The Fed began to tighten monetary policy in May 2013, when it announced its intention to taper large scale asset purchases. Despite Fed chair Janet Yellen’s recognition in recent testimony before Congress that financial conditions had become less favorable, her remarks demonstrate that the Fed is still tightening policy today. And because this policy stance is inappropriate for the stall speed US economy, the Fed is now at risk of tipping the economy into recession. Full commentary follows below.
By most accounts, the US economy is doing reasonably well. Granted nominal GDP growth is not nearly as robust as we would like. Nevertheless, even now, the economy is a good clip away from recession. Having said that, you should note that in my last two commentaries I have made clear that I view the US economy as having weakened to a stall speed level, making it unusually vulnerable to economic shock or policy error. And the Fed is now making exactly these policy errors that could tip the US economy into recession.
By selling off violently and displaying a renewed preference for safe assets, even ones of the longest duration, markets are telling us that the Fed is making these errors. And this is exactly as I wrote in January I feared it would be if the Fed persisted in inappropriately tight monetary policy in a world already beset by tight fiscal policy.
Let’s see if I can put into words what I believe is happening. I highly suggest you read my last two posts here and here. But I am going to try and highlight the most important takeaways from them here as I construct a narrative of how the markets and the Fed’s reaction function are playing off each other reflexively – and how this feeds into the real economy in a negative way.
Here are the comments I want to highlight as a baseline for where we are starting. First from the post “We are not in recession right now”:
What is occurring is that the growth in job formation has slowed, something consistent both with mid-cycle pauses and with actual recessions. And much of this job formation slowing has to do with energy. The next phase of this business cycle sees either an expansion of job formation slowing or losses to other sectors or a re-invigoration of job formation…
[…]
…the nexus of policy divergence, a strong dollar forcing China’s hand on currency and the slide in oil prices makes a continued Fed tightening cycle extremely dangerous. The market’s bears are telling the Fed this. And if the Fed doesn’t listen to the bears, they are going to murder Goldilocks in her sleep and rip the house to shreds. Then we will be in recession.
And then from the post “My thoughts on the US Q4 2015 GDP numbers”:
…as much as the Fed wants to normalize policy, in a largely deflationary global economic environment where every other central bank is easing, the level of policy divergence we are now seeing is a recipe for serious problems. We should expect further Chinese devaluation, more volatility in commodities and serious downside risk to the 2% growth prognosis for the US economy as a result.
Here’s what I was saying: The US economy, while not in recession, has slowed materially in the last year. And much of this owes to the collapse in energy capital expenditure. But much of it is due to the tightening the Fed has conducted since May 2013 by saying it would taper large scale asset purchases, then tapering them, then saying it would hike and then hiking. It’s not just capex that has caused the US economy to slow but also the strong dollar that is an outgrowth of Fed hawkish forward guidance and the divergence between that policy and monetary policy abroad.
Now we have reached a point where the confluence of energy capex shortfalls, the impact of a strong dollar on earnings and exports and an incipient inventory purge has put the US economy in stall speed. Meanwhile, fiscal policy is tight, with the deficit falling to 2.5% of GDP in fiscal year 2015 from 12.1% in 2009. This is not a case of private sector releveraging adding to public sector coffers but one in which fiscal policy has been purposely tight.
In this environment, the Fed is the only game in town, and is advised to provide some level of monetary offset to counteract the forces depressing economic growth. Instead the Fed is desperate to raise rates and is ignoring the material slowdown in US growth. Their monetary policy is, therefore, extremely dangerous and could lead to a credit crunch and recession in 2016, one that would be the result of policy error.
Markets front-run Fed policy moves by anticipating where the economy is heading based on the prevailing economic environment, the Fed’s anticipated reaction function, and the intersection of Fed policy and the real economy to influence future economic growth. But in order to do that the market must anticipate both real outcomes as well as Fed policy and the impact these have on the US and the global economy.
Since at least mid-2015, the Fed has been sending a hawkish signal that belies the slowdown in US nominal GDP growth. And when the Fed finally raised rates in December, markets started to realize that the Fed was insistent on a monetary policy stance that was extremely tight relative to the rest of the world and incompatible with the slowing evident in the US economy. Markets sold off.
Where we are now is where markets recognize the Fed’s policy message is incompatible with robust future growth and will force the Fed to keep rates lower for longer further into the future. That’s what currency markets are saying. That’s what high yield markets are saying. That’s what Treasury markets are saying. And that’s what equity markets are saying.
The markets are saying that they believe the Fed’s forward guidance in part – in that the Fed will remain in tightening mode for the foreseeable future. Janet Yellen said so again before Congress yesterday and Wednesday. However, this policy will cause the US economy to underperform as the ability for riskier borrowers to take on credit is impaired and the desire to take on credit for safer borrowers wanes. And as credit growth slows, so too will the US economy. The result will be a reversal of stance for an indefinite period into the future. That’s the message markets are sending the Fed.
I have come to doubt whether the Fed has been hearing the markets’ message. I question whether the Fed is on a policy path that is less data dependent than it cares to admit – hellbent on getting off zero after being stuck there for seven years. This is where the error comes in – and market volatility is the direct result of that error.
I recognize the Fed is in an unenviable position given it dropped rates to zero and has had to rely on so-called unconventional policy in order to achieve its dual mandate of supporting growth and keeping inflation low. But the reality is that the Fed is not omnipotent. Zero rates were never appropriate to begin with. NOMINAL rates that low encourage non-productive speculative investment that goes bad in cyclical downturns. We see that now with the massive losses of capital in the energy sector.
What should have happened is that augmented automatic fiscal stabilizers should have kicked in when global deleveraging occurred – cuts in payroll taxes, increases in the length of unemployment insurance, a pre-ordained schedule of infrastructure investment — all tied AUTOMATICALLY to the change in nominal GDP. And if nominal GDP returns to path or the economy ‘overheats’, these variables can just as easily go into reverse. None of this requires one political vote either – no cash for clunkers, no bridges to nowhere. It’s all pre-ordained and dependent on growth.
But that’s not the policy we have in the US or anywhere else in the developed world. Instead we have a policy framework in which fiscal policy is deemed risky and reckless interventionism only to be undertaken in extremis. But in this same framework, monetary policy is over-active and omnipotent, constantly adjusting in order to fine-tune the macro-economy. This policy framework has led us to an unsustainable private debt burden that can simply no longer be supported by further monetary policy intervention. Quantitative easing is just a swap of reserves for interest-bearing assets that skews private portfolio preferences toward risk. Negative rates are a tax on reserves that just makes credit growth worse.
We have reached the end of the line for monetary policy uber alles. If the Fed continues to err and the US economy does fall back into recession in 2016, the Fed will be out of bullets. No manner of QE, stimulative forward guidance or negative interest rates will produce the economic nirvana that some are expecting. Instead, what we will see is a renewed private deleveraging, credit growth going in reverse, and bad debt piling up in the financial sector.
It is at that point that the danger of political extremism will become acute and when we will most need an alternative economic policy framework.