The Approaching “Ice Age”

Is the economy plunging into an “ice age”?

And how might the authorities try to haul us out?

Today we hunt for answers in the “shadows.”

Details to follow. First the skeleton facts…

The federal funds rate is the interest rate the Federal Reserve controls directly — which presently rises to 2.50%.

Many traditional models calculate the effects of the fed funds rate upon economic conditions.

But the Federal Reserve hounded rates down to zero after the great financial crisis. And conventional analysis begins to fail at the zero bound.

Thus the world of economics entered a twilit region where all familiar reference points faded… and finally fell away.

But University of Chicago economists Jing Cynthia Wu and Fan Dora Xia were determined to penetrate the darkness at the zero bound.

The question they asked:

Can we develop an interest rate model that accounts for quantitative easing’s loosening effects?

They furled back their sleeves, spit upon their hands… and chained themselves to their desks.

An Alternate Model That Accounts for QE 

In 2014 their toils yielded an “alternate” fed funds rate:

The “shadow rate.”

As one observer explains the shadow rate:

When the federal funds rate hovers near zero, many economic models stop working. Researchers developed a “shadow rate” that can stand in for the fed funds rate, drop into negative territory and make those models functional again.

What did the shadow rate reveal?

In graphic form, the answer:

Who Says Interest Rates Never Went Negative?

Thus we learn the following:

In mid-2009 — after QE 1 entered high gear — the shadow rate turned negative.

Rounds two and three pummeled the shadow rate all the way to minus 3% by mid-2014.

Negative interest rates?

Here you have them — if you follow the official rate into the murky shadows.

The Tightening Cycle Is More Intense Than Many Believe

The chart reveals an additional fact…

The shadow rate began a steep rise in late 2014 — over one full year before Janet Yellen first  raised the official fed funds rate in December 2015.

From a negative 3% in mid-2014, the shadow rate spiked to just negative 0.74% in September 2015.

It converged with the fed funds rate that December… and has mirrored it in positive territory ever since.

Why did the shadow rate rise so steeply over a year before the official rate? Two reasons:

The Fed announced the end of quantitative easing in late 2014.

And Ms. Yellen began jawboning rates higher with “forward guidance” — insinuating that higher rates were on the way in 2015.

Thus financial conditions began to bite… and the shadow rate began its rise.

If we therefore consider the shadow rate, the Fed began tightening not in 2015 — but in 2014.

Who cares and so what?

It means this tightening cycle may be far more mature — and intense — than most realize.

Is the Current Tightening Cycle Really 4.5 Years Old?

The Federal Reserve has undertaken 12 tightening cycles since 1955. Each cycle has averaged two years.

But the current cycle is nearly 3.5 years old.

And if we account for the shadow rate… the current cycle is perhaps 4.5 years old.

Meantime, previous tightening cycles averaged roughly 3 percentage points, trough to peak.

The current cycle has officially covered the first 2.5 percentage points. But consider the shadow rate…

Recall that the shadow rate bottomed at negative 3% in 2014.

Like the official rate, it now rests between 2.25% and 2.50%.

It has therefore risen over 5 full percentage points off its 2014 low — far exceeding the 3% historical range.

Explains The Street:

That 5.4-percentage-point increase ranks the recent monetary-tightening cycle well ahead of the 4-percentage-point boost that took place from 1986–89 and the 3-percentage-point hike of 1994–95. It also exceeds the jump of 4.25 percentage points from 2004–06, which helped to trigger the 2008 financial crisis. 

And do not forget the effects of previous quantitative tightening.

“The Amount of Policy Tightening Is Unprecedented”

Joe Lavorgna, chief Americas economist at Natixis, believes QT may have effectively raised interest rates another 0.5%.

Add it to the 5.4% increase of the present cycle… and Lavorgna claims the Federal Reserve has tightened some 6% during the existing cycle.

As Lavorgna reminds us:

The Federal Reserve has not yanked the monetary reins so tightly since Paul Volcker in the early 1980s — when inflation ran to double digits.

“The amount of policy tightening is unprecedented,” Lavorgna concludes.

In summary…

We must conclude this tightening cycle has been longer and far more drastic than generally realized.

This degree of tightening has sunk the economy into previous recessions.

The following chart reveals that on each occasion tightening approached 5 percentage points… recession was close by.

Monetary Tightening Is Much Strong Than You Think

At what point will some hinge give way in the financial system, or some overburdened transmission belt snap?

We have no specific answer.

The Coming “Ice Age”

But Société Générale market strategist Albert Edwards believes current conditions indicate the “ice age” he has forecast since 1996 may soon be upon us.

Japan has been frozen in its own ice age since the late 1980s. And Edwards believes the next recession could plunge the United States into its own.

Assume it does.

How can the Federal Reserve melt the glaciers and unfreeze the rivers?

If we accept history as our guide, the Federal Reserve requires interest rates between 4% and 5% to tackle recession.

Only then does it wield enough “dry powder” to kindle a thawing fire.

Rates peaked at 5.25% in 2007, for example. The Federal Reserve therefore had cords of kindling on hand to throw against the following crisis.

Today’s 2.50% cannot give off the requisite sparks.

But what about renewed rounds of quantitative easing?

The Federal Reserve was able to vastly expand its balance sheet after the last crisis — from $800 billion to a preposterous $4.5 trillion.

But it lacks the monetary space to execute a similar coup. Even with QT, some $4 trillion hangs upon the balance sheet.

Additional QE might warm — but not enflame.

And then we come to the politics…

“QE for the People!”

QE has enriched Wall Street gloriously while Main Street has scratched by.

Additional QE may bring out the proles… with their torches and pitchforks.

Analyst Erik Townsend:

If they try to propose another round of QE that looks like the last several, I think the political left is going to say “no way.”

There’s going to be a huge revolt and people are going to say… if you’re going to create money out of thin air, it needs to be helicopter money. Give it to the people, not to Wall Street. 

“QE for the people!” will be the fiery slogan on their lips. And the politicians will hear them.

The politicians will carry their own slogan:

“I must lead the people, so I must follow the people.”

Out ahead of the people they will jump, carrying forth the flag of MMT, or helicopter money.

The rich already anticipate the pitchfork-wielding mob hoofing for Wall Street…

The Rich Join the Rabble 

To avoid mob justice, some are enlisting under its banners… and exchanging their Armanis for overalls.

Billionaire investor Bill Gross, for example, claims that MMT may prove one “necessary evil” to narrow the inequality gap. Higher taxes on him and his fellows is another.

Another billionaire Wall Street man — Ray Dalio — has just appeared on 60 Minutes to dilate about the need to reform capitalism.

He claims raising his taxes is one answer. (Has anyone prevented Messieurs Dalio and Gross from writing the Internal Revenue Service larger checks?)

Dalio also bats his eyelashes and blushes coyly in the direction of MMT:

“Policymakers pay too much attention to budgets relative to returns on investments.”

If only they did. Otherwise, the nation might not groan under $22 trillion of debt.

But more will be the medicine on tap…

More debt. More deficits. More fraud. More humbug.

That is, more of the same — only more so.


Brian Maher
Managing editor, The Daily Reckoning

The Daily Reckoning