Inside the Fed Tool Kit

The US economy is slowing perceptively. The Fed has created a mess. We’ve had a full year, 4 consecutive quarters, with average growth of about 1.2%  and with some revisions that may even go lower. That’s awful. 

First of all, that’s extremely close to recession. Second, it’s way below the Federal Reserve’s (Fed) projections of about 2.5%. Third, it’s way below potential of 3.5%. This is not just weak growth, it’s extraordinary weak, and dangerously close to recession.

What should the Fed be doing about that? One thing they might want to do is cut interest rates. They can only cut them 25 basis points without going negative.

Negative interest rates are another thing we’ve got to at least put into the mix. They could do one interest rate cut. They could do more quantitative easing. However, they probably won’t do quantitative easing until they cut the 25 points that are there now.

The sequence of Fed easing is, if they need it, first forward guidance.  This is where they promise not to raise rates for a long period of time, then comes one rate cut. Followed by that comes more forward guidance – and now we’re back to zero. Then the pattern begins again, where they promise to not to raise rates for another period of time, and then possibly another round of quantitative easing (QE4). I think the Fed will do all those things before they get to negative rates.

That’s what Yellen said at Jackson Hole and I think we have to give her credit for that being a pretty accurate representation of their playbook.

Whether that works and what is a good idea are separate issues.  But that’s what Yellen says is in the tool kit, and should be taken at face value.

There is one other tool in the Fed arsenal, which is currency wars.  That would be the ability to cheapen the US dollar. The Fed would be highly partial to a cheaper dollar.

The cheaper dollar imports inflation in the form of higher input prices.  This is because with a cheaper dollar, we have to pay more for our iPhones, Indian textiles, Chinese electronics and manufactured goods.  In a sense, the Fed likes a cheap dollar because it helps meet inflation goals to an extent.

The problem with the currency wars tool is that if one currency goes down, another currency has to go up. They can’t all go down at once against each other. There must be winners and losers in the currency wars. If there is a cheaper dollar, which the Fed might want, look for stronger yen, a stronger Euro, some other currency effects.

In this, there is a problem.

The problem the Fed has is that they have created asset bubbles in stocks and real estate with almost 8 years (three rounds) worth of quantitative easing.  Those factors coupled with a 0% interest rate policy that continues at extraordinarily lower rates.

They have created asset bubbles. Now the asset bubbles are at the point where the bubbles might burst. The stock market could go down. It went down 11% in January, early February of 2016. It went down 11% August 2015. We’ve seen 2 episodes of more than 10% corrections in the last 13 months.

The market’s clearly vulnerable and some of the volatility factors could easily go down 10-20% with one swoop.

Certainly a rate hike, which I think is completely off the table for the foreseeable future, would be just the thing to take the stock market down 20%.

Source: CNBC 

If that happens it’s going to be extremely destructive of confidence.

It’s going to be the opposite of what the Fed wants. It’s going to be deflationary, it will increase savings, reduce spending and reduce the volatility of money.

Regards,

Jim Rickards
for The Daily Reckoning

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