Boston Fed president Eric Rosengren, “with a straight face” talks about how the FED can affect the economy with nominal interest rates at zero:
I’ve called this talk “How Should Monetary Policy Respond to a Slow Recovery?” My answer to that question is: vigorously, creatively, thoughtfully, and persistently, as long as we have options at our disposal. And we do have options, despite having pushed short-term rates to the zero lower bound.
We think the FED’s options have been whittled away like the Black Knight’s in the Monty Python Movie:
Robert Prechter writes (emphasis added):
Economists hint at the Fed’s occasional impotence in fostering credit expansion when they describe an ineffective monetary strategy, i.e., a drop in the Fed’s target rates that does not stimulate borrowing, as “pushing on a string.” At such times, low Fed-influenced rates cannot overcome creditors’ disinclination to lend and/or customers’ unwillingness or inability to borrow.
We would add some thoughts to this simple concept. Prechter has emphasized credit expansion, but there is more to it than that. First, there is a difference between customers who are unwilling to borrow and those unable to borrow. Those unwilling to borrow are also likely unwilling to spend. While those unable to borrow are likely to have few assets to sell to feed their desire to spend. So… suppose the government bought all bonds, public and private, for (newly created) cash. Those who would spend but who had no assets to sell would receive no new cash and would not spend more. Those who had assets to sell will have received new cash in return for their bonds, but they didn’t want to spend in the first place. Any one or more of those individuals could have converted their close-to-zero yielding bond assets to cash and spent at any time, but chose not to. Will one who is unwilling to borrow and spend suddenly become more inclined to spend and thus make prices rise, simply because the makeup of his portfolio was changed – against his will- from close-to-zero yielding bonds to absolutely zero yielding bonds? The answer is unclear, particularly, if he expects prices to fall. The FED might want to take a survey of these folks…
A picture is worth a thousand words. The Dallas Fed provides this chart depicting, better than words can articulate, the Failed Policies of Barack Obama:
Rosenberg argues the nominal yield curve would be inverted right now if it were not for the fact that short term rates are essentially at zero. The Treasury shows the Friday July, 9 nominal yield curve as:
|Date||1 mo||3 mo||6 mo||1 yr||2 yr||3 yr||5 yr||7 yr||10 yr||20 yr||30 yr|
If we assume that expected inflation for the short term is (say) -3, that is, that deflation is expected over the short term, but that inflation is expected to rear its ugly head over the long term (say) + 3, then we can use Fisher’s relation that nominal rates less expected inflation equals real rates, to see that the REAL yield curve could be inverted right now:
2 year Short term nominal (.63) – expected deflation (-3.00) = 3.63 real
30 year Long term nominal (4.04) – inflation (+3.00) = 1.04 real
If the real yield curve is inverted, it’s an ominous sign…
Market Ticker often posts this graph of total debt (public and private) in the US:
We can see from that graph that the trend is now changed to “down” after 50 years of “up”. The Federal government has been unsuccessfully attempting to offset the decline in private debt with increases in public debt. With the trend to more austere budgets, the growth rate in Federal debt will also begin to decline, accelerating the decline in total debt. What does this mean for interest rates? A shrinking supply of total debt means there is a shrinking supply of debt securities in which investors can invest. All other things held constant, this implies that debt prices will be bid up and interest rates down. In the case of US Treasury debt, we can expect a significant fraction of it to be monetized – bought by the Federal Reserve and paid for with Dollars that don’t cost the Treasury any interest. This monetization process will not increase the total amount of dollars available, but it will further reduce the supply of interest bearing debt instruments available for investors to buy – resulting in still more upward pressure on Treasury prices and downward pressure on rates. There appears substantial probability that long term Treasury Bond rates could be cut in half (from 4 to 2%) within 18 months. Only when the private economy begins to recover with real, non-government financed growth will we have significant risk of a rise in interest rates.
Look at the photo of a dollar below:
See where it says “Federal Reserve Note” and where it says “This note is legal tender…”? Dollars are notes or debts, that is, obligations of the Federal Reserve. When the Federal Reserve buys US Treasury Bonds from the open market and pays for them with dollars (a process some refer to as “monetization” or “printing money”), it and the marketplace has simply exchanged one form of debt for another. The supply in the hands of the market of one kind of debt (dollars) increased while another (Treasury Bonds) decreased. Long before the Federal Reserve got involved to exchange dollars for Treasury Bonds – when the Treasury bonds were first created and sold to the public – that’s when the notional value (that is, the proceeds) of those Treasury Bonds was attached to goods and services. Increases in government debt, as well as increases in private debt (net), are inflationary. But not the monetization of the debt by the Federal Reserve.
At present, we have a situation where private debt is being reduced faster than government debt is being increased so that, in aggregate, total debts are declining – this is deflationary.
Technically, the total supply of debt can increase in an amount equal to the amount which society saves each year without inflation. Conversely, total debt (including new equity shares) must increase by the amount of savings each year, or… we will have deflation.
You don’t have to be a bank to inflate or deflate.
Jimmy Songwriter sitting at the bar has a flash of inspiration and quickly writes down a new song. His somewhat inebriated friend, Joey Songsinger hears the song once and enthusiastically offers to buy it for a price equal to “whatever it takes – even if it’s the whole income of the United States”. Jimmy Songwriter, as a joke and to teach his friend a lesson, tells Joey he will sell the song for $13 Trillion and that he would finance it and Joey signs a note to Jimmy for $13 Trillion. This single transaction goes on record as the highest price ever paid for a song… drives up the average price of all songs by a factor of thousands…and doubles nominal GDP and the average price of all goods and services in the United States. The next year at Christmas, when the note comes due, Jimmy sends his friend Joey an email offering to “settle” the note for $500. Joey gladly agrees. After all they both knew that’s what the song was truly worth …and what Joey could pay. That year, nominal GDP falls from the previously inflated level by roughly 50% with a 50% deflation in the price level as there are no more songs sold (and financed) for such exorbitant prices.
1. We didn’t need banks or the Federal Reserve to create the price inflation or the price deflation which followed. All we needed was debt creation and then the subsequent de-leveraging and return to “normalcy”.
2. Neither Jimmy nor Joey had the legal power to “print” or coin “money” and they did not need it to affect the price level.
3. Most importantly, what Jimmy and Joey do can offset and overwhelm whatever the Federal Reserve and the banks do.
Dave Rosenberg in his “Breakfast with Dave” for Thursday, May 20th points to the Shiller PE ratio:
In the past 130 years, whenever the Graham/Dodd/Shiller normalized P/E ratio goes above 20.6x (it is 21x today), the market experiences a significant correction – a correction of 31% on average over the next 16 months. It never fails.
It never fails… hmmm, 31% down on the S&P from here would put the S&P down to about 770.
This chart makes the point that:
The primary function of government now seems to be transferring wealth from one group to another through programs like Social Security, Medicaid, Medicare, unemployment benefits, the new health care system, etc. It’s hard to consider this kind of spending stimulative…
As the federal government’s main reason for existence has evolved from protecting its citizens to that of a Robin Hood, the Top 10% of all earners, from whom all this wealth is “transferred”, are forced to pay an ever rising burden of the cost of “government”, including the ruling elite’s “commission”. IRS data on the share of taxes these earners pay allowed us to prepare the following chart. As the chart indicates, the top 10% earners will soon be tapped out. Once the pot-of-wealth from which our government transfers runs dry the primary function of this government ceases to exist.