erode the real value of government bonds and reduce the U.S. debt-to-GDP ratio over time. The period from 1946 to 1970 is a classic case during which the U.S. debt GDP ratio declined from 100% to 30% before gradually going up again (today the ratio is 104%).
The difficulty is that in the 1950s and 1960s the economy had an inflationary bias due to a rapidly growing consumer population bumping up against capacity constraints. Today the situation is the opposite with an aging demographic and numerous deflationary forces from debt deleveraging and technology.
The Fed may want to engineer a mild form of negative real rates using financial repression, but it is not clear the Fed can actually do so given deep-seated deflationary trends. The Fed’s failure to hit its inflation targets for the past four years suggests this particular stimulus tool may not be availing.
Although the nominal Fed funds target rate is low, just 0.50% currently, it is still positive. The Fed could announce two 0.25% rate cuts at two successive FOMC meetings if it so chose.
This is unlikely at the moment because the Fed has announced its intention to increase rates three times in 2017. However, each rate hike can be viewed as adding one bullet to the Fed’s revolver, giving the Fed more ammunition to fire if the U.S. economy goes into a recession.
Historically, it takes 300 to 400 basis points of rate cuts to steer the U.S. economy out of recession. Fed policy today can be understood as a desperate race to get the fed funds rate to 3.5% before the next recession hits without actually causing a recession in the process.
The Fed is unlikely to achieve its goal because it may take until the end of 2019 to raise rates that much and the economy is likely to go into recession before then. Still, the Fed will raise rates as much as it can, whenever it can in order to cut them again when a recession emerges.
Negative interest rates were first viewed as an extension of interest rate cuts after the policy rate hit zero. If a central bank had a policy rate of 1%, it could implement four 0.25% rate cuts before hitting zero. At that point, the central bank could cut rates further by pushing the policy rate into negative territory.
This can be done by paying a premium above par for non-interest earning Treasury bills that mature at par thereby “earning” a negative total return on the bills. The original view was that negative rates were just more of the same from the perspective of rate cuts.
However, empirical evidence from negative rate experiments in Japan and Europe suggests that negative interest rates are not just more of the same from a rate cut perspective. Negative rates are designed to stimulate lending and spending. Yet, certain behavioral reactions produce the opposite of the effects intended.
Savers facing negative rates actually save more to compensate for lost interest. Consumers interpret negative rates as a deflation signal and defer purchases in anticipation of lower prices. Negative rates actually produce more saving and deferred spending.
While negative interest rate policy remains in the Fed’s policy toolkit, there are high hurdles to its use based on unsatisfactory results to date.
Forward guidance is the technical name for Fed propaganda or market manipulation through its choice of words in The Federal Open Market Committee (FOMC) statements, press conferences and speeches. It is used to signal future Fed policy without tying the Fed to specific dates and policy rates.
Forward guidance is one of the Fed’s favorite tools because it can be used ambiguously and can easily be reversed when the Fed wants to signal a change.
Forward guidance was used extensively in conjunction with quantitative easing (QE) from November 2008 to March 2015. The Fed executed three programs of QE called QE1, QE2 and QE3.
QE1 lasted from November 2008 to June 2010 and involved the purchase of $600 billion of mortgage-backed securities.
QE2 lasted from November 2010 to June 2011 and involved the purchase of $600 billion of mostly intermediate term Treasury securities.
QE3 started in September 2012, and was initially indefinite as to an end-date and the amounts to be purchased. QE3 involved both Treasury securities and mortgage-backed securities. Actual purchases reached $80 billion per month until December 2013 when a “taper” program began that reduced purchases monthly until they reached zero on Oct. 29, 2014.
The Fed’s goal was to suppress rates so that market participants would bid up the price of riskier assets such as stocks, real estate, and corporate debt.
Many purchases of risky assets are made on a leveraged basis with funds borrowed in short-term money markets such as repurchase agreements or floating rate notes.
In order to work as intended, market participants needed some assurance that the Fed would not suddenly change course, and raise rates. This would cause huge losses on the leveraged portfolios. The Fed provided this assurance by forward guidance.
Initially the guidance was provided by specific dates and intentions such as keeping rates at zero for an “extended period,” or “for some time,” or “at least through 2015” etc. Later the forward guidance took the form of expressions of intent such as “patient” with regard to rate hikes.
The meaning of words like “patient” was supplied by Fed insiders to friendly reporters like Jon Hilsenrath at the Wall Street Journal who dutifully passed the information along to readers and the market as a whole.
It was understood that some time would elapse between the end of forward guidance and the beginning of a rate hike cycle. This was designed to allow market participants time to unwind leveraged bets or arrange longer-term financing in an orderly way. Any market participants who missed the signals or read the tea leaves incorrectly were on their own.
Forward guidance officially ended in March 2015 when the FOMC removed the word “patient” from their policy statements. The first rate hike took place nine months later in December 2015.
Forward guidance worked exactly as planned in the sense of channeling investors into stocks and real estate instead of artificially low yielding Treasury notes. But, it is not clear what if any impact this “portfolio channel effect” had on economic growth.
It is more likely that the combination of QE and forward guidance created asset bubbles in stocks and real estate that are in danger of bursting or that will need to be unwound in the next liquidity crisis.
Forward guidance can be used independently of QE as it was in the brief period from November 2014 (after the taper) until March 2015 (the end of forward guidance). This is likely to be the case in future.
If the economy begins to show signs of a recession in 2017, the Fed will not only pause in its rate hikes, but will use forward guidance to indicate it does not intend to resume rate hikes soon.
Any future use of forward guidance will be a strong indication that rate cuts may be coming next. In an economic downturn, the likely sequence of events will be a pause in rate hikes (signaled by forward guidance), then actual rate cuts, then more forward guidance signaling that rates will remain at zero, and then finally a new round of quantitative easing, QE4.
Whether negative rates are added to this monetary science experiment remains to be seen. If negative rates are used, they are likely to be presaged by their own unique form of forward guidance.
Reducing the foreign exchange value of the dollar, also known as a currency war, is another means of trying to stimulate the U.S. economy. This can be done by coordinating rate policy with foreign central banks.
If the Federal Reserve pauses in its tightening cycle while the European Central Bank persists in its current taper of asset purchases, the net result is likely to be a decline in the USD/EUR cross-rate.
Currency wars can also be fought by direct market intervention, although this is rare and is usually reserved for cases of disorderly market movements in exchange rates.
The problem with currency wars is that any beneficial impact of exchange rate devaluation is strictly temporary as trading partners on the losing side tend to cheat and try to devalue their own currencies in a sequence known as beggar-thy-neighbor. The end result of currency wars is usually inflation in the form of higher import prices, rather than real growth through higher exports.
The final weapon in the Federal Reserve’s arsenal is the financial equivalent of nuclear war. The Fed could instantly create inflation and achieve nominal if not real growth by massively devaluing the dollar when measured as a unit of gold.
This was last done in 1933–34 and was highly successful. Stocks rallied and commodity prices boomed in the middle of the Great Depression (1929–1940). This boom was not sustained because the Federal Reserve and Treasury prematurely tightened monetary policy and fiscal policy in 1937, which put the U.S. economy back into a severe technical recession from 1937–1938.
The Federal Reserve could use this nuclear option by coordinating with the Treasury to make a two-way market in gold using printed money. This would work exactly like quantitative easing, except the Fed would buy or sell gold instead of Treasury bonds.
The Federal Reserve would set an arbitrarily high fixed price for gold such as $5,000 per ounce. The Fed would make that price stick by offering to buy gold from any seller at $4,900 per ounce and selling gold to the market at $5,100 per ounce. This amounts to a 4% band or spread around the target price, a classic pegging technique.
Gold could be removed from or added to the U.S. hoard at West Point, NY, and money would be created by or destroyed by the Fed in order to make the target price stick.
If, for example, the price of gold was $1,300 per ounce before the operation, the effect would be to devalue the dollar from 1/1,300th of an ounce of gold to 1/5000th of an ounce of gold, a 75% devaluation of the dollar. This devaluation would not take place in isolation.
A 75% dollar devaluation in gold would signal devaluation in all other goods and services and result in $100 per ounce silver, $200 per barrel oil, etc.
This is obviously an extreme measure and would only be used in the face of strong persistent deflation.
Yet, the fact that that technique exists and has been used in the past is one reason to conclude that deflation will not in fact persist beyond certain limits because the Federal Reserve and Treasury have the ability to stop it as they did in 1933.
This review of 7 Federal Reserve tools in their toolkit consisting of interest rate hikes to fight inflation, and a litany of tools to fight deflation, shows that the Fed will be fully engaged in manipulating the U.S. economy for an indefinite period of time.
Courtesy: Jim Rickards
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