Tuesday , July 16 2019

The Fed’s Pickle

Summary:
This is a follow-up to my subscriber post from earlier today on the US economy. For those of you who are not paying subscribers, let me summarize the post by saying I think the US economy is slowing but not in a recession. Nevertheless, I think we are likely to see a recession before the end of 2020. That’s actually my base case. The obvious questions regard policy responses, particularly the Fed’s. So I am writing this post to address some of that. 50 basis points won’t happen A few weeks ago, I spoke to David Rosenberg of Gluskin Sheff on Real Vision. Here’s the link. This was a follow-up to a March interview in which he predicted a capex recession and a bunch of other stuff. All of his points came to pass. He was perfect in prognosticating how the data would turn out and how

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This is a follow-up to my subscriber post from earlier today on the US economy. For those of you who are not paying subscribers, let me summarize the post by saying I think the US economy is slowing but not in a recession. Nevertheless, I think we are likely to see a recession before the end of 2020. That’s actually my base case.

The obvious questions regard policy responses, particularly the Fed’s. So I am writing this post to address some of that.

50 basis points won’t happen

A few weeks ago, I spoke to David Rosenberg of Gluskin Sheff on Real Vision. Here’s the link. This was a follow-up to a March interview in which he predicted a capex recession and a bunch of other stuff. All of his points came to pass. He was perfect in prognosticating how the data would turn out and how you should invest to take advantage.

Now, in June, Rosie was telling me the Fed was so far behind the curve, they would be forced to cut 50 basis points this month as a measure of prevention – to prevent a capex recession from becoming a real recession. I don’t think it will happen. Why? The June jobs number basically took that option off the table. There’s no way the Fed cuts 50 bips after a 224,000 non-farm payrolls print. It won’t happen.

The recession problem

But I still fear David is right about the Fed being behind the curve. And by that I mean that the breadth and depth of US economic slowing has reached a point where it’s not clear to me that it will trough and return to trend without our first going through a recession.

And this is where things get messy. First, it’s not even clear that cutting interest rates is accommodative monetary policy. It all depends on circumstances. On the one side, you can give debt relief to distressed borrowers and you can begin a wave of mortgage refinancing by cutting rates. But on the other side, you lower interest income.

Debt stress is not acute and we’ve already seen mortgage rates lower than they are now. So you’re not going to get a lot of juice there. But, you will reduce interest income if you lower rates. People like my mother, whose interest income was crushed when her bank CDs rolled over after Bernanke took rates down to zero are not going to start loading up on Tesla and Uber shares to get returns. They might go further down the quality spectrum toward junk. But, by and large, they will be forced to live with less interest income…and cut back on their spending as a result.

But, even if I’m wrong and rate cuts in this environment are stimulative, in the past several cycles, you’ve needed some 500 basis points of cutting and the Fed has less than half that. To use a pun, that won’t cut it.

So, the Fed’s in a bit of a pickle here. It doesn’t have the cover to get aggressive now – especially when you have hawks like Cleveland’s Loretta Mester saying they don’t even want to cut at all. And the Fed simply doesn’t have the firepower necessary to steepen the yield curve enough to help banks if their balance sheets deteriorate as the credit cycle turns. They will simply restrict credit.

How monetary policy works

But let me get back to how monetary policy supposedly works. I’ve been questioning the conventional story for some time. For example, here’s something I wrote in 2015 on the subject:

Let’s remember from a savings and consumption perspective we also have the lost interest income of some to measure against less interest debt burden for others. Let’s remember that when mortgage rates declined during this up cycle, mortgage borrowing for those with high credit scores also declined. The NY Fed’s research on mortgage origination suggests lower rates have had the (perverse) effect of accelerating pay downs among creditworthy mortgage borrowers.Now,  if high credit score mortgage borrowers have low marginal propensity to consume, lower rates could actually lower consumption. You’re getting a net shift to borrowers with low marginal consumption propensity away from others with higher consumption pattern. It is not clear to me that lower rates have the longer-term impact intended by policy because they have distributional effects.

The bottom line here is that zero rates could just as easily be deflationary over the long run by sucking interest income out of the private sector as they could be inflationary in supporting consumption. To me, it is wholly conceivable that low rates will not have the intended consequence of creating more consumption and higher GDP. Japan is the model here. Nothing I am seeing says that deflationary pressures are relenting in the US. And we should remember that quantitative easing replaces interest bearing assets in the private sector with non-interest bearing reserves, reducing interest income in the private sector outright. It can only be stimulative if it has portfolio balance effects or if it has credit-stimulating properties – which we already know from the research cited above, it may not have.

The way I see it, cutting rates is stimulative only to the degree it can spur enough excess consumption from those who get lower rates and have a higher marginal propensity to spend — over those who see their interest income whacked and cut back.

And so, I am very sceptical about the Fed’s allegedly having the tools to prevent a recession. More likely, they lower rates and accelerate the potential for recession by robbing savers of interest.

There is no fiscal relief coming either

You can forget about Congress passing more deficit-inducing legislation as we head into the election year too. That’s never going to happen.  First, we already have trillion dollar deficits that make any deficit hawks left in Congress antsy.

Second, the Speaker of the House, Nancy Pelosi, is a known deficit hawk who believes in Paygo. There’s no way she’s going to allow deficit spending unless it results in a broad-based pickup in income or reduction in taxes and is ‘paid for’ by taxes on the wealthy.

And third, why would Democrats support any sort of stimulus when Donald Trump is President? They wouldn’t. And they won’t. It simply won’t happen.

So, there is no fiscal relief coming.

Conclusion

So, this economy has to trough and right itself without any support from policymakers. It’s still early enough that I think there’s an outside chance we can do it. But that’s not my base case. My base case is for a recession by the end of next year. And without any policy support to stop it, we’ll just have to wait and see if I’m right.

Edward Harrison
I am a former European credit markets and M&A guy who started out as a diplomat. — so I have some pretty diverse interests.

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