As is well known, the Federal Reserve’s main tool in responding to the Financial Crisis in 2007 – 2009 has been quantitative easing (to lower long term interest rates) and direct reduction of the Federal Funds Rate (to lower short term interest rates). These measures definitely limited the severity of the Great Recession resulting from the Financial Crisis. But the recession ended in June 2009, more than seven years ago. In the meantime the continuation of such low interest rates is having many detrimental effects such as:
Pension funds, both public and private, have become greatly underfunded, creating crises especially for state and local governments with defined contribution plans.
Retirement plans for millions of seniors have been upset by erosion of savings.
Inequality has increased as affluent stock owners benefit from the rapid increase of asset prices as investors reach for yield.
Federal debt is soaring as low interest rates make it much easier for Congress to ignore large budget deficits.
The next recession, when it inevitably arrives, will leave the Fed in a bind. The only tools remaining are a new round of quantitative easing (additional bond purchases) and even lower (i.e. negative) interest rates.
The Fed’s dual mandate of low unemployment (currently 4.9%) and price stability (low inflation) is being met but is accompanied by anemic GDP growth averaging only 2% since the end of the Great Recession. Such slow economic growth is largely responsible for the populist revolt in the 2016 presidential race.
Conclusion. Monetary policy can only accomplish so much. It is critical for the Fed to wind down its $4.5 trillion balance sheet as its bond holdings mature and to keep raising short term interest rates. This will force Congress to step up to the plate with the changes in fiscal policy which are needed to stimulate economic growth.
The financial crisis of 2008 was the biggest shock to our financial system since the Great Depression of the 1930s. It caused a deep recession from which we are still recovering. To aid the recovery the Federal Reserve launched an unprecedented expansion of the money supply, referred to as quantitative easing, as well as keeping short term interest rates near zero. As explained by James Rickards, a portfolio manager at West Shore Group, in his new book, “The Death of Money, the coming collapse of the international monetary system,” such a severe recession would normally have caused a corrective period of deflation. Quantitative easing has warded off deflation and, so far, without igniting inflation. We are now in a catch-22 situation. Congress could and should adopt several policy changes to speed up the recovery as I described several days ago in “The Federal Reserve Cannot Revive the Economy by Itself.” But, if and when the economy does start growing faster, it will require great skill by the Fed to exit from its current policies without harm. If it contracts the money supply too quickly, it risks a sharp rise in interest rates. If it contracts the money supply too slowly, it risks a sharp rise in inflation. Mr. Rickards doubts that the Fed will be able to accomplish this fine tuning without another major crisis. Here are his Seven Signs of what to look for:
The price of gold ($1300 per ounce today). A rapid rise to $2500 will anticipate inflation. A rapid decrease to $800 signals severe deflation.
Gold’s continued acquisition by Central Banks. Large purchases by China, for example, will announce inflation.
IMF governance reforms, e.g. towards more voting power for China, will be an inflation warning.
The failure of regulatory reform, i.e. reinstatement of Glass-Steagall in addition to the Volcker Rule, will increase the chances of systemic failure.
System crashes, resulting from high-speed, highly automated, high volume trading. An increasing tempo of such events will cause disequilibrium which could close markets.
The end of QE, could give deflation a second wind and lead to a new round of QE.
A Chinese collapse (predicted by Rickards), will lead first to deflation and then inflation.
We all hope that the Federal Reserve can steer clear of a new, and much deeper, financial crisis. But it doesn’t hurt to have guideposts and Mr. Rickards knows what he’s talking about.
Harvard Economist, Martin Feldstein, has an Op Ed column in yesterday’s New York Times, “Saving The Fed From Itself”, which gets our current economic situation half right. First of all, Mr. Feldstein says that the Fed’s quantitative easing policy is inadequate because “the magnitude of the effect has been too small to raise economic growth to a healthy rate. … The net result is that the economy has been growing at an annual rate of less than 2 percent. … Weak growth has also meant weak employment gains. … Total private sector employment is actually less than it was six years ago. … While doing little to stimulate the economy, the Fed’s policy of low long-term interest rates has caused individuals and institutions to take excessive risks that could destabilize the economy just as it did before the 2007-2009 recession.” So far he’s right on the button!
But then he goes on to say, “To get the economy back on track,” Congress should enact a five year plan to spend a trillion dollars or more on infrastructure improvement and that this would “move the growth of gross domestic product to above three percent a year.” An artificial stimulus like this might work temporarily but then it ends and we’re back where we started. We need a self-generating stimulus that will keep going indefinitely on its own. How do we accomplish this?
The answer should be obvious. We do it by stimulating the private sector to take more risk in order to generate more profits. In the process they will hire more employees and boost the economy.
How do we motivate the private sector? By lowering tax rates and loosening the regulations which stifle growth. Closing tax loopholes and lowering deductions (which will raise revenue to offset the lower tax rates) has the added benefit of attacking the corporate cronyism which everyone deplores.
We really do need to put first things first. If we can jump start the economy by motivating the private sector to invest and grow, we will have more tax revenue to spend on new and expanded government programs as well as shrinking the federal deficit.
Why is this so hard for so many people to understand?
David Malpass, president of Encima Global LLC, has an op-ed in yesterday’s Wall Street Journal, “The Economy Is Showing Signs of Life”, pointing out that business loans, auto sales and hourly earnings are up. Mr. Malpass says that “The sequester is a bad way to set spending priorities, but it reduces the risk of future tax increases, contributing to the upturn in consumer and business confidence. … The good news is that an end to the latest version of the Fed’s quantitative easing would create space for more growth in private credit and a shift back toward market, not government allocation of credit. …Because America’s private economy is the world’s biggest net creditor and capital allocator, the United States will be the biggest beneficiary of a return to market based interest rates, with vast potential in efficiency, intellectual property and the capacity to innovate.”
Federal Reserve Chairman, Ben Bernanke, is given much credit for the fact that the Great Recession did not turn into another depression. But now, four years after the end of the recession, we have the twin problems of a slow growth economy, which keeps the unemployment rate much too high, and the potential for huge inflation caused by the vast increase in the money supply. Mr. Malpass makes an excellent argument that the economy has recovered enough so that further quantitative easing will now retard future growth. It clearly also increases the chance of runaway inflation.
Current artificially low interest rates also disguise the future damage now being created by huge federal deficit spending. When interest rates go back up, as they inevitably will, interest payments on our rapidly increasing national debt will also increase dramatically, and force far greater cuts in federal spending than are currently being caused by the sequester.
In other words, to speed up economic growth, curtail the risk of future inflation and to put more pressure on Congress to control federal spending, the Federal Reserve should begin to exit from quantitative easing in the very near future!