The Fed Isn’t a Magic Money Tree
There seems to be no end to the Federal Reserve’s arrogance. Fed officials believe that through their wise actions, they can eliminate the business cycle, lower unemployment and make society prosperous.
But it’s actually much more limited in what it can do.
All the Fed can reliably do is stop bank runs and limit liquidity panics. It can also fund (or “monetize”) the U.S. federal deficit, as it has done in recent months.
By buying essentially the same amount of U.S. Treasury securities the government has issued, the Fed has taken pressure to fund mammoth federal deficits off of the private sector.
But such actions are not cost-free.
They store up trouble for the future. These actions swell the Fed’s balance sheet, which will limit the Fed’s flexibility and its willingness to tighten policy during the next inflation spike.
The more the Fed intervenes, the harder it is for it to reverse course without causing damage.
By promising the public that it can do anything more than offer dollar liquidity, the Fed is setting up both investors and workers for disappointment.
Yet it’s going to try anyway. And it’ll only undermine its limited reputational capital in the process.
“Yield Curve Control”
The Wall Street Journal recently reported that the Fed is considering implementing “yield curve control” in the Treasury market. This policy hasn’t been used since WWII and the early postwar period.
It essentially funded the war effort. If unleashed today, it wouldn’t be done to support a civilization-saving war effort but to maintain the debt-saturated economy to which we’ve become accustomed.
Here’s how it would work in practice:
The Fed would set a target range, or cap, on yields for Treasury bonds of a specific maturity — say, 3-, 5- or 7-year Treasuries.
It would defend this target by buying unlimited amounts of Treasuries at that yield — however many it took to bring the yield down to its target rate (remember, bond prices and yields move in opposite directions. Buying bonds lowers their yield).
If adopted, the Fed would switch its QE policy from a fixed dollar amount (currently $120 billion per month) to an unknown amount that will depend on supply and demand in the Treasury market.
Yield curve control has been underway in Japan for the past few years. It has proven to not be effective at stimulating the economy, so there’s little reason to expect it would work here.
Here Comes Helicopter Money
We’ve had our fill of quantitative easing over the years, but it’s mostly inflated assets while doing little for overall economic growth.
The quantitative tightening, or QT, process that occurred from early 2018–mid-2019 slowly reversed that process until the Fed ran into a wall of resistance from the markets. Since then, we’ve obviously had another epic wave of QE.
But here’s what’s different about the current round of QE from the QE programs of the past decade:
A much greater proportion of the money the Fed has created to buy bonds will be injected into the real economy through the federal budget. It won’t just be sequestered on Wall Street, where it pumps up asset prices.
As the brand-new U.S. money supply that is currently sitting in the U.S. Treasury’s General Account at the Fed is injected into citizens’ checking accounts through stimulus checks, unemployment insurance, tax refunds, Social Security checks and more, consumers will have plenty of purchasing power.
The Treasury General Account balance is currently $1.5 trillion, which is easily 10 times higher than the historical average. This will be sent out to recipients of federal dollars in the months ahead.
Will the recipients spend it all at once?
No, they won’t. They’ll likely hold precautionary savings in a weak economy. But make no mistake: The cash is there, it will get into consumers’ hands and it will eventually be spent — even if the economy remains sluggish.
It’s like water that’s built up in front of a dam. All it takes is to open the sluices (in this case have the Treasury spend down its cash balance) to inject an unprecedented amount of cash into the economy.
The U.S. job market (and wages) won’t necessarily have to fully recover for a chronic inflation problem to set in, because the tool for the Fed to inject newly printed cash into the economy (through the federal budget) is well established.
That’s a recipe for stagflation.
Turning Money Into a Hot Potato
It involves a chronically high federal deficit, a Fed balance sheet that is expanding with the deficit and private-sector productivity growth that lags the growth in newly printed money.
Historical evidence shows that when government debt and deficits are high, central bank balance sheets are growing rapidly and private-sector productivity growth lags the growth in newly printed money, inflation will be the result.
When the public starts to recognize that supply of a fiat currency is too plentiful today and expects money supply to grow much faster than production of goods and services, then the public will start treating that currency as a hot potato.
This is the psychological part of inflation that’s so difficult for mainstream economists to grasp. It’s nonlinear and unpredictable. This is why Jim Rickards calls inflation a “psychological phenomenon.”
And that brings me to Modern Monetary Theory, or MMT.
MMT Doesn’t Understand Money
Consider this question: Do you hold cash as a store of value solely for the purpose of paying taxes?
Of course not. Thus, legal tender laws do not give fiat money intrinsic value. Fiat money only has value to the extent that its holders believe it can be exchanged for goods and services both now and in the future.
But Modern Monetary Theory (MMT) is ultimately based on the notion that fiat money derives its value from the fact that citizens need it to pay their taxes.
But MMT advocates might be surprised if they survey the public and discover that the public does not, in fact, save money for the sole purpose of paying federal taxes.
The exchange of fiat money for goods in the future is critical. In Chapter 5 of his book Aftermath, titled “Free Money,” Jim identifies the essential problem with MMT:
“The problem with… MMT is not that the theory is wrong as far as it goes; the problem is that it does not go far enough. MMT fails not because of what it says but because of what it ignores. The issue is not whether there is a legal limit on money creation but whether there is a psychological limit.”
Promoters of MMT consider taxation the solution to inflation. If inflation becomes a problem, their solution is to raise taxes, which would drain money out of the economy. But they don’t understand the psychology of inflation.
They focus on the accounting mechanics of dollar creation and downplay how their policy proposals might affect the use of dollars in the real world. I’ve seen no successful real-world case study showing that MMT works.
It’s an abstract theory that is not supported by historical evidence. That’s why detractors often make fun of MMT by calling it “Magic Money Tree.”
The Fed is not a Magic Money Tree today… and it wouldn’t become one even if MMT were officially adopted in the future.
Owning gold and gold-related assets is the best protection against the damage that the Fed and the federal government are doing today and what they’ll do in the future.
The damage isn’t yet obvious, but it will be more noticeable in time.
for The Daily Reckoning