- As the December FOMC meeting approaches, the Fed faces a real dilemma. Does the Fed leave interest rates on hold and risk undermining market confidence in the US recovery and the Fed’s own credibility? Or does the Fed start the process of raising interest rates, a move which will put in on a path that could also severely damage economic confidence?
- While it may be not clear to markets at this point, the view of The Money Enigma is that the Fed faces what could best be described as the “Bad Debtors’ Dilemma”. In simple terms, if you have borrowed lots of money and can’t really afford to repay it, how do you keep the faith of creditors? Do you wait as long as possible to begin repayments or do start making small repayments now in the hope that things will somehow work out?
- The dilemma facing the Federal Reserve is does the Fed push back normalization for as long as possible hoping markets won’t notice, or do they start the process hoping that normalization will not disrupt the economy and damage market confidence?
- Over the past ten years, the Fed has engaged in an extraordinary series of unorthodox policy actions, most notably cutting the Fed Funds rate to zero and quintupling the size of the monetary base. The success of this unorthodox policy approach has been underwritten by the notion that the US economy will recover “in time” and that the Fed will normalize monetary policy settings “eventually”.
- However, the markets, just like the unfortunate lender to our bad debtor, won’t wait forever. If the Fed waits too long to begin the process of “normalization”, then long-term economic confidence could be damaged.
- Alternatively, if the Fed does begin the process of normalization but then starts stalling on further rate rises or, even worse, stops the process of normalization and engages in more quantitative easing, then long-term confidence could be severely damaged. In either scenario, the end result is a poor one for the Fed and the US economy.
- The key problem for the Fed is that long-term economic confidence underwrites the value of the US Dollar. If market confidence in the long-term economic future of the United States is damaged, then the value of the US Dollar will fall and this will trigger a marked acceleration in inflation. Any sudden rise in inflation will not only damage the Fed’s credibility but also severely limit its ability to control economic outcomes.
You can listen my interview with the MiningMaven on this article by clicking on link below.
The Bad Debtors’ Dilemma
Let’s imagine that an old friend came to visit you a few years ago and asked to borrow some money. Your friend explained to you that they had hit some tough times and you decided to lend them $3,000.
A few months later, your friend returned. Their situation had not improved and they asked for some more cash. Again, you knew this person well so you felt happy lending them another $3,000. In fact, you were so confident in your friend’s ability to repay the money eventually that you said that they could come to you again if they needed to.
Sure enough, your friend turns up again a few months later and borrows another $4,000 on top of the $6,000 that you had already loaned them. By now the debt is significant, but you feel confident that your friend will repay the debt eventually. In fact, you tell your friend that there is “no rush” to repay the debt.
Now, what happens if your friend struggles to get back on his/her feet?
Your friend knows that, at some point, you are going to want your money back. So, what should your friend do, particularly if your wallet represents their “last resort”?
Should your friend, the bad debtor, keep putting off making any repayment to you, the lender, for as long as possible and hope that you don’t begin suspecting there is a problem? Alternatively, should the bad debtor attempt to keep the lender’s confidence by starting to make a series of small repayments?
For the bad debtor, the problem presents a real dilemma. On one hand, it is tempting to make no repayment and just hope that the lender doesn’t begin to suspect that something is wrong. However, this approach is not sustainable: the lender will get suspicious eventually.
On the other hand, starting to make small repayments, for example $100 per month, can also backfire even if does buy a bit more time. For example, the lender may begin to question why the monthly repayments are so small and why larger repayments are not forthcoming.
More problematically, if the bad debtor suddenly suspends the token $100 per month repayment, then this will definitely raise suspicions. For example, imagine your friend does start repaying you $100 per month for six months but then suddenly asks to reduce the monthly payments to $50 per month. Worse still, imagine how you would feel if your friend stopped the repayments altogether and came back to you asking for more money!
The Fed’s Dilemma
While the analogy may not be perfect, the view of The Money Enigma is that the Fed faces a dilemma similar to that faced by our bad debtor.
In simple terms, the Fed is engaged in a confidence game. The key to winning this game is ensuring that markets believe that the long-term economic future of the United States is sound. So far, the Fed has been very successful in playing this game, helped by the fact that the United States has a tremendous history of economic success. However, the inevitable monetary policy tightening cycle that confronts the Fed will test this market confidence.
In terms of our Bad Debtor analogy, the implementation of ZIRP by the Fed represents the first $3,000 lent to our bad debtor. Markets were happy for the Fed to cut the Fed Funds rate to zero in 2008 because there was a financial crisis and the Fed had a long and successful history of lowering interest rates in a time of crisis.
However, ZIRP was not enough to resolve the crisis. Therefore the Fed quickly came back to markets for the next $3,000, i.e. QE1. Although quantitative easing represented an unorthodox policy approach, market confidence was not damaged because this sudden expansion of the monetary base was viewed as being “temporary” in nature.
Ultimately, the Fed perceived that QE1 was insufficient, so the Fed came back for the next $4,000: QE2 and QE3.
Despite these extraordinary policy measures, the markets have never lost faith in the Fed. The view of the markets has been and remains today that the US economy will continue to do well over time and that this will allow the Fed to “normalize” monetary policy eventually.
The problem is that we are now approaching the point where this confidence will be tested. At some point, the Fed must normalize policy just as the bad debtor must repay the debt.
The challenge for the Fed is figuring out a way to do this that doesn’t damage market confidence. If the Fed is too slow to normalize policy, the markets may begin to lose faith in the Fed. If the Fed is too aggressive in its attempts to normalize policy, then it could easily knock the economy back into recession.
The “middle road” also represents a potential problem for the Fed. For example, let’s imagine that the Fed does raise the Fed Funds rate by 150 basis points over the next 12 months without damaging the economy. Superficially, this would be a great outcome. However, it still leaves a problem. The Fed still needs to reduce the monetary base by at least $2 trillion. In essence, raising short-term rates is only repaying the first $3,000. Ultimately the Fed needs to repay the entire $10,000 to keep the faith of the markets, i.e. it must raise short-term rates and reduce the monetary base to pre-crisis trend levels.
The greater concern is what happens if the Fed begins the normalization process in December but then has to stall this process or reverse it?
For example, what happens to market confidence in the long-term future of the United States if the Fed does raise interest rates to 0.75% and the US economy falls into recession in mid 2016? Alternatively, what happens to confidence if the Fed decides to sell $1 trillion of the bonds on its balance sheet and this triggers a crash in global equity and bond markets? [This second scenario is something that has been discussed in a previous post titled “Has the Fed Created the Conditions for a Market Crash?”]
In many ways, it is easier for the Fed to sit on its hands and do nothing rather than tempt these outcomes, just as it is easier for our bad debtor to avoid showing his/her hand by starting the repayment process. But ultimately, the misadventures of the Fed need to be reversed and this will be the point at which the confidence of the markets will be tested.
Why Does Long-Term Economic Confidence Matter?
Just as our bad debtor needs to maintain the confidence of our lender, so the Fed needs to maintain the confidence of markets. More specifically, the Fed needs to ensure that markets do not lost their faith in the long-term economic future of the United States.
Why does confidence in the future of the economy matter? Well, there are a couple of key reasons.
First, and most obviously, a loss of faith in the future of the United States is bad for business. If markets start to believe that the long-term rate of economic growth in the US will be much lower than previously expected, then capital spending will be slashed, business formation will be delayed and jobs will be lost.
Second, and less obviously, confidence in the long-term economic future of our society is a key determinant of the rate of inflation. In simple terms, high levels of confidence support the value of the dollar and keep a lid on the rate of inflation. Conversely, a sudden decline in long-term confidence could lead to a collapse in the value of the dollar and a sudden rise in prices.
The reasons for this are complicated, but we can use our bad debtor analogy to help explain the point.
Think back to our earlier example. Why does our bad debtor want to keep his/her financial situation a secret? In simple terms, our bad debtor knows that if the lender’s confidence is lost, then the lender will want his/her money back and will not be inclined to lend our debtor any more money.
In more technical terms, we can say that our debtor wants to prevent his/her cost of debt capital from rising. If the lender loses confidence in our debtor, then the lender will probably require a higher rate of interest on existing and future monies lent to that debtor.
The Fed faces a similar challenge, although it is a concept that is poorly understood by most economists. In essence, when the Fed expands the monetary base (“prints money”), it creates claims against the future output of society. In this sense, the monetary base can be considered to be the “equity of society”.
While confidence in the long-term economic future of society remains high, the Fed can issue money without impacting its cost of equity, i.e. without debasing the value of the US Dollar. However, if long-term confidence is lost, then the Fed’s “cost of equity” will rise. In other words, the Fed can continue to issue more dollars, but the value of each dollar is less.
How does a decline in the value of the dollar show up in the real world? Inflation.
All else remaining equal, if every dollar is worth less in absolute terms, then the price of all goods in dollar terms must rise. Every price is a relative measurement of the market value of two items. More specifically, the price of one good, the “primary good”, in terms of another good, the “measurement good”, is a relative measure of the value of the primary good in terms of the measurement good. If the market value of the measurement good falls, then the price of the primary good in measurement good terms will rise.
Therefore, if the value of money falls, then prices as expressed in money terms will rise and the rate of inflation will accelerate.
In summary, the view of The Money Enigma is that the Fed must maintain the confidence of the market just as our debtor must maintain the confidence of the lender. If the Fed loses the confidence of the market, then the Fed’s cost of capital will rise, just as the debtors cost of capital will rise if it loses the faith of its creditors. In practical terms, a rise in the Fed’s “cost of capital” means that the value of the US Dollar will fall, inflation will accelerate and the Fed will largely lose the ability to manage macroeconomic outcomes.
If you are interested in reading more about why the value of fiat money is so heavily dependent upon long-term economic confidence, then I would encourage you to read the following posts. First, I would suggest reading “The Evolution of Money: Why Does Fiat Money Have Value?” which attempts to explain why paper money with no intrinsic worth has any value at all. Second, I would suggest reading the follow on article “What Factors Influence the Value of Fiat Money?” If you are interested in the notion that the monetary base is, in essence, an equity instrument and proportional claim in the future output of society, then I would encourage you to read an older post “Money as the Equity of Society”.