The financial markets are hooked on easy money, low interest rates, and growth via debt issuance. Yet, it has become obvious to some market players, economists, and maybe even the Federal Reserve’s Federal Open Market Committee (the rate setting cabal), that current monetary policy is now hurting, not helping, the economy. Of course, monetary historians know that monetary policy was never meant to act alone, or in a vacuum, as is the case today around the world. The tools it possesses (interest rates the banks must pay and reserve creation) are too blunt and unfocused. Fiscal policy, which has the ability to target and fine tune, and, which historically worked hand in hand with monetary policy, has been held hostage to political partisanship. Monetary policy alone is insufficient to effectively or efficiently steer the economy.
So, after seven years of near zero interest rates and other radical actions, like Quantitative Easing (QE), we find that the economy has been turned topsy-turvy:
1) Citizens who have collected some semblance of wealth, normally those approaching retirement (today: the baby-boomer generation) find that the rate of return on their assets is so low that they must now spend less. And, many of them have postponed retirement as a result;
2) Those same citizens are driven into more risky investments causing asset prices, especially those of equities paying dividends and real estate, to inflate;
3) The wealthy, who already own equities and real estate, benefit the most; the middle class benefits the least, especially when a weak economy limits the growth of wages;
4) Pension funds and institutions, like insurance companies that rely on investment earnings, perform poorly. As a result, many ‘defined benefit plans’ are significantly underfunded. For corporate sponsors, this means lower future earnings. For state and local governments, this means a search for more revenue (higher taxes) or lower than promised retirement benefits for participants. This is a very significant issue that has not received the attention it deserves by the financial media;
5) When deposit account rates are 0% and loan rates fall, bank margins have nowhere to go but down. While banks in the U.S. have used the last few years to bolster their capital (required by the Dodd-Frank legislation), banks in Europe did not. There is a developing banking crisis in Italy which has now spilled over to Germany’s Deutsche Bank;
6) Companies have been borrowing at historically low rates to buy back their stock rather than to invest in growth via new plant and equipment. Data for the last couple of years shows flat to declining investment in plant and equipment resulting in negative productivity growth for six consecutive quarters;
7) Central bank bond purchase policies, especially in Europe and Japan (i.e., equivalent to QE in the U.S.) are dominating the fixed income markets to such an extent that negative interest rates exist for $13+ trillion of sovereign debt. The ECB’s €80 billion/month of purchases is so large that there is an insufficient amount of sovereign debt. As a result, they have been forced to buy corporate debt (a form of government picking winners and losers)!
The Fed is caught between a rock and a hard place. They engineered the recovery, or what we have had of it, via the wealth effect (equity and real estate prices rise), and now they know they must raise rates for all of the above reasons. But, given the current state of the economy, is this the right time? And if not now, then when?
The global economy is soft. U.S. GDP growth has been anemic. The initial government estimate of Q3 real GDP growth was 2.9%, after growth of a mere 0.8% and 1.4% in Q1 and Q2. While the Q3 number looks better, much of the growth was concentrated in inventories and a slight improvement in the trade deficit, which, together, added 1.4 percentage points to the GDP number. Without these, GDP growth would have been closer to 1.5%. At the same time, consumption growth fell from 4.3% in Q2 to 2.1%. So, the underlying trends are not encouraging.
The economies of Japan and Europe continue to struggle. And, while China hit their expected GDP growth number (6.7%) right on the nose, the trouble is, no one believes it. One must ask, if the Chinese economy is as strong as they say, why is their government weakening the value of their currency? Governments do that to boost growth via exports when internal growth is insufficient.
The prices of basic metals and materials, usually a good leading indicator of economic activity, remain weak. Wage growth in the U.S. is anemic, and we find deflation in most areas (except rents, which now appear to be rolling over in NY and SF). Corporate pricing power is nil. Capacity utilization is at recessionary levels, and with the dollar strengthening in anticipation of the Fed raising rates, manufacturing will surely move into contraction. Yes, the labor market appears tight, but the trend there has also turned negative.
What a conundrum! No easy answers. No easy outs. The best hope in the U.S. for the near term appears to be the continuation of slow, but fragile, growth.
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist and a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com.
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial and is the head of Fieldstone Research. www.FieldstoneResearch.com.
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.