A few hours ago I wrote a rather downbeat post on the prospects for the US economy that continued the thoughts from an article I wrote in the New York Times. A number of other sources have confirmed some of the logic behind that post since then. The Congressional Budget Office has said that the US taking on austerity by falling over the fiscal cliff next year would lead to recession and that the economy would be weak even if we did not. Sober Look showed us four fiscal cliff scenarios from Credit Suisse. The best case scenario was a 1.0% drag on GDP growth. And Greg Ip at the Economist argued as I did that fiscal agents were going to be contractionary and so, like it or not, it’s all up to the Fed now.
But let me go a bit further in my analysis here, specifically on how Fed policy works through the interest income channel.
In the last post I ended:
My conclusion: The Fed cannot fulfill its mandate in getting the United States to full employment without active policy efforts from fiscal agents irrespective of whether it tries new untested monetary policies. But fiscal agents are working against full employment…
I anticipate federal fiscal policy will become even more contractionary in 2013 when the fiscal cliff is reached. And the US economy will slip into recession – if it hasn’t done so already.
This is where those comments from:
The current economic malaise was borne out of high private sector indebtedness in an environment in which asset prices were falling. The result was what I call debt stress, that is a need to increase savings to pay down debts of underwater assets, mostly houses backed by mortgages. This is what Richard Koo calls a balance sheet recession. And the psychology of the balance sheet recession is a feeling of being trapped and suffocated by debt, underwater assets, high interest costs, and stagnant income.
Early in 2009, the federal government enacted fiscal stimulus to boost incomes. The Fed has also moved against this by lowering interest rates and reducing interest payments to bring back housing affordability. This has certainly reduced debt distress for debtors. But income and job growth remains anemic, in part because of cuts at the state and local level where government is severely revenue constrained. So the stimulus effect has faded.
With rates at zero percent, the Fed has therefore taken to unconventional monetary policy, quantitative easing and more aggressive central bank communications. The thinking here is that the Fed can reduce risk premia and induce shifts in private portfolio preferences that will boost asset prices and capital investment that lead to higher employment. (See here on how quantitative easing really works). But, the economy remains mired in slow growth because these policy tools have not been particularly effective. I have argued then that the Fed cannot save the day.
But what else could or should the Fed do? In the last post, I pointed to permanent zero (signaling that zero rates would be maintained for longer). I also pointed to rate easing (targeting non-policy interest rates). The Fed could always buy up financial assets like short-dated municipal bonds. And finally there’s nominal GDP targeting where the Fed explicitly says it will buy as many financial assets as is necessary for the economy to reach a nominal GDP growth target, whether the added nominal growth is from real growth or inflation. In nominal GDP targeting and in the related policy of relaxing the price stability mandate and going for a higher inflation rate target, the goal is to create enough inflation to pull forward demand and “jump start” an economy short of aggregate demand until companies start hiring people and boosting incomes.
All of these ideas are largely untested fallback options because the Fed Funds rate has reached the zero lower bound. If the Fed Funds rate were 5%, then the Fed would simply cut rates to stimulate the economy. However, over the last two recessions the Fed has cut rates so much that it now can cut no more and must try other untested policies to fulfill its constitutionally-enacted mandate of supporting full employment.
Here’s the thing: the household sector is still highly indebted and the financial system is still undercapitalized. The only reason that these problems look less onerous is because we are coming off a peak in the economic cycle. In a recession, household indebtedness, house price declines and credit writedowns would all come back with a vengeance and produce a toxic mix that would make things quite ugly. The problem is that balance sheet recession thing – an asset price, debt and income mix that lead to debt stress and deleveraging.
Can the Fed do anything about this in the absence of active fiscal support? I certainly don’t believe so. But it certainly can try and many are telling it that it would be irresponsible and reckless not to do so.
The interest income channel and banks
However, this is where the interest income channel and net interest margins come into play. See over the longer term, Quantitative Easing and Permanent Zero are toxic. I have written on this a decent amount before so let me quote the previous posts here. First there are the banks. As I wrote late in 2010:
I am starting to take the view that the Fed is reducing net interest margins. Back in 2008 and 2009, US banks benefited from low rates as their net interest margins were huge. For the first quarter of this year, JPMorgan Chase even had a negative net borrowing rate of interest while it made 324 basis points in net margin. They were effectively paid to borrow, leading to a more than 3% interest rate spread on loans. That’s a great story. Can it last, though?
The short answer is no. As the long end of the yield curve comes in due to either QE or what I have been calling permanent zero (PZ), as zero rates become a permanent state of affairs, interest margins have compressed. Rates will compress even more the longer rates stay at zero percent because the expected future rates will start to come down (see here on bootstrapping the yield curve).
What’s more is that PZ will be a big problem in a Shiller double dip scenario because banks will be set up for huge loan losses despite recent under-provisioning. Meanwhile they will have no way to make it back on net interest as long rates come down in a recession while short rates remain at zero percent, killing net interest margins.
This is the problem with QE and PZ money: it works in the short run, but is toxic in the longer-term. Now if liquidity was the real problem for banks, then the banks will have enough capital to ride through this. They will recover as many did in the early 1990s during the last banking crisis in the US.
If solvency is the banks’ problem, QE and PZ will be toxic.
So, if you follow my logic here, the fiscal cliff and anemic job and income growth equal anemic consumer demand and recession in 2013. That’s because austerity is not about producing short term growth. It kills it. If you back austerity, you have to be honest and acknowledge this as pundits like Hugh Hendry do. People like George Osborne who believe in confidence fairies don’t.
Meanwhile the Fed will probably extend permanent zero to 2015, flattening the yield curve. And that’s bad for net interest margins because if the yield curve flattens and we enter recession because of the fiscal cliff and despite the Fed’s best efforts, banks will have increased loan losses but also reduced net interest margins. This will be a self-inflicted economic wound because the signs of malinvestment excess from extremely low interest rates are all around us. When recession hits, these losses will crystallize. And there will be no steep yield curve to bail out the banks as we saw in in the early 1990s. The banks will have to take it on the chin like the Japanese banks did in 1997 – and we know what happened there.
The interest income channel and savers
Switching tack, lets look at households. Traditionally, people think of rate cuts as stimulative because of the effect on debtors. Interest rate cuts reduce debt payments for businesses and households that cause debt stress and they make it easier for companies to take on more debt to fund capital investment. But when we talk about interest income, its not just about debtors and banks, it’s also about savers. And in periods of low credit demand growth, it is the effect on lost interest income that overwhelms the effect on credit growth. In fact, I would argue that this policy actually helps tip economies into deflation.
In the US right now, demand for credit by what financial institutions deem creditworthy borrowers is not growing robustly enough to act as a credit accelerator. So, the real impact of lower interest rates in increasing nominal GDP is mostly from the lower debt service costs associated with those rates. This is countered by lost interest income for households, businesses and investment companies – which acts as a drag on growth, so much so that people are taking on risk and buying equities or high yield bonds or other higher risk assets – much as the Fed wants then to do.
What happen then in a recession? Ah, recession. This is where “the psychology of the balance sheet recession… a feeling of being trapped and suffocated by debt, underwater assets, high interest costs, and stagnant income” comes back with a vengeance. Suddenly people start deleveraging again and the economy tumbles downward. If the economy tumbles down far enough when inflationary pressure is already subdued, then inflation can tip into deflation as it did in Japan. And then the same people who were concerned about low rates stealing interest income become coupon clippers, knowing that deflation will bail them out. Suddenly, your economy is trapped in a deflationary rut – and central bank policy of zero rates helped to get it there.
My conclusion: the very policy tools people are pushing the Fed to use will have unintended consequences and could be deflationary accelerators unless Fed policy is aided by concrete attempts to reduce private debt, increase household income, write down assets, and reduce shadow inventory. If we do have a recession in 2013 – and I believe we will – then it is likely that deflation will take hold and the US will find itself in a very Japanese scenario.
[Update 2013: Note that the U.S. did not go over the fiscal cliff, which changed my outlook for the U.S. See March 2013's post "On continued recovery in the US". The framework remains valid. However, a longer recovery hopefully reduces the need for deleveraging.]