Our over-reliance on monetary policy is the problem

I am going to argue here that monetary policy is both less effective than fiscal policy, and that over-reliance on it unnecessarily politicizes monetary policy by putting unelected officials in too prominent an economic role.

I would argue that monetary policy should never be the primary macro policy driver in any economy. Yet, when you look around the world it is in almost every advanced economy. It is certainly that way in the eurozone, where interest rates are negative and the largest economy runs fiscal policy via a debt brake and a "black zero" no-deficit rule. And it's mostly that way in the United States, where every word a Fed official utters is parsed to discern what it means for the future of the economy.

That's no way to run an economy.

The Fed's Overtightening

Even so, yesterday's post was all about the Fed. And it was all about the Fed's ability to create policy errors that caused recession. And so, that link between Fed action and recession makes it seem like the Fed is omnipotent. It's not though.

I wrote something in the middle of my piece on the Fed's overtightening yesterday that I think is important in this context. And I want to use it as a jumping off point for this post on the over-reliance on monetary policy.

Here's the part to focus on:

Now, when I say ‘overtightening’, I am talking about investor confidence and financial conditions, not the real economy. I think of the real economy as largely independent of the financial economy except through the impact that investor confidence and access to credit can have. And so, I see monetary policy affecting the real economy primarily through the financial conditions and interest rate conduit, creating winners and losers as interest rates change and investors gain or lose confidence in the prudence of incremental capital investments.

There are a few things wrapped up in that paragraph. So let me take them one by one to show you why I see monetary policy having too big a role in business cycles.

The financial economy is not the real economy

You often hear people chastise others who are overly focused on financial markets by saying, "the stock market isn't the economy." And by that, what they're saying is that what happens in asset markets simply isn't a proxy for what's happening in ordinary people's lives. Just because asset prices go up or down doesn't mean it puts more or less money in peoples' pockets.

The financial economy is separate from the 'real' economy. It's interrelated, yes. But they are not the same.

So when you hear that the Fed raised rates 25 basis points or lowered rates 25 basis points, you wouldn't be totally off base if you shrugged your shoulders and asked "who cares?" All the Fed did was raise the rate for overnight lending of reserves. And that only affects how much banks have to pay to borrow reserves. It doesn't directly influence anything else - not Treasury rates, not mortgage rates, not credit card rates - and certainly not salary growth rates or unemployment - which are the things most people  care about.

Transmission problems

For the Fed to have any impact, there has to be a "transmission mechanism". That's the jargon. And the way this 'transmission mechanism' works is actually very much in dispute. When the Fed raises rates, it's supposed to feed through to interest rates in the rest of the economy and then into the economy as a whole, with a lag. But it doesn't always work that way. Back in 2005, Fed Chair Alan Greenspan was famously perplexed that the Fed was jacking up rates every meeting without meaningful impact on Treasury yields. Let me quote him at length to show you the problem:

Long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields.

The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year U.S. Treasury notes even if the more-distant forward rates remain unchanged. Historically, though, even these distant forward rates have tended to rise in association with monetary policy tightening.

In the current episode, however, the more-distant forward rates declined at the same time that short-term rates were rising. Indeed, the tenth-year tranche, which yielded 6-1/2 percent last June, is now at about 5-1/4 percent. During the same period, comparable real forward rates derived from quotes on Treasury inflation-indexed debt fell significantly as well, suggesting that only a portion of the decline in nominal forward rates in distant tranches is attributable to a drop in long-term inflation expectations…The broadly unanticipated behavior of world bond markets remains a conundrum.

The very next year, Greenspan's successor Ben Bernanke hypothesized Greenspan's 'conundrum' was the result of a 'savings glut'.

Given the global nature of the decline in yields, an explanation less centered on the United States might be required. About a year ago, I offered the thesis that a “global saving glut”–an excess, at historically normal real interest rates, of desired global saving over desired global investment–was contributing to the decline in interest rates... So long as these factors persist, global equilibrium interest rates (and, consequently, the neutral policy rate) will be lower than they otherwise would be.

And he used that as a reason to disregard an inverted yield curve - commonly seen as a harbinger of recession. Of course, recession began in short order -- and the mother of all financial crises too, making it clear that using the savings glut hypothesis to ignore recession warnings wasn't a very good idea.

Low rates don't spur investment

It is even more problematic than that though. Part of the thinking behind lowering interest rates is that lower rates will spur investment. Lower rates are supposed to induce businesses to go out there and buy stuff and to hire people. But the research doesn't show that's necessarily what happens.

For example, economic researchers at my alma mater Dartmouth wrote this in 2013 as the abstract for an economic study:

We study the factors that drive aggregate corporate investment from 1952–2010. Quarterly investment responds strongly to prior profits and stock returns but, contrary to standard predictions, is largely unrelated to changes in interest rates, market volatility, or the default spread on corporate bonds. At the same time, high investment is associated with low profit growth going forward and low quarterly stock returns when investment data are publicly released, suggesting that high investment signals aggregate overinvestment. Our analysis also shows that the investment decline following the financial crisis of 2008 represents a fairly typical response to changes in profits and GDP at the end of 2008 rather than an unusual reaction to problems in the credit markets.

I bolded the important bit.

Even the Fed's own research shows the problem. This abstract is from a 2014 Fed piece, appropriately titled "The insensitivity of investment to interest rates: Evidence from a survey of CFOs". Again, look at the bits I highlight below:

A fundamental tenet of investment theory and the traditional theory of monetary policy transmission is that investment expenditures by businesses are negatively affected by interest rates. Yet, a large body of empirical research offer mixed evidence, at best, for a substantial interest-rate effect on investment. In this paper, we examine the sensitivity of investment plans to interest rates using a set of special questions asked of CFOs in the Global Business Outlook Survey conducted in the third quarter of 2012. Among the more than 500 responses to the special questions, we find that most firms claim to be quite insensitive to decreases in interest rates, and only mildly more responsive to interest rate increases. Most CFOs cited ample cash or the low level of interest rates, as explanations for their own insensitivity. We also find that sensitivity to interest rate changes tends to be lower among firms that do not report being concerned about working capital management as well as those that do not expect to borrow over the coming year. Perhaps more surprisingly, we find that investment is also less interest sensitive among firms expecting greater revenue growth. These findings seem to be corroborated by a cursory meta-analysis of average hurdle rates drawn from firm-level surveys at different times over the past 30 years, which exhibit no apparent relation to market interest rates.

Conclusion: low rates do not necessarily spur greater capital investment. So when the Fed lowers rates to boost the economy, really all its definitely doing is helping borrowers at the expense of lenders by reducing both interest income and interest expense. In some situations, that may be stimulative. But, in others it may not be. 

Lower for longer may be poison

One last thing here: even if cutting interest rates is stimulative, how do we know keeping them low is also stimulative? Maybe it's the change in interest rates that matters, not the level.

I would argue that low interest rates may have a greater impact on investor behavior than on business investment.  They cause investors to 'reach for yield' to hit funding targets and investment rates of return hurdles. And they stimulate animal spirits by making speculative money-losing investments with the promise of future profit look more attractive. The FT's Robin Wigglesworth notes that:

Two decades ago, well over half of the global bond market boasted yields of at least 5 per cent... Today, a mere 3 per cent of the global bond market yields more than 5 per cent — the lowest share on record.

How are you supposed to hit your pension company's 7% return bogey? You can't -- unless you take on a lot more risk by buying lower quality bonds or ones with longer maturities or both. Try buying a 100-year Argentina bond, for example.

And let's not forget savers' behavior too. It's not at all clear that taking Grandma's savings account yield down to 0.25% is going to 'stimulate' the economy. It might just make Grandma poorer and cause her to spend less, making the lower for longer concept anti-stimulative. After all, the private sector is a net-receiver of interest.

The point is this: if we don't even know what the transmission mechanism for monetary policy is and how it works, how are we supposed to believe monetary policy is effective?

Global growth slowdown and panic

So, me, I don't believe monetary policy actually is that effective. The problem is that it's the only game in town. And in a world of slowing global growth, a Fed that is running higher interest rates than almost every other developed economy central bank is a Fed that is tightening financial conditions to the point of recession -- globally.

What's happened is that, while the Fed was raising rates, global growth slowed. And then a trade war has slowed growth even more. Right now, the global manufacturing sector is in a recession, even in the United States. Germany, Italy, the UK, Singapore and many other countries have just shown quarterly economic contractions. Some of these economies are likely in a recession. And that's caused a lot of people to fear recession in the US as well, particularly with the trade war escalating into a currency war. This is what inverted yield curves are telling us.

So, at the margin, a Fed that doesn't cut rates is a Fed that is tightening financial conditions to the point where they are the problem. And remember, since monetary policy doesn't have any direct impact on the real economy, they are also not the solution.  But because they are tightening financial conditions around the world, they are certainly the problem.

Given how much global growth has slowed, the last thing we need is an inverted yield curve or a financial panic.

Fiscal policy

If governments really wanted to stimulate, they would use fiscal policy because that puts money in people's pockets. And fiscal policy is orchestrated by elected officials whose conduct we have some say over through elections. That's not the case with monetary policy.

With fiscal policy, the question is always about priorities. For example, when Donald Trump signed the tax reform bill into law back in December 2017, the tax cut gains were slanted toward corporations and the wealthy. And while you might justify some of that on the basis that the wealthy pay the majority of taxes and many people in the US pay zero taxes, the reality is that tax cuts for rich go to the people with the lowest marginal propensity to spend. You're not going to get a lot of bang for your buck.

As Marshall Auerback wrote me:

We don't even have to invoke the moral arguments on inequality any longer (even though they are very strong). It should be blatantly obvious to anybody with a pulse these days that to continue to distribute the bulk of GDP's gains to an increasingly small number of people (with the highest savings propensities to boot) is invariably going to cause one's economy to grow less efficiently.

What's more is that the repatriation of overseas cash and tax breaks for corporations was premised on the concept that we would see a surge of capital investment. Supply side economics. The 'surge' never happened.

My view

Here's how I'd sum up.

I think monetary policy is ineffective. We don't even know how it works. Sure, rate policy can help at critical junctures in the business cycle by lowering interest payments when debtors are under stress. But, we've hit the limits of what central banks can do. As a result, we've resorted to quantitative easing, negative interest rates, and yield curve control. And for what? It's crazy.

The solution is staring us in the face: help put money in the pockets of the people who are facing the most severe financial stress in our economies. Those are the people who need the money the most and are most likely to spend that money too. Until we do that, the stress on our economic and financial system will continue to grow... and political unrest will continue to grow with it.

I am going on holiday now. Maybe the beach will put in a positive frame of mind.

Best,

Ed

The Fed overtightened. Now it's behind the curve. Recession awaits

Sorry for the alarmist post title. But the Fed has completely bottled it. I've been warning for some time that it could go this way. And now, we are in in the endgame.

First, the Fed overtightened through 2018. Then, forced at gunpoint by financial markets into a retreat this year, it has been very slow to recognize the tightening financial conditions. Now, it is so far behind the curve that a major recession is  breathing down our necks.

Let me put this all together below. And then I will tell you where I think it's headed. By the way, this is my occasional free newsletter post. If you like what you see and what to read more, please sign up as a paying subscriber.

Before the overtightening

Let me say at the outset that this expansion has been doubted at every step of the way. Anytime there was a hiccup in growth, invariably there was a whole panoply of voices telling us we were headed straight for recession and a bear market. It never happened - at least not in the US. The US economy has proved very resilient over this past decade.

I think the period right before Fed overtightening was no different. Back in late 2017 as the Treasury curve flattened, people were screaming "recession", telling us that the yield curve was flat enough to foreshadow recession in short order. 

It didn't happen. And I wrote about why I wasn't worried. Instead, the US economy went from strength to strength as Congress passed tax cuts (for the rich) and we saw at least a temporary boost in economic growth.

In fact, the economy was so strong by early 2018 that a lot of pundits were excoriating the Fed for being weak, not normalizing policy quickly enough, and spawning financial bubbles. They said the Fed needed to hike, and hike big.

At that juncture, in December 2017, I was telling you that the Fed had been and probably would continue to be more hawkish than you thought. And indeed, the Fed got religion. As I warned throughout 2018 it would do, the Fed eventually went from telling the market it would hike three times in 2018 to accelerating its timetable and hiking four times. Jay Powell even mused aloud in October about the Fed's being "below neutral" and needing to accelerate its timetable even more.

The overtightening

But, this was a mistake.

Behind the scenes, the overtightening scenario was building. The first time I wrote prospectively about the likelihood of a policy error was in November of 2017 when I warned that we were entering the most dangerous part of the business cycle. Here's how I put it, talking about the last business cycle that ended in December 2007:

In retrospect, one could argue that the Fed’s late interest rate hike campaign was a policy error – that the Fed should have seen the flattening yield curve as a canary in the coal mine and resisted raising its policy rates despite any concern about elevated asset prices.

I think this is the Fed’s real conundrum this late in a business cycle. If the economy is running solidly and leading economic indicators are bullish, the Fed is hard-pressed to not raise rates in an environment in which headline unemployment is low and falling, asset prices are rich, and lending standards have loosened — even if the yield curve is flattening. Aren’t they supposed to take the punch bowl away?

I don’t have the answer to that question. Time and again, late in the cycle, the Fed has indeed taken the punch bowl away. And the result was recession and financial crisis.

That’s exactly why this is the most dangerous period in the business cycle.

So I started talking about overtightening in earnest in March 2018, saying that the flattening curve was a sign of concern regarding overtightening, not a harbinger of recession -- meaning there was no reason to panic as long as the Fed understood what was happening in time. And as 2018 proceeded, I continued to beat the drum about this.

The point is a flat or inverted yield curve is just a signal. Risk free rates are mostly about future policy rates. So, an inverted curve isn't forecasting recession per se, it is reflecting anticipated lower policy rates due to economic weakness. Or it could just be a sign of disinflation as real yields rise relative to nominal yields.

But to the degree it is a sign of recession, the recession happens with a lag. The central bank has time to unwind its overtightening if it reads the signal, as the Fed did successfully in 1994. And this time is no different. If recession is coming, it's not baked into the cake in my view. But, policy error can get us there for sure.

Markets throw in the towel

Anyway, at some point, the market couldn't take it anymore and we had a market meltdown, with stocks cratering and bonds soaring in December because of renewed fears of recession due directly due to Fed overtightening.

Now, when I say 'overtightening', I am talking about investor confidence and financial conditions, not the real economy. I think of the real economy as largely independent of the financial economy except through the  impact that investor confidence and access to credit can have. And so, I see monetary policy affecting the real economy primarily through the financial conditions and interest rate conduit, creating winners and losers as interest rates change and investors gain or lose confidence in the prudence of incremental capital investments.

Jay Powell got it. In late December and January 2019, he repented. And he promised to ease off the brake, something he has done. But all of that previous tightening of financial conditions is still working its way through the system, particularly via the currency channel because, even after a 25 basis point cut in July, interest rate differentials between the US and the rest of the world are acute, perhaps even more acute than they were before.

Look at the chart Jim Bianco drew up on this yesterday.

Global yield curves

The Fed is well outside the norm here. In essence, we are at the point in the business cycle where even keeping rates still can be a stealth tightening when every other central bank in the world is easing. That is why the reserve currency, the dollar, is rising and curves are flattening.

Policy choices

In retrospect, I think the Fed's 25 basis point move in July was a mistake. First of all, let's remember there were two dissents at that meeting. So, there is certainly a faction at the Fed that wanted to stand pat in July. I can understand Powell's desire to keep everyone onside as much as possible. And the incoming data at that time were so good, it fooled the Fed into believing it could take an incremental approach. But almost immediately after the cut, trade progress, global economic data, and financial conditions have all deteriorated aggressively.

In fact, we are now at the point where the US yield curve is almost fully inverted out to seven years. And the 2-10 year spread is flirting with inversion, joining the 3mo.-10 year spread in spooking markets about the potential for recession in the US. And just last night, the 30-year hit an all-time low yield.

Optimally, the Fed would move intermeeting here. But that's not going to happen. And given the dissents we got in July, I think the most we can hope for from the Fed next month is 25 basis points. I could be wrong, especially if we continue to see market turmoil.

In sum though, I believe we may be headed for a situation in which a number of major economies tip into recession, trade tensions rise, financial conditions tighten further, and the yield differentials between the US and the rest of the world increase, forcing up the dollar. That's a recipe for further inversion, an equity selloff, and a wholesale stop on incremental capital investments. And that would increase the likelihood of recession, which has been my base case for 2020 for the past two months.

At that point, the Fed could move again. But the die would be cast. They would not be able to undo what they had already done by waiting. And the transmission of further overtightening would mean recession. Now is the time to act.

Other factors

A lot of people are talking about stress in dollar funding markets, one of the key concerns surrounding tightening financial conditions. One avenue through which this tightening may be happening is the basis swap market, where people exchange floating rate financial instruments that are marked to different bases (ie. LIBOR vs T-bills) or currencies (i.e. USD vs GBP).

Before the debt ceiling was increased and the US budget impasse resolved, the US Treasury had been running down its balances at the Fed. With the deal solidified, we are going to see a flood of issuance that will tie up regulatory capital at financial institutions and put the squeeze on dollar liquidity.

The premia that investors are paying to swap euros, yen or pounds into US dollars is already at high levels. The anticipated further tightening of these markets will make things even worse.

It's technical aspects of the financial markets that are creating tightened financial conditions. All of this is made worse by policy divergence, with the Fed remaining tight relative to the rest of the world. That accelerates curve flattening as punters frontrun the likely Fed (late) move to ease once it cottons onto all of this.

Recession

I don't think the Fed gets it, frankly. It overtightened in 2018 and has been slow to unwind. Now, markets are in a panic. The only thing that can save the Fed here are the data. If we get improved economic data, it would alleviate fears of recession, loosening financial conditions. But right now, the combination of weakening growth globally and tightening financial conditions is toxic. It has brought us to the brink of no return. Personally, I am looking at the Treasury curve inversion out to seven years as the sign to throw in the towel. Until then, I have some hope the Fed or the data will change enough to avoid recession and crisis.

The real panic will begin when sellers in some of the ETF and ETN markets realize at the worst possible time that there is no liquidity in their underlying markets. Turning high yield bonds, for example, into an easily tradable equity-like market has been one of the great illusions of this business cycle. When contagion from equities hits high yield, that's when it will get ugly. And the defaults, credit writedowns and recession will begin.

We're not there yet. But the Fed's not helping. Let's hope they see the light...and soon. We’ve got several months before things get really ugly. But, legitimately we have much less time for the Fed to act before recession is baked in the cake.

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