The Consequences of Helicopter Money
The Federal Open Market Committee, FOMC, of the Federal Reserve voted on Dec. 14 to raise interest rates 0.25%, as we expected. The vote was unanimous including doves such as Fed governor Lael Brainard.
While the rate hike was fully expected by markets, what was not expected was that the Fed struck a hawkish stance on future rate increases. Prior to the December FOMC meeting, the forecast was for two rate hikes before the end of 2017. On Dec. 14, the Fed signaled its intention to increase interest rates three more times in 2017.
The Fed based this more hawkish view on the fact that labor market conditions continue to improve, and slow but steady progress is being made in meeting the Fed’s inflation targets. As long as labor conditions are satisfactory, and inflation is not too high, the Fed will raise rates at a tempo of 1% per year, more or less, until a “neutral” fed funds rate of about 3.25% is achieved.
The Fed is engaged in this tightening cycle not because the economy is running “hot” (it’s not), but because they are desperate to raise rates enough to cut them again in a future recession. The Fed is behind the curve in this process. The Fed should have raised rates to about 3.25% over the course of 2009 to 2013. But, the Fed missed this entire interest rate cycle, instead engaging in fruitless experiments in quantitative easing or QE.
Unfortunately, the Fed is bent on a rate hike path at the worst possible time. Recent data on retail sales and industrial production were both weak. The super-strong dollar is deflationary at a time when the Fed is still failing to meet its inflation goals. The Fed may end up causing the recession it is trying to prevent. This policy conundrum is the result of eight years of policy manipulation.
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.
This contradiction between Fed omnipotence and Fed incompetence is coming to a head. The new Trump administration will confront the Fed and insist on accountability and rule-based decision making. The confrontation will present enormous risks and opportunities to investors.
The Consequences of 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.
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.