The Fed is 'pushing on a string'

With Fed Chair Jerome Powell averse to negative interest rates, the world's preeminent central bank will be forced into more QE...and run right smack into the Law of Diminishing Returns.

The U.S. equity markets may have snapped back in a big way — some 30% — from the March lows, and investors are (for now) ignoring the economic and earnings abyss that is the second quarter and looking to the Federal Reserve to escort markets across the void.

This week, Federal Reserve governors have been warning that the economic damage, the true unemployment rates, were worse than reflected in already alarming official numbers. Chairman Jerome Powell stated that the situation is “without modern precedent,” and, “significantly worse than any recession since World War II.”

Abysmal retail sales reports and the worst decline in industrial production in a century reinforced Powell’s earlier assertion that the economy will require more policy support from the Fed.

Having already dropped interest rates to near zero and facilitated a virtual marriage with the U.S. Treasury to prop up the financial system with trillions of dollars in liquidity backing, there’s great interest in what that future support will look like.

On that note, Powell was asked by a reporter in this week’s press conference whether the central bank was considering NEGATIVE interest rates. President Donald Trump, reliably rooting for easier monetary policy that stokes the economy, urged the Fed to consider negative interest rates.

While the idea of losing money in your savings account seems completely asinine (for good reason), it’s important to understand why the issue of negative rates is being entertained in the first place. Economic theory describes a ‘natural’ rate of interest (R*) that marks the point at which incentives for current versus future consumption are balanced. This rate is not static, meaning as economic prospects change throughout a cycle, so does the natural interest rate. Analysts use correlations between capital markets to derive a proxy for this rate.

The whole idea of the Federal Reserve manipulating interest rates (in theory) being: rates set below the natural rate, incentivize credit consumption and stimulate the economy; rates set above the natural rate would put a damper on credit consumption and cool off the economy. The natural rate is the ‘neutral rate’ for the Fed.

The problem for the Fed is that R* is currently significantly below zero. Such is the nature of a mandated recession in which lockdown policies destroy demand for credit in the near term, because they’ve destroyed the very demand businesses seek to supply.

Hence the questions about whether the Fed was considering negative rates; R* indicates policy is too tight and negative rates are the only obvious interest rate solution to stimulate the economy.

The central bank has been historically limited to certain kinds of policy tools, and negative rates have always been out of bounds. Not so for the central banks of Japan, European Union, Sweden, Switzerland and so on, which have long since dropped any aversion to negative interest rates in their seemingly futile efforts to revive growth and inflation. Could it happen here, too, considering the historically low natural rate of interest?

Powell rejected the notion of negative rates when asked, saying, the bank will not consider the policy because the current cocktail of zero rates and asset purchases “works.” So, a ‘no’ on negative rates, but that only means the Fed is pressured to ease policy using the second ingredient in the Fed’s cocktail — asset purchases.

Otherwise known as Quantitative Easing, or QE, which became common parlance following the Great Financial Crisis of 2009/9. In short, it’s the practice of the Fed buying financial assets to inject cash into the financial system in hopes of it spurring economic activity. If they cannot incentivize consumers by lowering interest rates, then they’ll attack it from the other end with direct injections into big banks and financial markets and and cross their fingers that it trickles down.

It has had many iterations over the last 10 years (QE1, QE1, QE3), and a loosening definition of which assets the Fed can buy, which has had the effect of ballooning the Fed’s balance sheet exponentially.

It also reliably boosted markets during those period. This next round stands to be Super QE, though.

That’s because the Fed has previously estimated that it takes $100 billion worth of QE to recreate the same short term impact on economic activity as 3 basis points (0.03%) of rate cuts. So, if the natural rate of interest (R*) is somewhere around -1%, and the Fed Rate is at zero percent, this means that in order to provide easing to match the natural rate, the Fed would need to grow its balance sheet by about $3.3 trillion.

This would be in addition to the current crisis operations of the Fed, which have already grown the central bank’s balance sheet by another than $2+ trillion in the last six months. In fact, the Fed began purchases of corporate bond ETFs this week, buying more than $300 million worth of the securities. Let’s repeat that: The nation’s central bank is openly buying corporate securities to prop up the market.

(Not even during the financial conflagration of 2008/9 did the Fed engage in such formerly taboo practices, but the ice was broken long ago by foreign central banks that have openly done it for years. For instance, the Swiss National Bank has a virtual trading operation, nearly single-handedly propping up megacap tech stocks during the late March swoon in stocks with billions in purchases funded by a printing press.)

Super QE would blow that sky high, if Powell and company hope to have the desired effect on the economy. But there is a festering problem with QE, no matter how ‘super’ it is: the Law of Diminishing Returns.

The Fed gauges the effectiveness of QE by looking at M1 money supply, which is the most basic measure of money supply, consisting of the amount of cash and cash equivalents in the nation’s bank accounts. If this increases, the Fed judges that it represents an increase in consumption, which is the goal. But with each passing QE, the effective increase to M1 has been smaller, and smaller, and smaller.

As noted in Zero Hedge, BMO Capital Markets analyst Daniel Krieter writes, "QE has fed through to the real economy in a slower manner than previous QE campaigns.”

Krieter estimates that with every dollar the Fed's balance sheet has grew under QE1, M1 supply increased $0.96 (pretty solid throughput); QE2 registered an increase of only $0.74; and that the latest coronavirus crisis asset purchases only provided a $0.34 increase to M1 money supply.

The Fed is pushing on a string. Even if they were to embark on a gargantuan Super QE in an effort to match the natural rate of interest, it is doomed to have diminishing effects on M1, or the correlated consumption, and the economy.

It’s not just a problem for the Fed; this ‘marginal utility of debt’ — the corresponding boost to GDP generated by each increase in new debts (QE) — is falling toward zero all over the globe as central banks have all used the same playbook for decades.

This will not keep them from pushing harder on that string. After all, their options are limited. Yet, while pushing on a string doesn’t affect the intended target (real economy), it does create unintended distortions, loops, and bulges in the strand. In keeping with this truism, every cent of Super QE that does not translate into the economy, will likely get reflected in capital markets instead. As with QE 1, 2, and 3, the positive effects for wages, inflation, or economic growth will prove slow(er) to come and an increasing proportion of the stimulus will do nothing more than inflate capital assets.

The powers that be on Wall Street would likely find that solution to be quite sufficient for their purposes, but it doesn’t necessarily bode well for Main Street. If all the QE in the world props up financial markets and capital assets, but does nothing for the real economy, then what is the point?

Many have an idea of how to answer that question already, and the inferences drawn from comparing dreadful joblessness with buoyant financial markets may inspire some soul searching by the American public in regards to the Fed’s proper role in our economy, their arbitrary powers to set the price of money, and the true effects of their policies. Who do they serve, exactly?

Until then, the Fed will keep pushing on a string in order to satisfy its shadow mandate of keeping markets elevated and Wall Street happy, as choppy as that prospect promises to be for the foreseeable future, until the ineffectiveness of this core tenet in central banking philosophy becomes impossible to ignore. When that finally happens, the debate over the rules of the game - negative interest rates, Super QE, outright stock purchases, direct Fed payments to Americans - will be moot.

It will be a completely different game.