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The Fed’s Troubled Road Ahead

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.

Needless to say, for the past 20 years the Fed has gone beyond its dual mandate of price stability and full employment to engage in full-scale manipulation of markets and the macroeconomy.

On Dec. 5, 1996, Alan Greenspan, then Chairman of the Federal Reserve, gave a speech in which he mused about whether valuations in the stock market reflected a degree of “irrational exuberance.” The irony was that stocks measured by the Dow Jones index doubled in value over the next three years before crashing over 40% from their peak on Dec. 31, 1999.

Greenspan’s restraint in 1996 was the beginning of a Fed theory that said the Fed should not lean against bubbles by raising interest rates, but should let bubbles burst and then “clean up the mess.”

A less charitable interpretation is that the Fed encourages bubbles by misguided interest rate policy and doesn’t care if everyday investors, like you, get crushed when the bubble bursts, as long as the banks are propped up.

In short, the Fed has become an all-purpose backstop for failing banks and falling markets.

This manipulation mindset is important to bear in mind both in assessing Fed policy going forward, and in understanding the instability that has built-up beneath the surface as the result of prior misguided manipulations.

Despite the mental anguish and forecasting errors of most market analysts, the Fed policy process is quite easy to understand. Three rules will give you all of the guidance you need to accurately forecast Fed actions:

The Fed will raise rates whenever it can until it reaches a target Fed funds rate of 3.25%. Beyond that, Fed policy will shift from a tightening bias to a neutral bias.
The Fed will not tighten if job growth slows materially or if financial conditions tighten for reasons unrelated to the target Fed funds rate.
All Fed commentary can safely be ignored unless it comes from the Chair, Vice Chair, NY Fed President or the FOMC itself.
That’s it. Of course, some explanation and interpretation of these rules is helpful.

The Fed’s desire to raise rates is unconnected to the usual business cycle considerations that go into Fed tightening or easing decisions. The Fed is making up for lost time. This means they are biased toward rate hikes even when the economy is not particularly robust.

On the other hand, the Fed will pause in its tightening whenever it sees a danger of weak job creation, tighter financial conditions, deflation, or weak growth. Specifically, job creation of less than 100,000 new jobs per month would put the Fed on hold.

Likewise, declining or negative readings on core price indices, especially the year-over-year PCE price deflator, will cause the Fed to pause until those readings reverse. A negative quarter or GDP growth would also cause the Fed to skip an otherwise planned rate hike.

Finally, a full-blown stock market correction of 10% or more would represent a tightening of financial conditions that would make a rate hike redundant.

Simply put, the Fed will raise rates in March, June, September and December of 2017, 2018, and 2019 unless growth, job creation, stock prices or inflation collapse. In that case, the Fed will pause as long as necessary until those conditions reverse. This simple formulation is the best guide to Fed policy in the years ahead based on current growth expectations.

But, what if these periodic “pause factors” grow even worse than anticipated? What if weak job creation turns into job losses? What if low inflation turns into persistent deflation? What if weak growth turns into a technical recession?

If the Fed needs to offer the economy more than a pause in its tightening path, it does have tools at its disposal to ease monetary conditions. It is possible that some or all of these tools may prove ineffective or not work as expected. Yet the Fed believes these tools are adequate despite the reservations of Fed critics.

One of the tools the Fed has in their toolkit to stimulate the economy if recession or deflation gains the upper hand is helicopter money…

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.

Read More @ DailyReckoning.com

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