The Fed Has Painted Itself Into A Corner? They Need A Helicopter Rescue

A Benjamin Cole post

Fed officials speak copiously and continuously about their unfulfilled urge for higher interest rates. This is a deep desire that U.S. central bankers were able to somewhat satiate from the early 1980s to 2008.

It is true that through much of the 1980-2008 period many Fed-rate increases led to lower inflation, and to weaker growth and sometimes recession, leading to lower interest rates. Rates were in long-term secular decline, but there were those euphoric passages (for central bankers) when rates could again be boosted, as during any economic recovery.

But, as Milton Friedman noted, 1) a central bank cannot tighten its way to higher interest rates forever, and 2) nominally low interest rates are a sign that money has been tight.

A couple generations of money-tightening has produced predictable results of low interest rates, low growth, as well as miniscule inflation.

The Fed is presently trapped. The central bank has little grip on long-term rates, now near historic lows. So raising the Fed funds rate and interest on excess reserves (IOER), will only dampen long-term rates again, the opposite of what the Fed says it wants.

IOER

And then there is the tar baby the Fed tossed into the corner into which it then painted itself: IOER.

Banks make money “on the spread,” that is the difference between borrowing costs and lending returns, usually about 300 basis points. Banks have overhead, labor costs, fancy HQs so that spread gets cut thin on the way to the bottom line.

But now banks collect 0.50% on IOER, the same reserves hugely swollen by QE. The Fed is eager to boost that to 0.75% soon, and possibly even higher in the 12 months ahead.

At some point it will make sense to banks to do nothing.

IOER may be one reason why U.S. commercial real estate loan volume only reached 2007 levels again in late 2015. Actually, 2016 has been a decent year for commercial real estate loan volume—finally eclipsing 2007 levels—but if the Fed raises IOER again, perhaps the IOER will be higher than the profit on a commercial property loan. The banks can go golfing on the 0.75% they make for keeping money in the vault.

Nirvana for central and commercial bankers at last!

Yet this problem of IOER-addled banks is doubly important, as many say it is banks that expand the money supply, when they extend a loan. Before QE, the main creation of new money was through bank lending, and banks primarily lend on real estate.

This gets into the whole exogenous v. endogenous expansion of the money supply dispute, which can put any sane person into knots for days.

But suffice it to say, the Fed is following a reckless and suppressive mission with a view towards higher IOER. The money hose could run dry long before the Fed could arrange tools to replenish the supply.

Paying banks to do nothing is an imprudent and dangerous precedent, and of course, only banks will closely monitor and lobby this IOER issue going forward. Like any federal dope, it will quickly become addictive.

Conclusion

The Fed likely should have never paid IOER.  But what is done is done. This makes the quantitative easing (QE) option going forward more problematic, as banks will accrue even more indolence-inducing reserves.

But the US will enter recession again someday, and likely with interest rates near or lower than today’s levels.

Really, the only recourse is to the helicopters. And that begs the question: Why wait until there is a deep recession again? How about preventative air drops anytime core-PCE dips below 2% YOY?

Or, better yet, whenever NGDP growth drops below 5%?

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Growth is to be avoided at all costs!

That´s the sort of reasoning a depression can bring about! In “How a Surprise Upturn in U.S. Growth Could Trigger the Next Recession”, we read:

Could the cause of the next U.S. recession be too much growth? That is one risk of an unprecedented environment in which investors are betting heavily on a perpetually weak economic expansion.

If markets are wrong–and the economy surges instead of sputters–the bad bets could roil the financial system, some economists are increasingly warning.

“Ironically, one can think of a scenario where a stronger-than-expected expansion leads to financial trouble, which in turn puts into question the expansion itself,” said former International Monetary Fund chief economist Olivier Blanchard.

Mr. Blanchard is the latest prominent economist to warn that a surprise upturn in growth may force the Federal Reserve to raise rates faster than investors expect. A jump in borrowing costs could catch many off guard, given that much of their portfolios are based on lower rates.

“If the economy were to pick up faster than markets think, which I think has substantial probability, it could lead to some financial turmoil,” Mr. Blanchard, now a senior fellow at the Peterson Institute for International Economics, said in an interview.

……………………………………………………………….

“When the Brexit smoke clears, if, as I expect, it clears, then the Fed should tighten,” said Mr. Blanchard. And given that it takes roughly a year for interest rates to have a substantial effect on the economy, that means the Fed can’t wait too long to raise the cost of borrowing to temper inflation.

“You have to anticipate,” he said. “If I was at the Fed, I would be slightly on the hawkish side.”

The economy is being smothered by the Fed. In that case all the risk is on the downside. Higher growth is a chimera!

Where does monetary policy enter the Fed´s equation?

To them, inflation, or its absence, is purely a cost phenomenon, pushed up or down by oil prices and/or the dollar and unemployment! Worse, they insist on reasoning from a price change! From the statement:

Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.

That “sing-a-long” has been going on for such a long time that “medium-term” has turned into “long-term” many moons ago!

I reproduce a set of charts that indicate the tightening of monetary policy (gauged by the falling trend in NGDP growth since mid-2014) is bringing the economy closer and closer to a recession (maybe in several quarters down the road the NBER will say that it began in early 2016!)

FOMC 270116_1

FOMC 270116_2

After leaving the Fed, Kocherlakota has been very “vocal”. From a post today:

Monetary Policy is Not About Interest Rates

The Federal Open Market Committee has a problem.  The problem is not that it raised rates by a scant quarter percentage point in December.   The problem is the overall policy framework that led the Committee to take that action.  The Committee needs to switch to a framework that is less focused on a particular time path of interest rates, and more focused on the achievement of its goals.    

The FOMC’s current policy framework goes back to at least mid-2013.   It can be defined by two key words gradual and normalization.  Both words refer to the level of monetary accommodation.  In terms of the target range for the fed funds rate, the word “gradual” is generally interpreted by those who watch the Fed closely to mean about four increases of a quarter percentage point.   The word “normalization” is generally interpreted to mean “returning to about 3.5 percent”.

Lars Christensen has evoked the same principal:

Frankly speaking I don’t feel like commenting much on the FOMC’s decision today to keep the Fed fund target unchanged – it was as expected, but sadly it is very clear that the Fed has not given up the 1970s style focus on the Phillips curve and on the US labour market rather than focusing on monetary and market indicators. That is just plain depressing.

Anyway, I would rather focus on the policy framework rather than on today’s decision because at the core of why the Fed consistently seems to fail on monetary policy is the weaknesses in the monetary policy framework.

The FOMC is an Executive Committee that thinks it´s over and above criticism. It can never do wrong! But they also say that “we´re not responsible”. In fact, they sell themselves as having “The Courage to Act”!

Monetary policy for the present depression, not for the next recession

At Bloomberg View, Clive Crook has a pretty depressing piece – “Monetary Policy for the Next Recession”:

By pre-crash standards, the big central banks have made and continue to make amazing efforts to support demand and keep their economies running. Quantitative easing would once have been seen as reckless. The official term of art — unconventional monetary policy — tacitly acknowledged that.

But QE isn’t unconventional any longer. It mostly worked, the evidence suggests. The world avoided another Great Depression. Yet even in the U.S., this is a seriously sub-par recovery; growth in Europe and Japan has been worse still. Now imagine a big new financial shock. It’s quite possible that all three economies would fall back into recession. What then?

And concludes:

What if ordinary monetary policy isn’t enough? What if central banks can’t discharge their inflation-target mandate without a hybrid fiscal-and-monetary instrument? QE has already posed that question — it’s a hybrid too — but in a much more subtle way. When the discussion turns to the Fed sending out checks, the issue is impossible to ignore.

It needs to be addressed. Independence for central banks only makes sense if they have the means to do the job they’ve been given. At the moment, they’re dangerously under-equipped.

He shouldn´t be enquiring about monetary policy for the next recession. All should be focused on monetary policy for the present depression”.

It´s amazing how many have been sold on the idea that the Fed is “out of ammo” or, equivalently, “dangerously under-equipped”.

The fact is that the Fed is not working it´s “firehoses” as it could. The only plausible answer to the “puzzle” is “because it chose not to”!

The charts below depict inflation (headline & core PCE) over different periods. This is followed by the chart depicting nominal spending (NGDP) growth (the Fed´s “firehose”) over the same periods.

Firehose_1

Firehose_2

The “Great Inflation” goes hand in hand with high and rising NGDP growth, i.e., the Fed is “inflaming” the economy.. Thereafter there is the “Volcker-Greenspan Adjustment” leading to the “Great Moderation”, which extends to 2007, a period during which, for much of the time, the Fed provides the “right” amount of “liquidity”.

Bernanke´s Fed thought that amount was “too much”. First, it “closed the taps” and then opened them up but with much less “water pressure”, insufficient for the “spending grass” to grow to heights it had reached during the “GM”!

This very simple story is sufficient to guide monetary policy. First to enable the economy out of the depression and then keeping it from falling into another!

 

There´s no risk of recession, we´re just depressed!

I usually find Ambrose Evan-Pritchard an interesting read. However, today he spins an unlikely optimistic tale on the near future of the US economy in “Ignore the ‘whiff of panic’ as US economy stalls”.

He ends with a picture of job openings

Cusp of recession_1

And writes:

The ratio of job openings to applicants is now higher than it was at the top of the last boom in 2007 by a substantial margin. Hours worked have surged. The labour market is tightening hard. Unless Americans have gone through a Puritan conversion, their swelling disposable income must soon start flowing into the shopping malls.

This is not the picture of a country on the cusp of recession.

Only no one is talking about “recession”. In fact, Jim Hamilton´s GDP-based Recession Indicator Index has rarely been as low as it is now for it´s more than 45-year history!

What people have stopped doing is referring to the post 2009 “recovery” as a “depression” (intimately called Bernanke-induced “little depression”). And the job opening picture is not at all inconsistent with that, which is well described in the chart below.

Cusp of recession_2

 

Reincarnation exists

John Tamny is Andrew Mellon reincarnated! In “Recessions Are Absolutely Beautiful, And Should Be Renamed ‘Recovery‘”, he concludes:

Thinking about all this, what’s plainly missed by Ip is the unseen.  Indeed, imagine how much lower unemployment would be and how much higher asset prices would be today if the Fed had allowed the economy to cleanse itself of all that was restraining it back in 2008.

Mellon-Tamny