The Fed’s Nightmare Scenario

Friday, December 28, 2018
By Paul Martin

By James Soriano
AmericanThinker.com
December 28, 2018

December 29 marks the twenty-ninth anniversary of the high-water mark in Japanese stocks. On that date in 1989 the Nikkei 225 Index closed at its all-time high of 38,915, but within months fell into “bear market” territory. It has never recovered. It’s astonishing to realize that the Nikkei today is 48% below its historic high.

The main reason for this is because Japan has been fighting the effects of deflation since the early 1990s. To try to reflate the economy, Japan brought short-term interest rates down to zero in 1994, the first major economic power to do so. Since then, its short-term interest rates have been near zero, and sometimes negative. The Bank of Japan has never been able to “normalize” interest rates back to their pre-1989 level.

One lesson to be gleaned from all this is that a bear market is not merely the name given to a sharp, but transitory, decline in stock prices caused by periodic fluctuations in the business cycle. It can also be a persistent background condition of generational duration, caused by human error in monetary policy making.

Another lesson is that the use of short-term interest rates as a tool of monetary policy can lose its effectiveness. The tool becomes useless in bringing about desired outcomes in the real economy.

The third lesson is that the first two lessons are connected. This is the nightmare scenario facing the US Federal Reserve Bank as it, too, tries to “normalize” interest rates, getting them up to a level prior to the Global Financial Crisis (GFC) of 2007-08.

Since 2015, the Fed has been gradually raising short-term rates. It has come in for sharp criticism amid signs of weakness in the US economy and the slide in stock prices on Wall Street. The criticism is not just about the interest rate hikes. It is also about the Fed’s move to “normalize” its balance sheet. This latter is typically called “quantitative tightening” (QT), which is the opposite of the “quantitative easing” of 2008-14 when the Fed bought some $4.3 trillion worth of securities, mostly intermediate term Treasury bonds, as a way to inject liquidity into the economy during the GFC and its aftermath.

Today the Fed is letting these bonds run to maturity. On the maturity date, it receives the face value of the bonds in cash from the US Treasury and removes them from its balance sheet. It then extinguishes the money. This means money is going out of existence, at the rate of about $50 billion a month.

Thus, the recent cycle of interest rate hikes is taking place within the context of the Fed draining liquidity from the market. Some analysts say that by the end of 2019, QT will have the effect of adding two percentage points to short-term interest rates, thus increasing the risk of a recession.

At a press conference on December 19, Fed Chairman Jerome Powell summed up the Fed’s policy stance, thus:

“We came to the decision that we would have the balance sheet run-off on automatic pilot and use rate policy as the active tool of monetary policy. I don’t see us changing that.”

One need not go any further than this statement to get a handle on the current situation. A close reading of it reveals four variables are in play. Powell pointed to something called interest rates and something else called the balance sheet. He pointed to something called a monetary tool and to something else not considered a tool. He linked interest rates and a monetary tool, but considered the balance sheet as something else.

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