Well, another FOMC come and gone, and the Fed remains on hold, paralyzed by the specter of deflation. No surprise there, the surprise was the dovish press conference. Since last Thursday there’s been much bemoaning the Fed’s loss of credibility, accentuated by (St Louis Fed’s) Bullard armchair quarterbacking early this week, saying he thought a hike would have been the appropriate policy. So the Fed appears to have a communication problem.
But here’s the real problem (and I am paraphrasing my friend Keith Weiner who is CEO of Monetary Metals). Zero and or negative rates destroy capital. Here it is again: ZERO RATES DESTROY CAPITAL. Here’s a link: http://snbchf.com/gold-standard/the-economy-is-in-liquidation-mode/ Initially, as rates fall, consumers and businesses are induced to borrow more; invest and spend. But if aggregate debt levels are already large, low rates do very little to spur economic activity. In fact, low rates destroy investment opportunity. Debt levels tend to increase and capital is misallocated, to the point that even relatively small increases in funding rates become an onerous weight as a percentage of cash flow. And this dynamic is particularly acute without the safety net of QE.
Back to last Thursday’s meeting. SOMEONE, (cough-cough, Kocherlakota) provided a negative interest rate on the Fed’s dot plot. So SOMEONE thinks a negative fed fund rate would help the economy. That’s plain wrong at this point. In the end, the credit markets are supposed to allocate capital based on certain metrics, including final demand. But low rates don’t necessarily force demand, they may create what Keynes called “unintended investment”. For example, the inventory to sales ratio becomes bloated (like now).
By the way, what the Fed is concerned about is not really deflation in the sense that one can buy a 54″ screen tv for what a 36″ screen used to cost. The pernicious deflation comes when final demand does not provide indebted companies with adequate cash flow to service debt. In this case, companies that are holding on by their fingernails either cut the prices of final products, or shed other assets to raise money. BAD deflation is a downward spiral of forced product and/or asset sales. The realization of this possibility leads to a Wile E Coyote moment like the stock market experienced right after the Fed announcement. The Acme rocket is tied to your back, the fuse is lit (in the form of an ‘all-clear’ no rate hike announcement from the Fed), the rocket goes off. And all of a sudden Wile E finds himself staring into the camera in suspended animation over the edge of the cliff with nothing but empty canyon underneath.
In the old days, we worked through these problems. Remember when Greenspan supposedly made a deal with Clinton? ‘I’ll keep rates low if you hold the budget under control.’ Remember that? And how Clinton complained that he was being held hostage by a bunch of bond traders (but ultimately adhered to the idea)? Well, the Greenspan / Clinton deal held, with a beneficial outcome. Now the economy is being held hostage by a variety of factors, some of which are non-domestic. As a percentage of global GDP, the US share has declined somewhat. The US must necessarily take the rest of the world into consideration when calibrating policy. Over the next couple of years, it means the Fed will be cautious in raising rates.
Alex Manzara
