A version of this article appeared in Barron's.
In the runup to the upcoming FOMC meeting, policymakers debate the value of what would normally be considered unorthodox policy actions. Even as the U.S. economy grows with labor markets operating at levels associated with full employment, a loud public debate ensues around appropriate policy action. The consequences of the Federal Reserve’s actions in the next week could be with us for much longer than we think, culminating in the next recession and increasing the risk to financial stability. The Fed will be starting yet another monetary sugar high that doesn’t address the underlying structural problems created by powerful demographic forces which are constraining output and depressing prices.
Scott Minerd leads a panel discussion on CNBC on the investment implications of the shifting Fed policy stance.
By almost every measure policy makers should be considering another rate hike in anticipation of potential economic overheating from looming limitations on output. Instead, debate has been focused on the need to take preemptive action to avoid a potential slowdown.
An abrupt shift in thinking was set in motion last December when, after raising overnight rates by a quarter of a percent, Fed Chair Jerome Powell signaled more hikes were to come and that balance sheet reduction was on "autopilot." Alarmed by the market tantrum that ensued, Fed policymakers began a mop-up campaign which included its now famous "pivot" to patience.
While the Fed has more than succeeded in stabilizing markets, the ensuing liquidity driven rally has boosted asset prices including stocks, bonds, precious metals, energy, and even cryptocurrencies.
As Europe faces prospects that negative rates may become a long-term fixture in the euro region, concerns are mounting in the U.S. that the global slide toward negative yields could infect the market for Treasury securities should the U.S. slip into a recession. These concerns are well founded. In the post-war era, the Fed has reduced short-term rates by an average of 5-1/2 percent during easing cycles associated with recession. The required stimulus in a recession today could necessitate large scale asset purchases of nearly $5 trillion to overcome the monetary limitations of the zero bound. Such a policy action could easily result in negative Treasury yields.
To immunize against the global contagion of negative rates, the Fed is intentionally overheating the U.S. economy in hopes of raising inflation above its 2 percent target rate. Once inflation approaches some undefined rate, perhaps 2.5 percent, the Fed will then reverse course by increasing rates to higher levels than we are experiencing today, creating another set of risks.
Additional accommodation this late in the business cycle is likely to push asset prices higher just as in 1998, when the Fed cut rates by 75 basis points during the Asian crisis, only to reverse course nine months later by raising short-term rates to the cycle high. Just as Fed accommodation inflated the Internet bubble then, asset inflation associated with stimulative policy at this point in the cycle is likely to have a similar impact.
Chairman Powell has been clear the Fed will go for broke, and do whatever necessary to keep the expansion going. Most likely, a quarter point next week will be followed by another half percent before year end. As long as the Fed doesn’t perceive that inflationary pressure is becoming too daunting a problem, policy makers are prepared to do anything to keep the economy going.
The real problem leading to the depressed term structure cannot be solved by the Fed short of the remote possibility of an overt policy to increase inflation well above 2 percent. This problem is the product of structural changes within the economy which have reduced growth potential relative to the past 50 years.
Demographics play an important role. Not only is an aging population creating an acute labor shortage, but the opioid crisis and failures in education and job training are limiting the supply of skilled labor.
Without growth in supply side inputs and increased demand associated with a faster growing, younger demographic, the real neutral rate is likely to remain low and may even fall into negative territory. The depressed neutral rate is limiting the power of policy makers to stimulate demand without risking significantly higher inflation and financial instability.
The simplest way to avoid recession and the associated negative rates would be a rapid increase in the supply of labor, aided by education, job training and solutions to address the blight of opioids. A rational immigration initiative could quickly offset the risks of a slowing economy by providing more workers to plug the yawning gap between open jobs and available workers. Two million new workers could raise output potential by 2 percent or more. This would push the neutral rate higher by stimulating economic growth while increasing the tax revenue to the U.S. Treasury from the rapid growth in personal income.
The Fed's current policy of anticipatory and preemptive rate cuts will lead to unsustainably high asset prices and increased financial instability. This can only make the next downturn worse. If the U.S. continues down the current policy path we will find out that the Fed’s cure for avoiding a near term recession and negative interest rates may ultimately make the disease worse.
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