The Zero-Interest-Rate Economy
By James J Puplava CFP, July 16, 2003
Twice a year the Fed is required to report to the Congress on monetary policy and the condition of the American economy. It is obvious from viewing the last two days of testimony that Mr. Greenspan is less confident as to where this economy is headed. There was plenty of optimistic talk about the future that was followed by an equal emphasis on future uncertainties. Downside risks in higher energy prices, especially natural gas, flagging demand amongst important trading partners, rising unemployment, weakness in business capital investment, an uncertain outlook for corporate profits and a downturn in consumer spending are just a few of the possibilities that could make the Fed's optimistic forecast for the economy turn out to be fiction. In other words, the Fed's optimistic forecast is filled with uncertainties. Conventional monetary policy is turning out to be less effective in producing an enduring economic recovery. Because conventional policy methods aren't working their traditional magic, the Fed is now studying alternative policy measures in order to prepare for the zero-interest rate economy. I'll have more to say about that in just a moment. First it is necessary to look at the present state of the economy and where it is heading.
In its July 15th report to Congress the Fed highlighted the fact that economic performance during the first half of this year has been subpar. Most of the reasons for this subpar performance are attributed to the uncertainty over the Iraq War, rising energy prices, lingering aftereffects from last year's accounting scandals and an excessive cautionary mood by business in general.
As of June when the report was prepared, there was no compelling evidence that a step-up in economic growth was firmly taking root in the economy. The Fed believes that a more expansive monetary policy was warranted given all of the economic risks that were still present in the economy. As a result the Fed cut interest rates for the 13th time in June, bringing the Fed funds rate down to 1%, a 45 year low. With monetary and fiscal policy now operating at full throttle, the Fed is positive that eventually economic growth will pick up later this year and into next year.
Source: Monetary Policy Report submitted to the Congress on July 15, 2003: Monetary Policy and The Economic Outlook
However, underneath that optimism is a nagging doubt as Fed policy makers study their next moves if economic growth begins to falter again. What is clear from the chart above is that the lowest interest rates in nearly half a century have failed to create another boom in the economy. The only identifiable result so far has been the creation of multiple asset bubbles in the bond, stock, mortgage, and housing market.
The Worst Case Scenarios
The Fed is now preoccupied with what happens when these asset bubbles burst creating an environment of deflation similar to what happened in the U.S in the 1930's and Japan in the 1990's. As shown in the next two graphs of the U.S. in the 30's and Japan in the 90's, deflation took hold of the economy as asset bubbles burst spilling over into the general economy causing production and economic output to decline.
Source: "Monetary Policy in a Zero-Interest-Rate Economy," Federal Reserve Bank of Dallas, May 2003. (pdf)
The Fed believes these problems could all have been avoided had the central bank in both countries moved sooner to inject more credit in the system. Fed officials here believe that their aggressive interest rate moves of 2001 have prevented deflation from gaining a foothold in the economy. The latest monetary report to Congress cites the success of these moves by mentioning the recent rise in stock prices, the narrowing of credit spreads on corporate debt, the strong housing and mortgage refi market and rising consumer sentiment.
While the Fed has achieved success in mitigating some of the harsher aspects of an economic downturn, all that it has been able to do is postpone the day of reckoning. The economic downturn has been mild when compared to previous recessions. This is because the first leg of the recession was triggered by a drop in capital spending by business. The drop in business investment remains weak to this day. As the charts below show, outside of spending on equipment and software, there are still no signs of a business-led capital spending recovery.
Even the software and equipment spending numbers are suspect because of hedonic indexing which over-inflates actual spending. The hedonic increases may show up in the GDP numbers, but those actual dollars are not realized by anyone. The manufacturer of the product doesn't receive those dollars, nor do the retailers. In reality these are fictional dollars that don't exist anywhere outside the realm of statistical entries in some government economic ledger.
By injecting enough liquidity in the financial system, the Fed has been able to narrow the gap in interest rates between high and low quality debt.
However by lowering credit spreads, all that has been accomplished is that a lot of bankrupt or near-bankrupt companies have been given a temporary lease on life that will not last. This has prevented the liquidation of much of the 90's bubble boom and the malinvestments that went along with it from ever being liquidated. The result is that economies here and around the globe are still plagued by excess capacity contributing further to the deflationary effects of the credit bubble. The very act of preventing this liquidation prevents this excess capacity from ever being eliminated. This excess capacity then continues to exert pricing pressure on manufactured goods, reducing corporate profits as companies lack pricing power. Corporate profits are then reduced which prohibits a rebirth in capital spending. It also leads to further unemployment as more companies trim payroll costs in order to remain profitable and conserve cash flow.
This is why the worst is yet to come.
The economy will not recover as planned because any recovery is based on consumers continuing to add more debt in order to maintain consumption. The problem for the U.S. is that the majority of this consumption outside of housing is being spent on foreign goods. This doesn't help domestic manufacturers or businesses and contributes further to America's trade deficits. It is the exporting of America's credit bubble through our growing trade and current account deficits that is exporting deflation globally through excess credit and investment.
As America continues to buy more than what others buy from us, those exported dollars are then deposited into the banking systems of our trading partners, inflating their money supply leading to credit expansion and asset bubbles in those countries, i.e. Japan, Mexico, and Asia. In addition to creating bubble economies overseas, many of those countries are then redepositing those dollars back here in the U.S. helping to fuel asset bubbles here in stocks, bonds, mortgages and real estate.
The magnitudes of these deficits are staggering when you consider the cumulative trade deficit is over $3 trillion since 1983, the last year the U.S. ran a traded surplus. In the last three years alone, the trade deficit has grown by $1.2 trillion approaching 5% of GDP. At the present rate of growth it will shortly surpass 6% of GDP. Clearly this level is unsustainable.
It is now hoped that the depreciation of the dollar will help to correct America's growing trade and current account deficits. However, that hasn't happened as evidenced by the graph up above that shows the trade deficit is getting larger. The reason for this is the countries that we have the largest trade deficit with, such as China and Japan, aren't effected by the dollar's decline due to either the pegging of their currency (China), or intervention (Japan).
What is evident though is that America's consumption based trade deficits can’tgo on forever. The economy in the U.S remained positive in the U.S. during the first half of the year, thanks to consumer spending which now makes up the majority of U.S. GDP. Consumers continue to buy new cars, new homes, and other consumer type items that keep the economy from heading back into recession.
This consumption has been made possible by declining and low mortgage rates and rising housing prices. Overall consumer debt continues to grow at an annual rate of 10% as montage and credit card debt expands. Delinquency rates have stabilized except in the subprime market where they continue to escalate.
This growth in consumer borrowing is dependent on inflating asset bubbles and declining interest rates. However, as everyone well knows this trend can not continue indefinitely. Housing prices can not rise to the sky and mortgage rates can’tgo to zero. Even though mortgage and debt burdens don't look at that ominous despite their increase, it is only because they are compared to inflating asset values. There are growing signs that the consumer may be fast approaching the end of the line as evidenced by the increase in the savings rate and the decline in the wealth to income ratio as shown below.
As companies continue to struggle with excess capacity and a lack of pricing power the unemployment picture will worsen. This is starting to show up in the decrease in money velocity (see chart below) and the Fed is now considering moves to counter this trend from asset monetization to implanting some form of a carrying tax on money.
As more consumers lose their jobs, consumption in the economy will be reduced. Aggregate demand will be reduced with the coming retrenchment by the consumer while excess manufacturing capacity remains in place. As demand falls so will prices, which will result in more excess capacity and falling business profits. Falling profits and excess capacity will force businesses to lay off even more workers. This is going to lead to financial stress in the system and the next crisis which will take place in the financial sector, especially with GSE's and banks. Who do you think is making all of those mortgage loans?
The next leg of the recession is going to be driven by a retrenchment in consumer spending. When it hits, it will be that much more devastating because there is nothing the Fed can do to prevent it. Government spending will then be the only viable sector left in the economy to keep us from heading into a severe depression. There is nothing on the horizon globally that can replace the American consumer as an engine of economic growth.
Government is Alive and Well
Believe it or not, the only healthy sector left in the economy is the government. It is the only sector that can afford to spend money and run deficits. Despite all of the political rhetoric about deficits, they are still manageable when compared to the size of the economy.
Tax cuts aren't the problem.
A $350 billion tax cut over a ten year period is the equivalent of $35 billion a year in stimulus. This is not what is producing the large increase in the size of the government's deficit. A $35 billion tax cut must be compared to a $10 trillion annual economy and a $2 trillion annual government budget. The $35 billion is too small so its impact on the economy will be small. The tax cuts should have been much larger given the size of the economy and the size of the government's budget. It may be news to the majority of those who are in congress but a recession, anemic economic growth, and a rising unemployment rate is what is contributing to the big jump in the government's budget deficit. When a worker loses his job he impacts the government's deficit in two ways. The first impact of a new unemployed worker is that without a job he no longer is paying taxes. This reduces government tax revenues. The second impact to the budget deficit is that unemployment claims increase which means the government must now shell out more money while its revenue sources are diminished.
Tax revenues are also reduced when corporate profits decline as shown in the graph of profits below. It should also be understood as profits decline companies lay off more workers which further reduces tax revenues and increases government expenses even further. It becomes a vicious self feeding cycle as the credit bubble unwinds as all bubbles must.
What economic and fiscal policy has been able to do is keep the economy from going deeper into recession. This policy hasn't eliminated recessionary risks; it has just postponed them. In fact, by flooding the markets and financial system with money Fed policy has actually aggravated the situation and made it worse.
Lowering interest rates has helped to fuel a mortgage-housing-consumption bubble. It has also encouraged speculation in the financial markets. As interest rates head to zero investors have sought out higher yields in the junk bond markets.
Money has flown into the low grade corporate bond sector lowering the spread between high and low grade debt. This is allowing weak companies to refinance or add more debt which postpones the liquidation of the bubble economy's malinvestments. This, as I have already mentioned, keeps capacity utilization rates low contributing further to deflationary forces within the economy. This will render monetary policy ineffective. It is one reason why 13 rate cuts have failed to give us an enduring recovery. It is why it has been necessary to increase fiscal stimulus and reduce tax burdens even further. None of this will rectify matters because all credit bubbles eventually deflate, and I mean always with no exception. It remains now a matter of just how severe this coming correction will be and just exactly how bad policy response will be in trying to ameliorate the pain.
What is becoming increasingly clear after viewing Mr. Greenspan's testimony on capital hill is that neither the Fed Chairman nor congress understands the nature of the problem which continues to be too much credit in the system. The Fed believes the problem is that not enough credit or liquidity has been added to the system. This is clear from examining recent Fed speeches and research reports. (I recommend reading the Dallas Fed research paper from May of this year and the 1999 research report on our Fed site.) Current monetary thinking at the Fed is that more aggressive monetary stimulus is needed to combat deflationary forces in the economy.
The problem now for the Fed is that the economy is in danger of stalling again as industrial output declines. With interest rates close to zero conventional policy methods are losing their effectiveness. So the Fed is now actively studying unconventional policy methods from implementing a carrying tax on holding cash to monetizing assets. The "carrying tax" might be difficult to implement politically at the moment because things haven't got that bad yet. Essentially the carry tax would involve assessing a 1% tax per month on idle cash making the effective rate on holding cash a negative 12% per year. Recent Fed papers have cited a similar recommendation by a prominent 1930s economist, Irving Fisher. During the Great Depression as money velocity fell Fisher recommended implementing a tax on cash in order for it to maintain its status as legal tender.
The government already has the technology in place to implement such a program. The Fed admits putting such a policy in place over the next year may not be politically possible. But given where events are headed over the next decade this becomes a distinct policy option.
Other considerations include "dropping money from a helicopter" option. The Fed is considering actually purchasing real goods and services. Since its present charter does not allow for this it would have to coordinate this policy with fiscal policy makers. It would involve having the government purchase goods and services which it would finance with debt. The Fed would then buy that debt by printing money out of thin air. This is what is referred to as "monetizing debt."
Finally the Fed is also considering buying domestic securities. Various securities would become targets for open market operations. The Fed can implant this option today without having to coordinate its actions with others. Allowable securities for purchase are confined to government securities, bills of exchange and banker's acceptances. The Fed is prohibited from purchasing private assets shown in the box on the left. However, the Fed is pondering this option. It has even been suggested that it do so in FOMC meetings.
A recent paper even poses the question what would happen if assets in the "not allowed" column were moved over to the "allowed" category. Fed researchers point out that this isn't a moot possibility since certain emergency provisions in the Federal Reserve Act allow the Fed to sidestep restrictions in the case of an emergency. It has been strongly suggested by major newsprint publications in this country from the Washington Post to the New York Times that the Fed may actually be intervening in the markets at key trough levels or when selling has overwhelmed the markets such as last July. (See Dallas Fed report.)
These policy initiatives should not be ruled out or thought of as moot points. Interest rates are heading towards zero in this country and we have yet to experience a sustained economic recovery. Credit continues to flow into the financial system and in the economy creating further asset bubbles wherever that credit flows to and lands. We now have asset bubbles in stocks, bonds, real estate and mortgages. When the Fed talks about deflation it is referring to these asset bubbles. These inflated asset bubbles is all that stands between another debt and financial crisis and another depression in the U.S. The real danger now is that the failure of monetary stimulus to resurrect an economic recovery may cause the Fed out of hubris to overshoot monetary policy resulting in hyperinflation. There are no pleasant outcomes. We are heading towards debt deflation and depression or hyperinflation. The failure of Washington and Wall Street to understand the very nature and cause of this crisis is what is preventing us from effectively dealing with it. Meanwhile the bond market is telling us that there is trouble on the horizon. Barometric pressure is falling.
Back to reality as markets headed south again today. Mr. Bubble's testimony before the Senate failed to generate confidence in the stock market. The bond market recovered today after yesterday's one-day rout that sent bond yields soaring to 10-week highs. The yield on 10-year notes is once again approaching 4% while the 30-year bond is heading back towards 5%. Helping out today's bond market were comments by Mr. Bubbles that he hasn't completely ruled out plans to buy and monetize more government debt as a last ditch effort to ward off asset deflation.
Disappointing profit reports from Ford (earnings down 27% as sales decline) and Lucent. Lucent now says that it won't return back to profitability until some time in 2004. Although profits are up this year for the S&P 500 most of that profit is coming from the energy sector. The energy and financial sector is what is generating most of the profit. The Nasdaq 100 has yet to return back to profitability.
While profits this quarter are important, what companies are going to be saying about the second half of the year is even more important given the huge run up in stock prices since March. We're back to bubble like valuations based on a perfect outcome for the economy and profits. Profits will beat out estimates this quarter because expectations for this quarter have been so low. According to Thomsen Financial pro forma or CRAP, profits are expected to grow by 13 percent in Q3 and by 21 percent in Q4. However, stock valuations now border on the absurd with P/E multiples for the major indices running between 28-32. These numbers are probably understated today given the poor quality of today's earnings which don't account for all expenses.
On a positive note the recent run up in the Dow Transports suggest that a possible recovery is lastly approaching. Goods move on planes, trains, and trucks. And right now the Transports are moving suggesting a slight improvement in the months ahead.
Volume increased today to 1.66 billion on the NYSE. It hit 1.91 billion on the Nasdaq. Market breadth was negative by 22-10 on the NYSE and 18-14 on the Nasdaq. The VIX rose .45 to 22.29 and the VXN edged up .04 to 33.99.
Graphic source: Monetary Policy Report submitted to the Congress on July 15, 2003: Monetary Policy and The Economic Outlook and "Monetary Policy in a Zero-Interest-Rate Economy," Federal Reserve Bank of Dallas, May 2003. (pdf)
© 2003 James Puplava