Don’t Blame Jay Powell!

Markets have welcomed recent action by the Federal Reserve to lower interest rates, end quantitative tightening, and promise more interest rate cuts in the future. Stocks, bonds and gold have all been climbing based on this newfound easing by the Fed.

This stands in stark contrast to the situation in December 2018 when the Fed completed the last of four rate hikes in 2018 and stock markets staged the Christmas Eve Massacre which topped off a full-scale market correction from October 1 to December 24, 2018.

The Fed (and markets) have been recovering from the Fed overtightening ever since. But, with a weak economy and declining markets in late 2018, why was the Fed tightening in the first place?

The Fed usually tightens when the economy is overheating and inflation or asset bubbles are expanding dangerously. None of that was the case in late 2018. The answer is that the Fed was raising rates and reducing its balance sheet (so-called “quantitative tightening” on QT) in order to prepare for the next recession.

It usually takes five percentage points of rate cuts to pull the U.S. out of a recession. The Fed was trying to get rates up from about 2% to closer to 5% so they could cut them as much as needed in a new recession. But, they failed.

Interest rates only reached 2.5%. The Fed also reduced its balance sheet from $4.5 trillion to $3.8 trillion, but that’s still well above the $800 billion level that existed before QE1.

The market reaction and a slowing economy caused the Fed to reverse course and engage in easing. That’s good for markets, but terrible in terms of getting ready for the next recession. In short, the Fed (and other central banks) have only partly normalized and are far from being able to cure a new recession or panic if one were to arise tomorrow.

The Fed is therefore trapped in a conundrum. It needs to rate hikes to prepare for recession, but lower rates to avoid recession. It’s obviously chosen the latter option.

But if a recession hit now, the Fed would cut rates by another 2% in stages, but then they would be at the zero bound and out of bullets.

Beyond that, the Fed’s only tools are negative rates, more QE, a higher inflation target, or forward guidance guaranteeing no rate hikes without further notice.

This is not the result of bad leadership by Jay Powell. It’s the result of ten years of bad leadership by Ben Bernanke and Janet Yellen that gave us the zero rate policy from 2008 to 2015. It would have been helpful to raise rates in 2010 or 2011 when the economy was in the early stages of its expansion.

First the Fed cut interest rates to zero and held them there for seven years. This extravaganza of zero rates, quantitative easing (QE) and money printing worked to ease the panic and prop up the financial system. But they did little to improve the real economy.

The zero interest rate policy (ZIRP) didn’t work, so the Fed went to QE. After QE1, QE2 and QE3 (2008–2013) came the “taper” (2014) and then the “liftoff” in rates (2015), followed by “pause” and “patience” when it came to more rate hikes (2016–19).

These steps did nothing to restore growth to its long-term trend or to improve personal income at a pace that usually occurs in an economic expansion. Unfortunately for him, the Bernanke-Yellen science experiment has been dumped in Jay Powell’s lap.

Now in 2019, it’s back to rate cuts as the trade war and slowing global growth have policymakers considering the implications of a new recession without the firepower they need. As things stand, the next recession may be impossible to get out of. And the odds of avoiding a recession are low.

The only way out is for the Fed to guarantee inflation “whatever it takes.” It really all comes back to market manipulation.

The problem with any kind of market manipulation (what central bankers call “policy”) is that there’s no way to end it without unintended and usually negative consequences. Once you start down the path of manipulation, it requires more and more manipulation to keep the game going.

Finally it no longer becomes possible to turn back without crashing the system.

Of course, manipulation by government agencies and central banks always starts out with good intentions. They are trying to “save” the banks or “save” the market from extreme outcomes or crashes.

But this desire to save something ignores the fact that bank failures and market crashes are sometimes necessary and healthy to clear out prior excesses and dysfunctions. A crash can clean out the rot, put losses where they belong and allow the system to start over with a clean balance sheet and a strong lesson in prudence.

Instead, the central bankers ride to the rescue of corrupt or mismanaged banks. This saves the wrong people (incompetent and corrupt bank managers and investors) and hurts the everyday investor or worker who watches his portfolio implode while the incompetent bank managers get to keep their jobs and big bonuses.

But the bigger problem is there’s no way out, as I said. One manipulation leads to another. My greatest fear is that the U.S. is becoming like Japan, which has used every trick in the book to no avail.

In my 2014 book, The Death of Money, I wrote, “The United States is Japan on a larger scale.” That was five years ago.

Japan started its “lost decade” in the 1990s. Now their lost decade has dragged into three lost decades. The U.S. began its first lost decade in 2009 and is now entering its second lost decade with no end in sight.

What I referred to in 2014 was that central bank policy in both countries has been completely ineffective at restoring long-term trend growth or solving the steady accumulation of unsustainable debt.

In Japan this problem began in the 1990s, and in the U.S. the problem began in 2009, but it’s the same problem with no clear solution.

The irony is that in the early 2000s, Ben Bernanke routinely criticized the Japanese for their inability to escape from recession, deflation and slow growth.

When the U.S. recession began during the global financial crisis of 2008, Bernanke promised that he would not make the same mistakes the Japanese made in the 1990s. Instead, he made every mistake the Japanese made, and the U.S. is stuck in the same place and will remain there until the Fed wakes up to its problems.

Bernanke thought that low interest rates and massive money printing would lead to lending and spending that would restore trend growth to 3.2% or higher.

But he ignored the role of velocity (speed of money turnover) and the unwillingness of banks to lend or individuals to borrow. When that happens, the Fed is pushing on a string — printing money with no result except asset bubbles.

That’s where we are today. And there’s no relief in sight.


Jim Rickards
for The Daily Reckoning

The Daily Reckoning