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Currently economists and market watchers roughly fall
into two camps: Those who believe that the Federal Reserve must begin raising
interest rates now so that it will have enough rate cutting firepower to
fight the next recession, and those who believe that raising rates now will
simply precipitate an immediate recession and force the Fed into battle
without the tools it has traditionally used to stimulate growth. Both camps
are delusional, but for different reasons.
Most mainstream analysts believe that the
current economy can survive with more normalized rates and that the Fed’s
timidity is unwarranted. These people just haven’t been paying attention. The
“recovery” of the past eight years hasn’t been just “helped along” by deeply
negative real interest rates, it is a singular creation of those policies.
Since June 2009, when the current recovery began, traditional economic
metrics, such as GDP growth, productivity, business investment, labor force
participation, and wage growth, have all been significantly below trend. The
only strong positives have been gains in the stock, bond and real estate
markets. We have had an “asset price” recovery rather than a bona fide
economic recovery. This presents unique risks.
Asset price gains have been made possible
in recent years because ultra-low rates have driven down the cost of
borrowing, encouraged speculation, and pushed people into riskier assets.
Donald Trump was right in the presidential debate when he noted that the
whole economy is “a big fat ugly bubble.” Any rate hike could hit those
markets hard across the financial spectrum and can tip the economy into
contraction. Look what happened this January when the market had a chance to
digest the first rate increase in 10 years. The 25 basis point increase in
December 2015 led to one of the worst January's in the history of the stock
market. Since then, the Fed has held off from further tightening and the
markets have treaded water. There is every reason to believe that the
sell-off could resume if the Fed presses ahead.
Our current “expansion,“ which began in
June of 2009 is 88 months old, and is already the fourth longest since the
end of the Second World War (post-war expansions have averaged 61
months) (based on data from National Bureau of Economic Research and
Bureau of Labor Statistics). But although it is one of the longest it has
also been the weakest. Despite fresh optimism nearly every year, we have not
had a single year of 3 percent GDP growth since 2007. More ominously, the
already weak expansion is beginning to slow rapidly. GDP growth has been
decelerating, averaging just 1% in the past three quarters. (Bureau of
Economic Analysis) And while hopes were high for a significant rebound
in Q3, as has been the pattern all year, rosy estimates have recently been
sharply reduced.
Typically rate-tightening cycles start in
the early stages of a recovery when the economy is still gathering momentum.
As I have argued before, a rate tightening campaign that begins in the
decelerating tail end of an old and feeble recovery is bound to unleash
problems.
So I agree with those who believe that
rate hikes now will bring on recession, but I disagree that we should keep
rates where they are. They believe we need to keep the stimulus pedal to
the metal…and when that’s not enough, to cut a hole in the metal and push
harder. I believe that despite the short term pain that will surely follow,
we need to raise rates now to break the addiction before it gets worse.
The “keep rates at zero camp” argues that
global economic developments have made traditional GDP growth nearly
impossible to achieve. These believers in “the new normal” fear that the Fed
is mistakenly waiting for growth that will never come. Larry Summers,
the leader of this group, recently argued in the Washington Post that the
Fed will never be able to raise rates enough in the short term (without
plunging the economy into recession) to gather enough ammunition to effectively
fight the next recession. In his view, to raise rates now would be to risk
everything and get nothing.
Summers knows that central bankers now do
not have the caliber of bazookas that their predecessors once carried
(Bernanke was able to slash interest rates over 400 basis points in a few
months). So he advocates continued stimulus until newer means can be
developed to head off the next recession before it develops. (He promises to
reveal those new ideas soon…really).
Given all the economic realities that central
banking has attempted to suspend in recent years (such as the antiquated
belief that lenders should be paid to lend rather than being charged for the
privilege), it’s no great stretch for them to consider the next big leap and
call for an age of permanent expansion.
To do this they must short-circuit the
business cycle, which up until now has regulated prior monetary
mismanagement. Rather than being some naturally occurring process, the
business cycle actually results from artificially low interest rates.
Mistakes are made during the booms, when rates are held artificially low, and
are then corrected during the bust, once those rates are allowed to
normalize. Ironically, the busts are actually the benign part of the
process, and should not be resisted, but embraced. But to mitigate the
short-term pain associated with actually correcting those mistakes, central
banks typically opt to paper them over for as long as possible. The problem
is that this time the papering over process has gone on for so long, and
involved a record amount of paper, that correcting the mistakes now will
necessitate a recession so severe that it is unthinkable. The only
apparent “solution” is to make sure one never arrives.
To do so Fed must replace the “ups and
downs” of the economy with the “ups and ups.” This futile process will
likely involve the Fed intervening directly in the equity markets (by
actually buying shares), or in the real estate market (by buying properties
or making loans) or into the consumer economy by directly distributing money
to citizens. But since contractions are necessary and healthy,
especially when markets have gotten ahead of themselves, attempting to
short-circuit them does more harm than good. Yet despite how crazy such a
policy sounds, Yellen just suggested that she thinks it’s not only a good
idea, but that the Fed is already giving it serious study. Given the damage
our crazy monetary policy has already inflicted in the past, one can only
imagine what kind of devastation awaits.
Just this week the International Monetary
Fund issued a report about the dangers of global debt growth, which has
reached $152 Trillion, or roughly twice the size of global GDP. They
noted that the growth of private debt has recently led the upswing. With
negative rates actually paying some companies to borrow, should this be a
surprise? And while it’s nice that the IMF raised a red flag, it’s
pathetic that their only proposed solution is to call for governments to
increase public debt through fiscal stimulus (based on what should now be the
debunked theory that deficit spending creates growth).
Even more pathetic is Alan Greenspan
attempt on CNBC this week to blame the current low growth economy on
Congress, and its failure to reign in entitlements. Greenspan is correct
in his determination that "the new normal" results from the plunge
in productivity gains that is a function of drops in savings and capital
investment. But he can’t absolve the Fed. Had they not monetized the ever
growing Federal deficits, or kept interest rates artificially low for so
long, market forces would have forced cuts in entitlement spending years ago.
These actions, originated with Greenspan himself, enabled Congress to
repeatedly kick the can down the road.
According to Greenspan, to spare the
public the pain of higher interest rates the Fed has no choice but to hold
its nose and accommodate any level of debt Congress chooses to
accumulate. But the ability to pursue unpopular policy is precisely they
are
supposed to be politically independent. What
good is an independent central bank that simply helps incumbents win
reelection?
Given that the Fed has already
unsuccessfully exhausted so much firepower, it is unfortunate that it never
seriously questions whether their policies are actually harmful. Modern
economists simply can’t imagine that throwing ever more debt on the back of a
weak economy actually prevents it from recovering.
I think it’s high time the Fed finally
moves rates well into positive territory. The next recession has been on its
way for years, and it will arrive no matter what the Fed does, if it’s not
already here. Sometimes reality hurts, but fantasy can be more damaging in
the long run.
The real choice is not between recession
now or recession later. It’s between a massive recession now, or an even more
devastating one later. Either way, there is no Fed policy that will be able
to fight it. But that is not because the Fed is out of bullets, but because
it never had any real bullets to fire in the first place. All it had was
morphine to numb the pain as the wound festered. Now is the time to bite the
bullet, endure the pain, and allow the wound to actually heal. This will also
allow us to finally bury the idea of a new normal, enjoy a real
recovery with all of its traditional benefits, and actually make America
great again.
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