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.
Investing involves risk, including the possible loss of principal. This material is distributed or presented for informational or educational purposes only and should not be considered a recommendation of any particular security, strategy or investment product, or as investing advice of any kind. This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and/or a legal opinion. Always consult a financial, tax and/or legal professional regarding your specific situation.
This material contains opinions of the author or speaker, but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. No part of this material may be reproduced or referred to in any form, without express written permission of Guggenheim Partners, LLC.
Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management.
©2019, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.
Guggenheim Investments represents the investment management businesses of Guggenheim Partners, LLC ("Guggenheim"). Guggenheim Funds Distributors, LLC is an affiliate of Guggenheim.
Read a prospectus and summary prospectus (if available) carefully before investing. It contains the investment objective, risks charges, expenses and the other information, which should be considered carefully before investing. To obtain a prospectus and summary prospectus (if available) click here or call 800.820.0888.
Investing involves risk, including the possible loss of principal.
*Assets under management is as of 09.30.2020 and includes leverage of $14bn. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Europe Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management. Securities offered through Guggenheim Funds Distributors, LLC.
Guggenheim Investments. All rights reserved.
Research our firm with FINRA Broker Check.
• Not FDIC Insured • No Bank Guarantee • May Lose Value
This website is directed to and intended for use by citizens or residents of the United States of America only. The material provided on this website is not intended as a recommendation or as investment advice of any kind, including in connection with rollovers, transfers, and distributions. Such material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. All content has been provided for informational or educational purposes only and is not intended to be and should not be construed as legal or tax advice and/or a legal opinion. Always consult a financial, tax and/or legal professional regarding your specific situation. Investing involves risk, including the possible loss of principal.