The government and the Fed succeeded in inflating financial asset prices but what about everyone else? Does raising interest rates now make sense? Part 3 of 3.
WASHINGTON, Dec. 19, 2015 – In Part I of this three-part series, we outlined the history of how the U.S. Federal Reserve Bank came to deal with inflationary and deflationary environments, post-1937. In Part II, we provided a brief history of the Great Recession’s onset, how the Fed and the federal government dealt with it (or not) and discussed the current trap the nation’s central bank and government—not to mention the U.S. taxpayer—all need to escape.
In this, our final installment, we’ll illustrate how the Fed’s current approach may be built upon that mythical element some of us call “hopium.” There is little if any precedent for the strategy the Fed carefully articulated Wednesday, and it’s by no means certain that this new strategy will work since it goes against a monetary policy that remained after the Fed last screwed things up in 1937.
Here we are in 2015, and the Fed finds that the U.S. economy is in uncharted territory, just as it was in 2007-2009. They know we remain below that 2 percent target inflation rate (if you forget about beef and groceries), at least the way the federal government currently figures it. They know, though they don’t acknowledge it in so many words, that commodities are actually deflating in price rather than inflating. So that means they should be “injecting” money into the system by lowering interest rates, right?
Well, no, because the Fed was already printing money and injecting it into the system at a record pace from roughly 2008 through 2014. By 2014, however, the flooding of markets with free money had ceased to have much effect on boosting the economy, raising wages or helping with unemployment, which, according to the government’s little-discussed U-6 measure, is still hovering around 10 percent—not the phony 5 percent the administration loves to brag about. It’s something we’ve discussed in our columns many times, but it’s an inconvenient truth the major financial media prefer to ignore.
Why did the Fed’s massive monetary pump-priming exercise, known as quantitative easing or QE, fail to do much more than stabilize the U.S. economy? The unfortunate answer is that most of this free QE money was used by rich traders, bankers and hedge fund managers to pump up the price of their own stock and financial holdings.
By executing massive corporate stock buybacks—borrowing money to retire outstanding corporate shares from the open market—corporate bigwigs inflate their companies’ apparent earnings not by creating new products and bringing people back to work, but by lessening shares outstanding in the company.
This simple sleight of hand—cynically labeled “enhancing shareholder value”—mathematically raises earnings per share even if those earnings are actually declining. Dividing earnings into fewer and fewer shares creates the appearance of success and growth, and appearance, like celebrity, is all you see in today’s United States.
By demonstrating the appearance of success and growth, corporate bigwigs can trigger ever bigger incentive bonuses for themselves while simultaneously making it seem as if they’re getting the U.S. back on track to prosperity. It’s a perfect closed system. The nation’s 1 percent has returned to prosperity, and we see this on the news every night and read about it in useless fanzines like People. But where’s the prosperity for the rest of us?
The new Fed interest rate policy: Will it work?
In an initial effort to bring the entire U.S. monetary and economic system back to what used to be normal, the Fed finally decided this week, after months of Hamlet-like dallying, to cautiously begin raising interest rates. The aim is to drain at least some of the excess trillions of dollars in circulation out of the system—the dollars the Fed had originally pumped in to save the banking and financial system. The central bankers are hoping against hope that they can do this so slowly that people and institutions won’t feel it very much and so business will go on as normal.
The Wall Street Journal explained the Fed’s aims Thursday quite succinctly (articles available to subscribers only):
…the Fed will seek to drain money from the financial system, moving rates higher to prevent the economy from overheating. Fed officials are raising rates not to slow growth, but to reduce the amount of stimulus they are providing…
The details laid out by the central bank represent a significant shift in how the central bank seeks to influence borrowing costs. In recent decades, the Fed adjusted the fed-funds rate—the rate on overnight loans between banks—by buying or selling Treasurys, which added or decreased the total amount of banks’ reserves. But the large amount of reserves added to the system since the crisis has made this approach less effective.
Fed officials believe their new tools will allow the central bank to control short-term rates.
But, as we explained in Parts 1 and 2 of this series, the Fed is doing precisely the opposite of what it has successfully been doing since 1937. In effect, it’s fighting deflation by raising interest rates. Previously, since their 1937 mistake, they’ve fought deflationary or recessionary economic periods by cutting interest rates.
To put it in another way, the Fed is hoping to accomplish what it used to accomplish by injecting dollars into the system by draining them instead. It’s an interesting paradox, and no one really knows how this new tactic will work.
The Fed has belatedly recognized that the trillions of excess dollars it and the Treasury created to stem the corrosive tide of the Great Recession have done little if any good for the underlying U.S. economy. Most small businesses and individuals still can’t get a bank loan today even if they offer to peddle their souls to the devil. No loans or fewer loans mean no growth and no increase in individual consumption. No loans, no real growth.
By allowing rates to slowly rise, the Fed hopes to find a sweet spot where banks will finally start loaning money to average American families, enabling them to grow businesses and investments and increase their quality of life. If the banks can actually make money on smaller loans again, the U.S. might at last reclaim the kind of economic activity the country enjoyed in the 1980s and 1990s.
But to accomplish this, the Fed is doing precisely the opposite of what it’s been doing since 1937. In effect, it’s fighting a quiet but persistent deflation by raising interest rates. Ever since 1937, it has fought deflationary or recessionary economic periods by cutting interest rates. Making this new tactic work will be quite the challenge to say the least. We can’t recall that it’s ever been carried out this way before.
On the other hand, the Fed knows it needs to get billions and billions of essentially misused dollars out of the system. Without doing so, the government will in effect be transforming our grandchildren into miserable, indentured servants of the federal government, so large will be the debt they eventually inherit. And thinking ahead, we’re pretty sure these grandkids aren’t going to put up with this situation for very long.
What’s in the Fed decision for the average American citizen?
Having run out of its standard ammo, the Fed hopes to alter the current situation in which the U.S. government, i.e., the American taxpayer, is on the hook for paying back trillions of dollars that were allegedly created to juice the economy, get everybody back to work and get most American consumers back to their spending ways.
Instead, most of those dollars have ended up sitting in bank vaults and/or juicing not the economy but wealthy stockholders and large corporations that deployed those dollars to increase the apparent value of companies and personal wealth on a massive scale. This is indeed a redistribution of wealth, but not quite the kind of redistribution that anyone ever expected during a hard-left Democrat-led administration.
The Fed now hopes it can begin to alter this destructive course without damaging the vital real estate or stock markets it’s taken such pains to pump up in the first place. The problem is, when you’re peddling vast quantities of that man-made element hopium, your credibility is on the line. That said, if the Fed’s current fiscal flight path proves effective, we may yet escape seven-plus years of needless economic malaise we’ve already endured in this country.
But does the Fed have enough credibility left to pull this off? Or have both the Fed and the federal government worn out their welcome with America’s workers and taxpayers, the majority of whom still have nothing to show for their unreal patience with our increasingly flawed financial system?
We’ll soon discover the answers to both these questions, either via stock and bond market action in 2016 — or the morning after the first Tuesday of next November.Click here for reuse options!
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