One Manipulation Leads to Another
By now you have heard the Fed lowered interest rates today by 25 basis points. This was fully expected. The deeper story is that the Fed’s attempt to “normalize” monetary policy has failed.
It never came close to raising rates to between 4% and 5%, the level history shows is required to fight recession. The Fed also announced an end to quantitative tightening (QT) today, two months ahead of schedule. Its balance sheet is still much higher than it was in 2008.
The question now is, what comes next?
Powell disappointed markets today when he indicated the rate cut was a “midcycle adjustment to policy.” The Fed did not commit to more rate cuts. They may cut in September or not. This was disappointing to markets and is one reason stocks retreated despite the easing.
The Fed was trying to raise rates to prepare for the next recession. But, they came close to causing a recession last December. In effect, the Fed failed in its primary mission and is now in retreat.
This creates uncertainty about whether the Fed will retreat more or resume its preferred rate hike path. One thing we know about markets is that they can’t stand uncertainty and will remain volatile until this tension is resolved.
How did we get here?
We all know the outlines of how the Fed and other central banks responded to the financial crisis in 2008.
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 it 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.
Now, after a 10-year expansion, policymakers are considering the implications of a new recession. There’s only one problem, as I said: Central banks have not removed the supports they put in place during the last recession.
Interest rates got up to 2.50% (back down to 2.25% today), but that’s far lower than the 4–5% rates that will be needed so the Fed can cut enough to cure the next recession. The Fed has reduced its balance sheet from $4.5 trillion to around $3.8 trillion, but that’s still well above the $800 billion level that existed before QE1.
In short, the Fed (and other central banks) only partly normalized and are far from being able to cure a new recession or panic if one were to arise tomorrow. It will take years for the Fed to get interest rates and its balance sheet back to “normal.” And now that it’s going in the other direction, even longer.
But the current expansion is already the longest on record. It can’t be expected to last much longer. When it does strike, the next recession may be impossible to get out of. The central banks just don’t have the “dry powder” to fight it with.
And that comes back to a deeper problem…
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.
All it does is set the stage for a bigger crisis down the road.
The bigger problem is there’s no way out, as I said. One manipulation leads to another.
The zero interest rate policy (ZIRP) didn’t work, so the Fed went to quantitative easing (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). Now the Fed’s back to cutting rates. We can’t say when it will end.
The Fed also announced today that it’s ending QT prematurely. The point is that the Fed has not normalized rates and they have not normalized their balance sheet. It’s just one manipulation after another with weak results and no way out.
The latest form of manipulation is what’s called a “standing repo facility,” which is just another flavor of QE. Under this facility, banks would swap their cash reserves at the Fed for Treasury securities on the promise that they could swap back into cash immediately if needed.
Essentially, this manipulation would allow banks to hold fewer reserves than presently required, knowing the Fed would have their backs if they ran into trouble.
This is just another accounting gimmick to pretend to clean up the Fed’s balance sheet. It won’t be the last manipulation. We’re a long way from that. In all likelihood, we’re only getting started.
But there’s little reason to believe conditions will improve. The fear is that the U.S. could become like Japan…
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 is 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, former Fed Chair 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 we are today. Today’s rate cut will do nothing to reverse it.
for The Daily Reckoning