The Fed’s Nightmare Scenario
December 29 marks the twenty-ninth anniversary of the high-water mark in Japanese stocks. On that date in 1989 the Nikkei 225 Index closed at its all-time high of 38,915, but within months fell into “bear market” territory. It has never recovered. It’s astonishing to realize that the Nikkei today is 48% below its historic high.
The main reason for this is because Japan has been fighting the effects of deflation since the early 1990s. To try to reflate the economy, Japan brought short-term interest rates down to zero in 1994, the first major economic power to do so. Since then, its short-term interest rates have been near zero, and sometimes negative. The Bank of Japan has never been able to “normalize” interest rates back to their pre-1989 level.
One lesson to be gleaned from all this is that a bear market is not merely the name given to a sharp, but transitory, decline in stock prices caused by periodic fluctuations in the business cycle. It can also be a persistent background condition of generational duration, caused by human error in monetary policy making.
Another lesson is that the use of short-term interest rates as a tool of monetary policy can lose its effectiveness. The tool becomes useless in bringing about desired outcomes in the real economy.
The third lesson is that the first two lessons are connected. This is the nightmare scenario facing the US Federal Reserve Bank as it, too, tries to “normalize” interest rates, getting them up to a level prior to the Global Financial Crisis (GFC) of 2007-08.
Since 2015, the Fed has been gradually raising short-term rates. It has come in for sharp criticism amid signs of weakness in the US economy and the slide in stock prices on Wall Street. The criticism is not just about the interest rate hikes. It is also about the Fed’s move to “normalize” its balance sheet. This latter is typically called “quantitative tightening” (QT), which is the opposite of the “quantitative easing” of 2008-14 when the Fed bought some $4.3 trillion worth of securities, mostly intermediate term Treasury bonds, as a way to inject liquidity into the economy during the GFC and its aftermath.
Today the Fed is letting these bonds run to maturity. On the maturity date, it receives the face value of the bonds in cash from the US Treasury and removes them from its balance sheet. It then extinguishes the money. This means money is going out of existence, at the rate of about $50 billion a month.
Thus, the recent cycle of interest rate hikes is taking place within the context of the Fed draining liquidity from the market. Some analysts say that by the end of 2019, QT will have the effect of adding two percentage points to short-term interest rates, thus increasing the risk of a recession.
At a press conference on December 19, Fed Chairman Jerome Powell summed up the Fed’s policy stance, thus:
“We came to the decision that we would have the balance sheet run-off on automatic pilot and use rate policy as the active tool of monetary policy. I don’t see us changing that.”
One need not go any further than this statement to get a handle on the current situation. A close reading of it reveals four variables are in play. Powell pointed to something called interest rates and something else called the balance sheet. He pointed to something called a monetary tool and to something else not considered a tool. He linked interest rates and a monetary tool, but considered the balance sheet as something else.
This approach brings the nightmare scenario into view. In the face of deceleration in the US economy, the path is open for the Fed to reverse course on its recent rate hikes. But what if the economy does not respond as intended? What if, as in Japan’s experience, the interest rate tool becomes ineffective when it is close to zero? As one joke has it, when your interest rates are zero, the central bank has only two options: either it raises rates, which contracts the economy, or it raises rates, which contracts the economy. Something like this bad joke is going on today in the US.
It is important to ask the right questions in the current debate over monetary policy. Currently, the debate keys on answers having to do with more or less: how high or low should interest rates be set? The more penetrating question would yield an either-or answer: should the primary monetary tool be interest rates? Or should that be scrapped?
A new monetary policy paradigm is needed. A new outlook would flip the emphasis in Chairman Powell’s statement above so that the Fed’s balance sheet becomes the “active tool” of monetary policy, while interest rates are relegated to a secondary concern — or discarded entirely in favor of letting the market decide the level of short-term rates.
This new paradigm would be a rule-based approach to monetary policy. One way to do this would be to use the price of gold as the rule for determining the quantity of dollars demanded by the economy. Accordingly, if the daily price of gold settles above its long-term moving average, that would be considered an “inflationary” signal. The Fed should drain liquidity from the system; it would sell bonds. If the daily price of the gold settles below its long-term moving average, that would be a “deflationary” signal. The Fed should inject liquidity into the system; it would buy bonds. The Fed would take no action if the price of gold roughly approximates its long-term moving average. Regardless of the signals, using short-term interest rates as an “active policy tool” would be discarded.
The 2016 Republican Party Platform renewed the party’s call for the creation of commission “to consider the feasibility of a metallic basis for U.S. currency.” In the past, there have been fitful moves in Washington in this direction. What is needed today is a debate that would examine alternative means for monetary policy-making. It would certainly be an improvement over the current rancor and bitterness as to how the Fed is doing its job on setting interest rates.