A Recession Is Coming…and the Fed Can’t Stop It
Is the Federal Reserve ready for the next recession?
The answer is no.
Extensive research shows that it takes between 300 and 500 basis points of interest rate cuts by the Fed to pull the US economy out of a recession. One basis point is 1/100th of 1%, so 500 basis points of rate reduction means the Fed would have to cut rates by 5%.
Right now the Fed’s target rate for Fed funds — the so-called ‘policy rate’ — is 1.75%. How do you cut rates 3–5% when you’re starting at 1.75%? You can’t.
Negative interest rates won’t save the day. They’ve been tried in Japan, the Eurozone, Sweden and Switzerland, and the evidence is that they don’t work to stimulate the economy.
The idea of negative rates is that they’re an inducement to spend money; if you don’t spend money, the bank takes it from your account — the opposite of paying interest.
Yet the evidence suggests people save more with negative rates in order to meet their lifetime goals for retirement, healthcare, education, and so on.
If the bank is taking money from your account, you have to save more to meet your goals. That slows down spending or what neo-Keynesians call ‘aggregate demand’.
This is just one more example of how actual human behaviour deviates from egghead theories.
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Zero means zero
The bottom line is that zero means zero. If a recession started tomorrow, the Fed could cut rates 1.75% before they hit zero. They would then be out of bullets.
What about more quantitative easing, or ‘QE’?
The Fed ended QE in late 2014 after three rounds known as QE1, QE2 and QE3 from 2008–2014.
What about QE4 in a new recession?
The problem is that the Fed never cleaned up the mess from QE1, QE2 and QE3, so their capacity to run QE4 is in doubt.
From 2008–2014, over the course of QE1, QE2 and QE3, the Fed grew its balance sheet from US$800 billion to US$4.4 trillion. That added US$3.6 trillion of newly-printed money, which the Fed used to purchase long-term assets in an effort to suppress interest rates across the yield curve.
The plan was that lower long-term interest rates would force investors into riskier assets such as stocks and real estate. Former Fed chairman Ben Bernanke called this manipulation the ‘portfolio channel’ effect.
These higher valuations for stocks and real estate would then create a ‘wealth effect’ that would encourage more spending. The higher valuations would also provide collateral for more borrowing. This combination of more spending and lending was supposed to get the economy on a sustainable path of higher growth.
This theory was another failure by the eggheads.
The wealth effect never emerged, and the return of high leverage didn’t return either.
There is a lot more leverage overseas in emerging-market dollar-denominated debt, but that’s not what the Fed was hoping for. The EM dollar-debt bomb is another accident waiting to happen.
The only part of the Bernanke plan that worked was achieving higher asset values, but those values now look dangerously like bubbles waiting to burst. Thanks, Ben.
Firing up the money-printing machine
The problem now is that all of that leverage is still on the Fed’s balance sheet.
The US$3.6 trillion of new money was never mopped up by the Fed; it’s still there in the form of bank reserves. The Fed has begun a program of balance sheet normalisation, but that program is not far along. Its balance sheet is still over US$4 trillion.
That makes it highly problematic for the Fed to start QE4. When they started QE1 in 2008, the balance sheet was US$800 billion. If they started a new QE program today, they’d be starting from a much higher base.
The question is whether the Fed could take their balance sheet to US$5 trillion or US$6 trillion in the course of QE4 or QE5?
In answering that question, it helps to bear in mind the Fed only has US$40 billion in capital. With current assets of US$4.4 billion, the Fed is leveraged 110-to-1. That’s enough leverage to make Bernie Madoff blush.
To be fair to the Fed, their leverage would be much lower if their gold certificates issued by the Treasury were marked-to-market. That’s a story for another day, but it does say something significant about the future role of gold in the monetary system.
Modern Monetary Theory (MMT), led by left-wing academics like Stephanie Kelton, sees no problem with the Fed printing as much money as it wants to monetise Treasury debt. MMT is almost certainly incorrect about this.
There’s an invisible confidence boundary where everyday Americans will suddenly lose confidence in Fed liabilities (aka ‘US dollars’) in a hypersynchronous phase transition. No one knows exactly where the boundary is, but no one wants to find out the hard way.
It’s out there, possibly at the US$5 trillion level. The Fed seems to agree, although they won’t say so. Otherwise they wouldn’t be trying to reduce their balance sheet today.
So if a recession hit tomorrow, the Fed would not be able to save the day with rate cuts, because they’d hit the zero bound before they could cut enough to make a difference. They would not be able to save the day with QE4 because they’re already overleveraged.
What can the Fed do?
All they can do is raise rates (slowly), reduce the balance sheet (slowly) and pray that a recession does not hit before they get things back to ‘normal’, probably around 2021. What are the odds of the Fed being able to pull this off before the next recession hits?
Not very good.
Have a look at the chart below. It shows the length of all economic expansions since the end of the Second World War…
US economic expansions since the Second World War
Source: LPL Research; NBER
The current expansion is shown by the orange bar. It started in June 2009 and has continued until today. It is the second-longest expansion since 1945, currently at 107 months.
It’s longer than the Reagan-Bush expansion of 1982–90.
It’s longer than the Kennedy-Johnson expansion of 1961–69.
And it’s longer than any expansion except the Clinton-Gingrich expansion of 1991–2001.
Just on a statistical basis, the odds of this expansion turning to recession before the end of 2020 are extremely high.
In short, there’s a very high probability that the US economy will go into recession before the Fed is prepared to get the US out of it.
That means, once the recession starts, the US may stay in this situation for decades, which is exactly what happened to Japan beginning in 1990. By the way, Japan’s most recent GDP report for the first quarter of 2018 showed negative growth.
Japan has had three ‘lost decades’. The US is just finishing its first lost decade…and may have two more to go.
The Fed will start the next recession
The situation is even worse than this dire forecast suggests. The reason is that, by preparing to fight the next recession, the Fed may actually cause the recession they’re preparing to cure. It’s like trying to run a marathon while being chased by a hungry bear.
The Fed needs to raise rates and reduce their balance sheet in order to have enough policy leeway to fight a recession. If they move too quickly, they’ll cause a recession. If they move too slowly, they’ll run out of time and get eaten by the bear.
This is the ultimate monetary finesse. This mess was caused by Bernanke’s failure to raise rates in 2010 and 2011 when the economy was in the early stages of an expansion and in a better position to absorb rate hikes. It was also caused by Bernanke’s insistence on QE2 and QE3 despite zero evidence then or now that it does any good. (QE1 was actually needed to deal with a liquidity crisis, but that was over in 2009. There’s no excuse for what came later.)
A recession is coming, the Fed is unprepared, and it’s extremely unlikely it’ll be prepared in time.
Though, while the Fed may not be ready, you can be.
This is a time for investors to increase their allocation to cash and precious metals as insurance against a potential collapse scenario much worse than a recession.
The only other recommendation is to do what the Fed is doing…pray.
All the best,