Why the Fed Depends on Easy Money

Yesterday we reported on the effect the Fed Chairman’s dovish comments had on markets.  The change from a “long way” from neutral to “slightly below” was interpreted as the cheap money game will continue so let’s all jump back into debt funded shares.  Minutes of the last Fed meeting released afterwards revealed that “A couple of participants noted that the federal funds rate might currently be near its neutral level".  “A couple” is far less convincing and the market corrected a little last night.  Such is the fixation on the Fed.

Followers of Austrian Economics know the Mises Institute well.  Named after the famous Austrian Economist Ludwig von Mises, the institute promotes Libertarianism and a free-market capitalist economy.  It’s not everyone’s cup of tea and it doesn’t need to be to appreciate some of the arguments in respect to central banks and their role in our modern economy.  Regular readers know of the role central banks have played since the GFC in creating this current “Everything Bubble”.  Below is an article penned after that Fed news yesterday that is worth reading to understand the bigger picture.  The article assumes you know that the Fed, still independent of Government direction, was actually formed by the big banks themselves in 1913.  Many people don’t know this and that the Fed is essentially of and for the banks.

“The Fed Has Become Increasingly Dependent on Easy-Money Policy

“I think we have much more of a Fed problem than we have a problem with anyone else”, said US President Donald J. Trump on 20 November 2018. While the press, mainstream economists, and bankers cry wolf, the US President hits the nail on its head: The Fed is the source of significant economic and political trouble. By issuing US dollar out of thin air, it sets into motion unsustainable booms, which sooner or later turn into bust.

What is more, the Fed, expanding the US dollar quantity through credit expansion, nurtures the “deep state”: Providing it with the financial means to buy voter consent; to increase its impact on all walks of peoples’ lives; to make possible its aggressive military adventures on a world-wide scale; and to keep alive and kicking its monetary system – that couldn’t survive without an ever deeper state.

Viewed from this perspective, is it not good news that the Fed wants to tighten its policy further? Well, the truth is that Fed interest rate changes do not and cannot solve any problems caused by the Fed’s meddling with interest rates in the first place. By its very nature, monetary policy inevitably creates economic distortions – which appear in the build-up and bursting of speculative frenzies and the notorious boom and bust cycles.

By reviewing how the Fed has been setting interest rates in the past, you might get the impression that things have become ever more problematic. Just consider Figure 1, which shows annual US nominal GDP growth and the Federal Funds Rate in per cent. Eyeballing these two series suggests that the Fed has set its interest rates more or less in line with nominal GDP growth.

Mises - FED interest rate

The "Interest Rate Gap"

Mainstream economists would not find any fault with such an interest rate setting. They would argue that the central bank should, in principle, increase its interest rate if and when economic growth accelerates, and it should lower borrowing costs once GDP expansion loses steam. (A formalized version of this viewpoint has been made popular by the concept of “Taylor interest rate rules.”)

The really interesting finding, however, comes out in Figure 2: It shows the difference between annual nominal GDP growth and the Fed’s main interest rate in percentage points. Moreover, as we can see, this time series has been drifting upwards: from cycle to cycle, the Fed has allowed the gap between nominal GDP growth and its main refinancing rate to widen. In other words: It appears that the Fed’s policy has become increasingly expansionary.

In this context, we have to remind ourselves what artificial lowering of the market interest rate — and this is what the gap between nominal GDP growth and the Fed’s main refinancing rate represents — does to the economy. For instance, it inflates asset prices. In the case of stocks, expected future profits are discounted with a lower interest rate, thereby increasing their present value and thus stock prices.

Pretty much the same happens with real estate prices. As asset prices go up on the markets, their value as collateral in credit transactions also rises. Borrowing on the part of asset holders becomes economically more attractive. Lenders, encouraged by collateral gaining in value, ease their lending standards. As a result, rising asset prices set into motion a borrowing and lending spree.

Furthermore, artificially suppressed market interest rates encourage consumption at the expense of savings. The economy is then living beyond its means. Initially, output and employment increase. Sooner or later, however, it becomes evident that the “boom” is unsustainable, and that it (other things being equal) inevitably has to turn into “bust”.

To fend off the bust, the central bank prevents the artificially lowered interest rate from rising. In fact, to keep the boom going, the central bank has to push the market interest rate to ever lower levels. This is actually what the Fed has been doing for decades: It has set into motion a boom through pushing down market interest rates, and in times of crises, it has lowered borrowing costs even further.

Once the economy recovered, the Fed has raised interest rates, but only very hesitantly. This may explain why the gap between nominal GDP growth and the Fed’s key interest rate has grown so substantially over time. With the Federal Funds Rate currently standing in a band of between 2.00 and 2.25 per cent, Figure 1 b would suggest that the Fed’s rate hiking spree might be pretty close to an end.

What Should — and Can — Be Done

But as noted earlier, this would by no means bring the problems caused by Fed monetary policy to an end. But what should and could be done? Let us conclude this article with what Murray N. Rothbard has to say about the Fed, the problems it creates, and how an economically sound solution would look like:

The American economy has suffered from chronic inflation, and from destructive booms and busts, because that inflation has been invariably generated by the Fed itself. That role, in fact, is the very purpose of its existence: to cartelize the private commercial banks, and to help them inflate money and credit together, pumping in reserves to the banks, and bailing them out if they get into trouble. When the Fed was imposed upon the public by the cartel of big banks and their hired economists, they told us that the Fed was needed to provide needed stability to the economic system. After the Fed was founded, during the 1920s, the Establishment economists and bankers proclaimed that the American economy was now in a marvelous New Era, an era in which the Fed, employing its modern scientific tools, would stabilize the monetary system and eliminate any future business cycles. The result: it is undeniable that, ever since the Fed was visited upon us in 1914, our inflations have been more intense, and our depressions far deeper, than ever before.

There is only one way to eliminate chronic inflation, as well as the booms and busts brought by that system of inflationary credit: and that is to eliminate the counterfeiting that constitutes and creates that inflation. And the only way to do that is to abolish legalized counterfeiting: that is, to abolish the Federal Reserve System, and return to the gold standard, to a monetary system where a market-produced metal, such as gold, serves as the standard money, and not paper tickets printed by the Federal Reserve.””

The market rallied yesterday because it was surprised by the dovish or ‘easier’ perceived policy shift.  It was surprised as common thought is rates should indeed be hiked considerable more.  The above puts into perspective maybe why that won’t happen.  That inevitably means more inflation and creating a bigger bubble to burst.  Both are wonderful for gold.