By Lacy H. Hunt, Ph.D., Economist
The Fed's capabilities to engineer changes in economic growth and inflation are asymmetric. It has been historically documented that central bank tools are well suited to fight excess demand and rampant inflation; the Fed showed great resolve in containing the fast price increases in the aftermath of World Wars I and II and the Korean War. In the late 1970s and early 1980s, rampant inflation was again brought under control by a determined and persistent Federal Reserve.
However, when an economy is excessively over-indebted and disinflationary factors force central banks to cut overnight interest rates to as close to zero as possible, central bank policy is powerless to further move inflation or growth metrics. The periods between 1927 and 1939 in the U.S. (and elsewhere), and from 1989 to the present in Japan, are clear examples of the impotence of central bank policy actions during periods of over-indebtedness.
Four considerations suggest the Fed will continue to be unsuccessful in engineering increasing growth and higher inflation with their continuation of the current program of Large Scale Asset Purchases (LSAP):
- First, the Fed's forecasts have consistently been too optimistic, which indicates that their knowledge of how LSAP operates is flawed. LSAP obviously is not working in the way they had hoped, and they are unable to make needed course corrections.
- Second, debt levels in the U.S. are so excessive that monetary policy's traditional transmission mechanism is broken.
- Third, recent scholarly studies, all employing different rigorous analytical methods, indicate LSAP is ineffective.
- Fourth, the velocity of money has slumped, and that trend will continue—which deprives the Fed of the ability to have a measurable influence on aggregate economic activity and is an alternative way of confirming the validity of the aforementioned academic studies.
1. The Fed does not understand how LSAP operates
If the Fed were consistently getting the economy right, then we could conclude that their understanding of current economic conditions is sound. However, if they regularly err, then it is valid to argue that they are misunderstanding the way their actions affect the economy.
During the current expansion, the Fed's forecasts for real GDP and inflation have been consistently above the actual numbers. Late last year, the midpoint of the Fed's central tendency forecast projected an increase in real GDP of 2.7% for 2013—the way it looks now, this estimate could miss the mark by nearly 50%.
One possible reason why the Fed have consistently erred on the high side in their growth forecasts is that they assume higher stock prices will lead to higher spending via the so-called wealth effect. The Fed's ad hoc analysis on this subject has been wrong and is in conflict with econometric studies. The studies suggest that when wealth rises or falls, consumer spending does not generally respond, or if it does respond, it does so feebly. During the run-up of stock and home prices over the past three years, the year-over-year growth in consumer spending has actually slowed sharply from over 5% in early 2011 to just 2.9% in the four quarters ending Q2.
Reliance on the wealth effect played a major role in the Fed's poor economic forecasts. LSAP has not been able to spur growth and achieve the Fed's forecasts to date, and it certainly undermines the Fed's continued assurances that this time will truly be different.
2. US debt is so high that Fed policies cannot gain traction
Another impediment to LSAP's success is the Fed's failure to consider that excessive debt levels block the main channel of monetary influence on economic activity. Scholarly studies published in the past three years document that economic growth slows when public and private debt exceeds 260% to 275% of GDP. In the U.S., from 1870 until the late 1990s, real GDP grew by 3.7% per year. It was during 2000 that total debt breached the 260% level. Since 2000, growth has averaged a much slower 1.8% per year.
Once total debt moved into this counterproductive zone, other far-reaching and unintended consequences became evident. The standard of living, as measured by real median household income, began to stagnate and now stands at the lowest point since 1995. Additionally, since the start of the current economic expansion, real median household income has fallen 4.3%, which is totally unprecedented. Moreover, both the wealth and income divides in the U.S. have seriously worsened.
Over-indebtedness is the primary reason for slower growth, and unfortunately, so far the Fed's activities have had nothing but negative, unintended consequences.
3. Academic studies indicate the Fed's efforts are ineffectual
Another piece of evidence that points toward monetary ineffectiveness is the academic research indicating that LSAP is a losing proposition. The United States now has had five years to evaluate the efficacy of LSAP, during which time the Fed's balance sheet has increased a record fourfold.
It is undeniable that the Fed has conducted an all-out effort to restore normal economic conditions. However, while monetary policy works with a lag, the LSAP has been in place since 2008 with no measurable benefit. This lapse of time is now far greater than even the longest of the lags measured in the extensive body of scholarly work regarding monetary policy.
Three different studies by respected academicians have independently concluded that indeed these efforts have failed. These studies, employing various approaches, have demonstrated that LSAP cannot shift the Aggregate Demand (AD) Curve. The AD curve intersects the Aggregate Supply Curve to determine the aggregate price level and real GDP and thus nominal GDP. The AD curve is not responding to monetary actions, therefore the price level and real GDP, and thus nominal GDP, are stuck—making the actions of the Fed irrelevant.
The papers I am talking about were presented at the Jackson Hole Monetary Conference in August 2013. The first is by Robert E. Hall, one of the world's leading econometricians and a member of the prestigious NBER Cycle Dating Committee. He wrote, "The combination of low investment and low consumption resulted in an extraordinary decline in output demand, which called for a markedly negative real interest rate, one unattainable because the zero lower bound on the nominal interest rate coupled with low inflation put a lower bound on the real rate at only a slightly negative level."
Dr. Hall also wrote the following about the large increase in reserves to finance quantitative easing: "An expansion of reserves contracts the economy." In other words, not only have the Fed not improved matters, they have actually made economic conditions worse with their experiments. Additionally, Dr. Hall presented evidence that forward guidance and GDP targeting both have serious problems and that central bankers should focus on requiring more capital at banks and more rigorous stress testing.
The next paper is by Hyun Song Shin, another outstanding monetary theorist and econometrician and holder of an endowed chair at Princeton University. He looked at the weighted-average effective one-year rate for loans with moderate risk at all commercial banks, the effective Fed Funds rate, and the spread between the two in order to evaluate Dr. Hall's study. He also evaluated comparable figures in Europe. In both the U.S. and Europe these spreads increased, supporting Hall's analysis.
Dr. Shin also examined quantities such as total credit to U.S. non-financial businesses. He found that lending to non-corporate businesses, which rely on the banks, has been essentially stagnant. Dr. Shin states, "The trouble is that job creation is done most by new businesses, which tend to be small." Thus, he found "disturbing implications for the effectiveness of central bank asset purchases" and supported Hall's conclusions.
Dr. Shin argued that we should not forget how we got into this mess in the first place when he wrote, "Things were not right in the financial system before the crisis, leverage was too high, and the banking sector had become too large." For us, this insight is highly relevant since aggregate debt levels relative to GDP are greater now than in 2007. Dr. Shin, like Dr. Hall, expressed extreme doubts that forward guidance was effective in bringing down longer-term interest rates.
The last paper is by Arvind Krishnamurthy of Northwestern University and Annette Vissing-Jorgensen of the University of California, Berkeley. They uncovered evidence that the Fed's LSAP program had little "portfolio balance" impact on other interest rates and was not macro-stimulus. A limited benefit did result from mortgage-backed securities purchases due to the announcement effects, but even this small plus may be erased once the still unknown exit costs are included.
Drs. Krishnamurthy and Vissing-Jorgensen also criticized the Fed for not having a clear policy rule or strategy for asset purchases. They argued that the absence of concrete guidance as to the goal of asset purchases, which has been vaguely defined as aimed toward substantial improvement in the outlook for the labor market, neutralizes their impact and complicates an eventual exit. Further, they wrote, "Without such a framework, investors do not know the conditions under which (asset buys) will occur or be unwound." For Krishnamurthy and Vissing-Jorgensen, this "undercuts the efficacy of policy targeted at long-term asset values."
4. The velocity of money—outside the Fed's control
The last problem the Fed faces in their LSAP program is their inability to control the velocity of money. The AD curve is planned expenditures for nominal GDP. Nominal GDP is equal to the velocity of money (V) multiplied by the stock of money (M), thus GDP = M x V. This is Irving Fisher's equation of exchange, one of the important pillars of macroeconomics.
V peaked in 1997, as private and public debt were quickly approaching the nonproductive zone. Since then it has plunged. The level of velocity in the second quarter is at its lowest level in six decades. By allowing high debt levels to accumulate from the 1990s until 2007, the Fed laid the foundation for rendering monetary policy ineffectual. Thus, Fisher was correct when he argued in 1933 that declining velocity would be a symptom of extreme indebtedness just as much as weak aggregate demand.
Fisher was able to make this connection because he understood Eugen von Böhm-Bawerk's brilliant insight that debt is future consumption denied. Also, we have the benefit of Hyman Minsky's observation that debt must be able to generate an income stream to repay principal and interest, thereby explaining that there is such a thing as good (productive) debt as opposed to bad (non-productive) debt. Therefore, the decline in money velocity when there are very high levels of debt to GDP should not be surprising. Moreover, as debt increases, so does the risk that it will be unable to generate the income stream required to pay principal and interest.
Perhaps well intended, but ill advised
The Fed's relentless buying of massive amounts of securities has produced no positive economic developments, but has had significant negative, unintended consequences.
For example, banks have a limited amount of capital with which to take risks with their portfolio. With this capital, they have two broad options: First, they can confine their portfolio to their historical lower-risk role of commercial banking operations—the making of loans and standard investments. With interest rates at extremely low levels, however, the profit potential from such endeavors is minimal.
Second, they can allocate resources to their proprietary trading desks to engage in leveraged financial or commodity market speculation. By their very nature, these activities are potentially far more profitable but also much riskier. Therefore, when money is allocated to the riskier alternative in the face of limited bank capital, less money is available for traditional lending. This deprives the economy of the funds needed for economic growth, even though the banks may be able to temporarily improve their earnings by aggressive risk taking.
Perversely, confirming the point made by Dr. Hall, a rise in stock prices generated by excess reserves may sap, rather than supply, funds needed for economic growth.
Incriminating evidence: the money multiplier
It is difficult to determine for sure whether funds are being sapped, but one visible piece of evidence confirms that this is the case: the unprecedented downward trend in the money multiplier.
The money multiplier is the link between the monetary base (high-powered money) and the money supply (M2); it is calculated by dividing the base into M2. Today the monetary base is $3.5 trillion, and M2 stands at $10.8 trillion. The money multiplier is 3.1. In 2008, prior to the Fed's massive expansion of the monetary base, the money multiplier stood at 9.3, meaning that $1 of base supported $9.30 of M2.
If reserves created by LSAP were spreading throughout the economy in the traditional manner, the money multiplier should be more stable. However, if those reserves were essentially funding speculative activity, the money would remain with the large banks and the money multiplier would fall. This is the current condition.
The September 2013 level of 3.1 is the lowest in the entire 100-year history of the Federal Reserve. Until the last five years, the money multiplier never dropped below the old historical low of 4.5 reached in late 1940. Thus, LSAP may have produced the unintended consequence of actually reducing economic growth.
Stock market investors benefited, but this did not carry through to the broader economy. The net result is that LSAP worsened the gap between high- and low-income households. When policy makers try untested theories, risks are almost impossible to anticipate.
The near-term outlook
Economic growth should be very poor in the final months of 2013. Growth is unlikely to exceed 1%—that is even less than the already anemic 1.6% rate of growth in the past four quarters.
Marked improvement in 2014 is also questionable. Nominal interest rates have increased this year, and real yields have risen even more sharply because the inflation rate has dropped significantly. Due to the recognition and implementation lags, only half of the 2013 tax increase of $275 billion will have been registered by the end of the year, with the remaining impact to come in 2014 and 2015.
Additionally, parts of this year's tax increase could carry a negative multiplier of two to three. Currently, many of the taxes and other cost burdens of the Affordable Care Act are in the process of being shifted from corporations and profitable small businesses to households, thus serving as a de facto tax increase. In such conditions, the broadest measures of inflation, which are barely exceeding 1%, should weaken further. Since LSAP does not constitute macro-stimulus, its continuation is equally meaningless. Therefore, the decision of the Fed not to taper makes no difference for the outlook for economic growth.
Dr. Lacy Hunt, executive VP of Hoisington Investment Management Company, is an internationally known economist. Before his position at HIMCO, he served as senior economist for the Federal Reserve in Dallas, and as chief US economist for HSBC Group.
Dr. Hunt was one of the blue-ribbon speakers at the just-concluded Casey Research Summit in Tucson, AZ, and his presentation was voted to be "the scariest speech" of the Summit by many attendees. However, Dr. Hunt was only one of the many experts—among them James Rickards, Bud Conrad, and Chris Martenson—who warned of the dire consequences of the Fed's prolonged manipulation of the US economy. Listen to the entire Summit, including timely investment advice and specific stock picks, in the comfort of your home. More here…
13 thoughts on “Federal Reserve Policy Failures Are Mounting”
IS THIS what we were waiting for?"The economy is too fragile for the Federal Reserve to touch," Sung Won Sohn, an economist at California State University, said. "The shenanigans in Congress have hurt confidence and increased uncertainties, most likely hurting both consumer and business spending as well as hiring."
Job growth has fallen sharply in the past three months after a promising start this year. The economy has added an average of 143,000 jobs a month from July through September. That's down from the 182,000 average gain during from April through June and well below the 207,000-a-month pace from January through March. I thank you FirozaliA.Mulla DBA
Stock prices will start their plunge tomorrow if close today is negative. Prepare for over a 40 percent drop .
Very sound account on monetary politcs, and I guess Mr. Hunt made right remarks especially to the money multipler, which is one of the key parameters in the model the discusses. http://en.wikipedia.org/wiki/Money_multiplier
Props to Dr. Hunt for this detailed analysis. But it is really not all that complicated to see that QE just does not work. QE does not work because the Fed credits large amounts of cash to Big Banks who keep some and turn around and lend the rest to the big corporations. These big corporations buy back their stock and/or generate huge stock compensation packages. The money never gets to the poor and middle class, so the rich get richer and the poor get poorer. And this my friends is the recipe for the next Great Depression. Remember how much Alan Greenspan helped us when the housing market bubble he created collapsed, and then as a result the banks failed. It reminds me of the phrase, "I'm from the Government, and I'm here to help". Thanks, but no thanks to this Federal Reserve Board!
Nothing required like a a bunch of data, or any figures studies, if one can think upon basic principles of Mathematics, it can be very clearly point-out that not just or only fed, but central banks world wide are practicing and playing jugglery, only jugglery, nothing else, without any concerned with reality or real requirements. Interest rates, Debts, and data are their weapons and they themselves just don't know the ultimate impacts - results or end of this show.
I am fully, 101% pessimistic about the end of this story, every thing will destroy everywhere, entire financial system will collapse in a never before seen mode, people will not understand what to do? and how can survive? and we bound to start with "Zero"
Sorry, Rasesh Shukla, but if you think that there is such an terrific end, which you propose, than maybe you should look into the past, what happened, when a country is financially collapsing: There are still ways to overcome, and life will continue. Have you ever thought about that the money you hold in your hands, can change its valuation, and you don't know it?
Thanks for your feedback.
Accordingly, i would like to clarify some points like:
I am not specifying either U.S. or any other country for such financial failure, it may start from anywhere, but rapidly it will spread world wide, as all economies are interconnected.
Second thing, life will surely continue, because as a Law of nature, efforts for survival till the end, however, it will be very painful and also in a very harsh manner.
Last Point, possibilities are endless forever, so never think impossibility for any thing. Before 2007 how many people have predicted bankruptcy of TBTF (Too Big To Fall) corporations like Lehman or AIG however, we have found that, and in a same manner, we will find certain situations, about which, one cant think over possibility thereof, at this juncture, so not only a changing value of money in our hand, but even future tender-ability or existence it self as a currency can also be redoubtable, History provides us many many alike examples.
I remember the time in 2008, when rumors spread, that a big bank (one of the TBTF) is likely to fall in due course, and I remember, that I did not think in anyway, that it might be Lehman, which failed some days after. Maybe also because Lehman was not on my radar that times. But when I saw the results, and especially, that ratings for this bank were high-score even near to its end, then I began to distrust the whole rating industry.
I never never relay or consider ratings, rating agencies, either crocks or foolish or inefficient, i think, not a single case we can found, in which things taken place as per rating.
What a lot of you guys don't get, or don't want to get, is the fact that THE DEBT CONTROLS EVERYTHING. It is inanimate, it is very menacing, very dangerous, very ominous. And it controls the entire show of politics, economics, and our very future. It does not care what little time wasting political side shows we busy ourselves with. Too little too late has never been more accurate. From here on out until it's painfully clear the tables need to be cleared and reset from scratch, the debt controls the agenda. The puppets will go through the motions, in total denial. Hard to accept, but that's the reality.
ONE GREAT thing about India and China is the land the people and the resources like IT now . USA had these but the pride of USA has gone so low that we have no idea after the fiscal cliff that we had and we await to January 2015 , if many will have faith in USA dollar I doubt these as the Bloomberg commentary also say in the like manner . I mean who would trust the economy that let us fall not once but twice I thank you Firozali A.Mulla DBA
It is sad that we still in spite of having our finance not fixed try to enter the water os the foreign water. Is this democracy or madness I wander "Economists are even able to dismiss the vast weight of empirical evidence against the validity of their model, drawn from economic history, by the simple device of closing their eyes and chanting the ‘as if’ mantra, which goes as follows: it may appear that successful firms owe their success to the exercise of market power. It may appear that once a firm achieves dominance, it is very hard for competitors to break it down. It may appear that the long-standing success and dominance, and the ways in which such qualities are achieved, of companies such as Ford and Procter and Gamble contradict the assumptions of the theory. But, nevertheless, it is ‘as if competition in the sense of the competitive model, with its infinite number of firms, prevails.' I thank you FirozaliA.Mulla DBA
Mostly a good article except for the inflation quotes. Anyone who lives in the real world and pays for actual day to day expenses knows that the CPI figures are completely bogus. It doesn't take much research to discover the formulas were dramatically changed to calculate inflation, last time in 1999. The fact that health care premiums which eat up a large part of the regular person's budget only is assigned a less than 2% weighting in the CPI formula right then and there should tell you all you need to know that "1% inflation" is a complete lie.
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