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Federal Reserve – Economy and monetary policy word collage.
Those few articles that say the Federal Reserve wants to cause a stock market selloff are nonsense. Behind the Fed’s inflation-fighting stance is an even larger goal: To restore health to the U.S. economy and financial system. “Health” means fully-functioning capitalism, regulated primarily to ensure fairness. Doing so will return the growth catalyst that has been missing for over a decade.
The path to health
For too many years the Fed has usurped capitalism’s key role of capital pricing that produces a beneficial allocation of financial resources. Capitalism’s strength comes from better ensuring that highly desirable activities and projects receive the financial resources necessary – all at a price beneficial to capital providers: investors and savers.
Arguing that near-0% interest rates (highly abnormal by capitalism’s and history’s standards) were needed to rescue the financial system in 2008 was understandable. However, extending that strategy for the following decade was not. The rationale that “growth was okay, but not good enough” was an inadequate excuse to dramatically override the capital markets’ key role. It also created “hidden” pain for the $trillions of assets dependent on a fair income. Worse, the Fed caused those important providers of capital to suffer an inflationary (purchasing power) loss every year.
So, why do it? To foster growth – right?
There is no proof of good growth, much less better growth. In fact, Fed chair Ben Bernanke’s argument that growth wasn’t good enough was an admission that the Fed’s actions were ineffective. The conclusion that those actions should, therefore, be extended and expanded was based on wishful thinking.
Moreover, there was frustration with how the Fed’s largess was being used. Without capitalism’s pricing mechanism (market-determined interest rates), there was no check on borrowers’ cash desires. The access to overly cheap money allowed funding for poor- or non-economic purposes. Examples are “dividend” payments, share repurchases, over-leveraged financial structures and (worst of all) poor capital investments.
As time passed and growth remained “too low,” Bernanke’s Federal Open Market Committee (12-economists) doubled down on their belief that they, alone, could improve capitalism’s processes by creating more money (labeled, “quantitative easing”). That clever title nevertheless meant the Fed was adopting the historically flawed and disproved belief that printing money can create real economic growth without hyping inflation.
With growth still mundane, the other shoe fell – the Fed pushed congress to spend more (AKA, “fiscal” growth support). With rates held low and the Fed willing to purchase bonds, the U.S. government was free to borrow-and-spend at low cost. This long-disproven approach of using deficit government spending to produce growth without inflation was based on economist John Maynard Keynes’ theoretical work. It was pushed during the 1960s and 1970s even as inflation kept rising. Nevertheless, the last decade saw the government decrease taxes and increase spending, pushing deficits and debt into the $trillions with little regard for future financial consequences.
The Federal Reserve’s first attempt to return interest rate setting to the capital markets was a self-inflicted failure
Interest rate raising from near-0% began hesitantly in 2016 under Fed Chair Janet Yellen. It was then more steadily expanded under Fed Chair Jerome Powell through 2018. At that point the key 3-month US Treasury Bill rate had reached 2.5% and the 1-year inflation (CPI less food & energy) rate was 2%, finally generating a positive real return of 0.5%. That was a huge accomplishment.
The Bernanke, Yellen, Powell years of interest rate setting
John Tobey (FRB of St Louis – FRED)
Alas, it was not to be. Wall Street, representing the 0% borrower interests, created a false fear. It was that the 10-year US Treasury bond rate fell below the 1-year rate. Yelling it was an “inverted yield curve,” Wall Street claimed that the crossover was a sure precursor of a recession. That claim was nonsense for four reasons.
- First, there were no excesses that required a recession to correct
- Second, inversions can and do occur for other reasons without a following recession
- Third, the shifts caused by the Fed’s rate-raising actions produced an unusual period
- Fourth, the inversion came as demand drove the 10-year yield down, not as tight money drove the 1-year yield up
However, the Fed being the Fed, the economist theorists caved to the Wall Street practitioners. So, after first “pausing,” Powell starting reversing, giving up what he had accomplished. (The 10-year and 1-year yield declines during the pause period resulted from investors rushing to lock in the yields before the anticipated Fed cuts occurred.)
The previous failed attempt to return interest rate setting to the market
John Tobey (FRB of St Louis – FRED)
What a shame, with investors and savers once again getting the short end of the stick.
Then came the Covid-19 shutdown
The Covid-19 shutdown naturally caused the Federal Reserve and congress to jump into action. With the past decade’s actions to fall back on, the Fed’s steps were quick and easy: 0% interest rates and an enormous increase in money supply. On the fiscal side, congress, facing an immediate problem (little time to debate), doled out payments to everyone. Following, there were establishment subsidies and loan programs.
The actions seemingly worked as the reopening and rebound began. While government payments began to fade away, the Fed maintained its shutdown stance – neither reversing the interest rate cut nor pulling back on the excess money created. As a result, with the economy beginning to grow again, the stage was set for excess spending and its natural result, rising prices – inflation.
Finally, after first arguing that the price increases were “temporary,” then “transitory,” the Fed threw in the towel. Now it has assumed the role of “inflation fighter.”
Okay, but look at the tactics: Raising interest rates up to a more normal level and ever-so-slowly reducing their bond holdings (thereby decreasing the excess money supply). In other words, without admitting their previous mistaken actions, the Fed is attempting to be the white-hat protector of economic and financial system health. Whatever… At least things are moving in the right direction.
Wall Street fails to have its way again
A few weeks ago, the Wall Street push was on again to use the almost-inverted 10-year US Treasury bond yield vs the 1-year yield. Overly tight money! Recession! However, this time Powell resisted the shouts and persisted, publicly saying inflation must be controlled, even if it means pain.
Importantly, that word, “pain,” has become the rallying cry of the bears and the media. The mindset is now so negative that any news is delivered as one more problem. (A good example – The rising oil prices had been a reason for a coming recession. Now, it’s the falling oil prices.)
Who wins and who loses?
Think about this. Whose ox is being gored this time around, with rates rising? The easy answer is all those who committed themselves to borrowing at low interest rates in the future. For example, highly leveraged companies or funds that will need to borrow in the future either to pay off current debt that will be maturing or to maintain leveraged growth.
Also hit are the deficit spenders that need funding – either through borrowing (this includes the U.S. Treasury) or through a financing channel. That latter will be affected by higher rates also.
Home buyers have been singled out, but incorrectly. While higher mortgage interest rates affect affordability, the new 6% level is not a historical deal breaker. Instead, it is a reasonable level at which high quality, well-funded financial institutions are ready to lend. Already the housing market dynamics are favorably adjusting, with prices coming off their peaks, buyers less willing to engage in a bidding war, and the inventory of houses for sale rebuilding. Apparently gone, too, are those cash buyers who poured into the market in the fourth quarter of 2021, seeking properties to rent out. In other words, normality is returning to the housing market, and that sets a better stage for future growth than the overwrought period that is now behind us.
On the plus side are savers and short-term investors. They’re ecstatic. So, too, are non-speculative funds (e.g., retirement, life/annuity insurance, nonprofit, state/local government, and company reserves). And remember that the increased income flow will improve financial health as well as allow increasing benefits and/or lowering costs.
The bottom line: The benefits of the Federal Reserve’s actions are already visible
The economy’s and financial system’s regained health and normality will produce unexpected, highly desirable benefits. Currently, we are seeing a massive return of income to the holders of the $22 T in U.S. money supply (as measured by M2). Using the 3-month US Treasury Bill’s current yield of 3.2%, the potential, annual interest income flow is about $700 B, up from next to nothing. (By the way, to appreciate that $22 T money supply size – it is equivalent to the annual GDP.)
So… It’s time to be optimistic.