As Growth Slows Down, the Fed Will Be the Last to Know
You are well aware that the Federal Reserve is raising interest rates. This policy started in December 2015 with Janet Yellen’s “liftoff” from zero and has continued through seven more rate hikes in 2016, 2017 and 2018, with another hike expected this December.
The cumulative impact is to put the high end of the range for the fed funds rate at 2.5% by year-end. More of the same is widely anticipated for 2019. The endgame is a rate of 3.5% by early 2020. At that point, the Fed may pause to re-evaluate but may keep going.
The Fed calls this approach “gradual” but it’s not. There’s a huge difference between a 0.25% rate hike (that’s the Fed’s tempo per hike) starting at 2% versus starting at 6%. In both cases, the hike is 0.25%, but the impact on bond prices and economic activity is much greater when you start with the lower base. There are highly technical reasons for this, having to do with concepts called “duration” and “convexity.”
We don’t need to dive into those. Suffice it to say that hikes from a lower base are much more impactful. In short, the Fed’s policy today is a body blow to an economy that’s still recovering from the worst recession since the Great Depression.
Other major central banks are either following in the Fed’s footsteps (Bank of England) or preparing to do so in the near future (European Central Bank). Even the money-printing and stock-buying Bank of Japan has acknowledged the central bank’s game can’t go on forever. Leaving China to one side (it’s a political shell game leading to a historic credit crisis), the central banks are either raising rates or getting ready.
If this rate hiking were the only major monetary development in the world, that would create a challenging environment for investors in stocks, bonds, gold and real estate — all interest-sensitive in different ways. But it’s not the only major development.
Behind the curtain, central banks are either slowing down the printing presses or actually burning money. This marks the end of quantitative easing (QE) for the Bank of Japan and the ECB and the start of quantitative tightening (QT) in the case of the Bank of England and the Fed.
From 2008–2014, U.S. critics of the Fed complained about rampant money printing under the banner of QE. There was even a popular cartoon that showed Ben Bernanke on the outside of a helicopter with one hand on a strut and the other hand throwing money out of the helicopter with a wild-eyed look on his face. This was a send-up of the infamous “helicopter money” that Bernanke advocated, an idea he nicked from uber-monetarist Milton Friedman.
Many U.S. investors assume QE is still going on. It’s not. QE was reduced with the “taper” beginning in December 2013 and was stopped completely by November 2014. The Fed then kept money supply constant until October 2017 when QT began. Instead of Bernanke dangling from a helicopter, picture Jay Powell near a furnace with a shovel and a huge pile of $100 bills. Powell is madly shoveling the money into the furnace, burning it. That’s what reducing the money supply looks like, and that’s what the Fed is doing now.
This money burning, or QT, is officially called “balance sheet normalization.” The Fed increased its balance sheet from $800 billion to $4.4 trillion from 2008–2014 under the policy of QE. Now they’re trying to get back to a reasonable number. It won’t be $800 billion, but the target could be around $2.4 trillion. That’s still a $2 trillion money supply reduction from the 2014 high.
Analysts estimate every $600 billion of balance sheet reduction is roughly equivalent to a 1.0% hike in the fed funds rate. So in addition to the 3.5% of rate hikes from 2015–2020, you can add on another 3.0% of implied rate hikes from QT. A total of 6.5% of rate hikes (3.5% nominal and 3.0% from QT) in five years from a zero base is one of the most extreme examples of monetary tightening in the history of the Fed.
It compares to the Volcker tightening from 1979–1981. Volcker intentionally set out to crush inflation even if it meant a recession (there were two recessions from 1980–1982). In contrast, there is no inflation on the horizon today and the economy is probably heading for a recession without any help from Jay Powell.
The global phenomenon is neatly illustrated in the chart below. This chart combines the QE and QT of the BoE, BoJ, Fed and ECB using colors to show the individual contributions of each central bank.
The Fed’s QE1 (2008), QE2 (2010) and QE3 (2012) stand out clearly in the three blue spikes. The BoE also had three waves of smaller magnitude shown as green waves from 2010–2016. The BoJ started late (in 2011) but has never stopped since, as shown in the red wave. Finally, the gray wave is the ECB. They were also late to the party but made it up in volume.
What’s important about this chart is not where we’ve been but where we’re going. The Fed is already in negative territory (the blue wave below the “0” line starting in 2018). The BoE is neutral but is also ready to go negative. The ECB and BoJ are still positive but trending down sharply; the ECB will go negative in 2019, according to current plans.
The black trend line shows the aggregate of all four central banks. It crashed in 2018 (mostly because of the Fed) and will go negative globally in 2019. Before long, our cartoon of Jay Powell shoveling cash into a furnace will have to be updated to include Mark Carney, Mario Draghi and Haruhiko Kuroda.
Americans today are celebrating back-to-back quarters of strong growth. That’s fine, but it’s dangerous to ignore the trend. Since April 2018, we’ve seen growth of 4.2% (Q2), 3.5% (Q3) and an estimate of 2.9% (Q4, per the Atlanta Fed). The trend is pointing down. This trend tends to confirm the view that 2018 growth was a “Trump bump” from the tax cuts that will not be repeated.
The trend line points to a return to the 2.2% growth that prevailed from 2009–2017. This is exactly what one would expect from the extreme tightening described above. As usual, the Fed will be the last to know.
for TheDaily Reckoning