by Jim Rickards, DailyReckoning:
In recent decades, the Fed 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 Fed 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 Fed steps in. The Fed 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 Fed may desire, could have far less potency and far greater unintended negative consequences than either may expect.
Negative Real Rates Achieved Through Financial Repression
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.
Interest Rate Cuts in a Recession
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.
Savers Save More When Facing Negative Interest Rates
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.
Market Manipulation and QE
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.
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