On macroeconomic hubris and the Fed’s permanent zero rate policy
The Fed will be stuck at zero for a very long time, perhaps forever. Investors who are anticipating the Fed’s tightening are premature in their assessment of when rate hikes can reasonably occur. Ben Bernanke and other Fed members have made this clear. Below I set out in long form, why this is so.
I had been meaning to write a brief piece on Fed policy today when I saw a good jumping-off piece in the Wall Street Journal that makes doing so easy. In the piece, Ben Bernanke is quoted laying out three reasons for the recent uptick in yields.
One reason is “probably the unwinding of leveraged and perhaps excessively risky” positions in the market.
“It’s probably a good thing to have that happen, although the tightening that’s associated with that is unwelcome,” he said.
This is exactly the Fed’s problem and it goes to the (lack of) effectiveness of monetary policy as the principal tool for macroeconomic policy. Let me lay this out in long form.
The Great Moderation
In the years that led up to crisis, we had a period that some were calling the Great Moderation, which I have called the asset-based economy. Adherents of the Great Moderation way of thinking see the great bull market at the end of last century as a hallmark of effective macroeconomic stewardship. Only subsequently have they begun to question whether the subsequent period right now is so difficult because of poor macroeconomic stewardship.
For example, in a speech just last week sponsored by the National Bureau of Economic Research in Cambridge, Massachusetts Ben Bernanke demured that “one cannot look back at the Great Moderation today without asking whether the sustained economic stability of the period somehow promoted the excessive risk-taking that followed. The idea that this long period of calm lulled investors, financial firms and financial regulators into paying insufficient attention to building risks must have some truth in it.”
Hindsight is 20-20, right? No, not exactly. Bernanke goes on to answer the question in the next paragraph dismissing any blame for the crisis:
My own view is that the improvements in the monetary policy framework and in monetary policy communication, including, of course, the better management of inflation and the anchoring of inflation expectations, were important reasons for that strong performance. However, we have learned in recent years that while well-managed monetary policy may be necessary for economic stability, it is not sufficient.
What really happened during the period from 1982-2008 was that we in the midst of a massive credit inflation that was made possible by falling interest rates throughout the developed economies. In 2009 I took a brief look at the Asset-Based Economy at economic turns and what I found is that during cyclical upswings there was a massive leveraging in the United States across all areas of the private sector that was never fully unwound in recession. Instead, we saw the central bank cut interest rates to help kick start recovery by reducing the price of credit. In so doing, the central bank also allowed credit growth to massively outstrip economic growth over a secular period of a quarter century.
Below is the best chart from my 2009 piece highlighting this:
So, so-called effective monetary policy was actually an enabler of an asset-based inflation which added to growth in what seemed to be a sustainable way when viewed through a narrow cyclical prism. However, looking at debt aggregates from a secular perspective, you can see the hockey-stick style increase in debt during the Great Moderation in the chart above. I went into this at great length when discussing the origins of the next crisis in 2010 because what is key is that we have reached a secular bottom in interest rates. And that means the policy of reducing rates to feed through into economic growth won’t work unless you can get rates up during the up cycle in order to reduce them in the next down cycle. The economy has to be sufficiently robust enough for the Fed to be able to raise rates at all. And then when the next cyclical trough comes, it can lower them and get the kick start it wants again.
My view is that this won’t happen. Look at the following chart:
Source: The doomsday cycle, Peter Boone and Simon Johnson
What this chart shows you is exactly how the Great Moderation happened at all. It was a period marked by a secular increase in private debt enabled principally by lower interest rates and deregulation. Without the lower rates, private debt would be much lower and economic growth with it. And notice that, despite the moniker ‘Great Moderation’, this chart labels recurring and frequent crises throughout this period. In short, the Great Moderation is a lie. It was neither a period of calm or moderation. It was a period of excess, that is being unwound now.
Fiscal versus monetary policy
The Great Moderation is what could be termed the Great Monetary Policy Experiment. By that I mean that fiscal policy fell out of favour after the inflation of the 1970s and monetary policy gained primacy as a policy tool. The Great Moderation then was the result of guiding economic policy principally via monetary policy’s use of the interest rate lever without relying on fiscal policy in any large measure. The conclusion of this experiment, as one should expect, was the growth in private sector’s ‘monetary’ stock i.e. credit. After all, policy makers were telling the private sector that it was all about monetary matters and credit.
This game is now over but the paradigm remains. Yes, fiscal policy has had its day via massive trillion budget dollar deficits. However, after the initial crisis fiscal flurry in 2009 and 2010, the budget deficits were only an artefact of automatic stabilizers and low tax receipts. In fact, the fiscal drag in the Obama Administration has been the greatest since Eisenhower. You wouldn’t know this from listening to what people are saying in the media. But the numbers are telling you that fiscal policy is NOT the principal tool the US government has used to fight this economic crisis. And we are now looking to cut fiscal spending in the US. Fiscal is out.
What does this mean for the economy? I like to point out that monetary policy does not add net financial assets to the private sector but fiscal policy does. And this is significant in an environment in which policy rates are at zero. What it means is that there can be no credit boom from the Fed’s interest rate lever. But given the primacy of monetary policy, there can be no addition of net financial assets from government largesse to boost the economy either. Instead, the economy is relying on the Fed’s quantitative easing to help boost asset prices and keep long-term interest rates low.
So the Fed faces a problem. This way of adding stimulus invites speculation as investors leverage up and reach for yield. And the Fed doesn’t like this – hence Bernanke’s comments highlighted at the outset. The increase in yields is therefore positive in Bernanke’s view if it chastens speculators who are leveraging up in a way that could be destabilizing. On the other hand, the Fed wants low rates because it means more credit growth, lower debt burdens, and higher economic growth as a result.
Bernanke made clear in his testimony before Congress that the Fed is more accommodative as a way of actively counteracting tighter fiscal policy. He began his speech saying, “The economic recovery has continued at a moderate pace in recent quarters despite the strong headwinds created by federal fiscal policy.” Bernanke wants lots of monetary stimulus then as a safeguard against debt deflation. But of course rates are at zero percent i.e. they can’t go any lower. So, how does the Fed finesse this problem? It uses its other unconventional tools – the ones that have caused investors to reach for yield and take on risk. I don’t envy the Fed.
The lack of effective policy tools in an economy with a debt-laden household sector and poor wage trends means that economic growth will be poor for quite a long time. This in effect means that Bernanke’s zero rate policy is permanent. Going back to the reasons long rates have climbed, it is notable that Chairman Bernanke admits that zero rates are here to stay. After talking about rates rising because leveraged, risky plays are being unwound, the WSJ piece outlines his other two reasons:
Another reason for rising rates, Mr. Bernanke said, is better economic news. “As investors see brighter prospects ahead interest rates tend to rise.”
Finally, Mr. Bernanke said investors misinterpreted his June 19 statements about the Fed’s plans for winding down the program. Fed officials have tried to be very clear, and he reiterated the message in his testimony.
“We’ve not changed policy. We are not talking about tightening monetary policy,” Mr. Bernanke said Thursday during his second day on Capitol Hill delivering the Fed’s semi-annual monetary policy report to Congress.
Rather, Fed officials have merely tried to lay out a tentative timeline of how they see the bond-buying program winding down and how that will be tied to the economy, he said.
“But I want to emphasize that none of that implies that monetary policy will be tighter at any time in the foreseeable future,” he said.
The Fed is concerned about the speculators, yes. So it wants to taper its purchase of assets if at all possible. And so it is laying out a reasonable timetable to do so. But it still wants accommodation and the only avenue left is interest rate policy. That means zero rates for a long, long time aka permanent zero. But the Fed’s own researchers have called into question the efficacy of the FOMC’s Zero Interest Rate Policy.
It is the delta in rates that matters i.e. how much they go lower over a discrete time frame, not how low they are in absolute terms. Zero rates are now killing regional bank profits as they are toxic to net interest margins. That gives banks a huge incentive to diversify into non-interest income channels and to reach for yield. My fear here is that we already have significant malinvestment that gets found out only during the next cyclical downturn. And having gone through some brief thoughts about being at the zero lower bound when recession begins, I can only reiterate that the US would face a difficult credit workout in that next cyclical downturn.
For now, we are in recovery. And for most punters, that’s really all that matters. But the macro policies being employed now are not macroprudential and this will lead to problems for shares when the next downturn occurs.