Michael Gentile, Editor-in-Chief, JHU
The Federal Reserve will soon unwind what remains of the economy’s savings. The Fed will begin selling $10B of assets each month and accelerate until that rate reaches $50B, and ultimately until they’ve shed about $2 trillion total. Economists expect the operation to “carry minimal market impact.”
Monetary policy has never been played at these stakes, except in 2008. In response to a plummet in household and corporate savings, the central bank’s balance sheet fattened to $4.5 trillion worth of government bonds and distressed mortgage-backed securities to, in turn, stimulate the economy. In that sense, quantitative tightening is not a new game but the second half, begun ten years later to sedate the economy.
So what’s the score? Though many pundits point to 4.2% unemployment, many others have considered our first half a failure. After all wage growth has been tepid and concentrated among few industries, and others—like retail—have witnessed its titans fall. These unconvinced others believe that dropping short- and long-term interest rates to zero, for as we long as we did, should’ve powered economic growth longer than it has. Truth be told, since quantitative easing ended in 2014, GDP growth has only surpassed 3% in three of the last eleven quarters, including our last.
Of course, best cases rarely test out, especially on the scenario’s first trial. That said, we don’t yet know if we’re living in a worst case. With a spending spree of such scale, the unemployment rate had to fall. Just because we’ve matched pre-crisis lows doesn’t diminish the $4.5 trillion allowance we needed to get there. In the short-term—yes, ten years can be short-term—risks of stimulus are tenuous.
Ten years later, tightening rates higher and the Fed’s way back down present as many unknowns and opportunities for mistake. But this time, we can at best slow the economy and at worst submerge again into crisis. Viewing the macroeconomy through the lens of national savings best shows how much more slippery our slope is today.
Through this lens, bond buying is an act of saving. Typically, savings don’t stuff mattresses but are borrowed and invested by companies and governments in this way. If borrowers don’t want to invest, they offer interest rates low enough that people won’t want to save, and vice-versa if they do. However, in the Great Recession, many borrowers lost their lenders’ savings and discouraged savings further. Net national savings— what’s left after companies pay dividends and after governments and households pay their bills— even went negative.
By buying government bonds, the Federal Reserve lent the country this shortfall and much more, funding federal bailouts and keeping the lights on while we hopefully regained our footing. But these past two years, while the Fed has tapered its spending, net savings has fallen in line with national growth to only $355B. Households and companies never recovered.
That said, we assume the Fed knows that selling an average of $30B of bonds a month would exhaust our savings base within a year; that they also expect the budget deficit to widen by $100-150B before 2019, per today’s administration.
For their math to add up, the Fed must be assuming a tax cut that’ll get consumers’ savings out of bed. The president’s most recent proposition allows businesses to write off capital depreciation at the time of investment. In short, while firms have traditionally paid a fraction less in taxes each year—on account of their equipment aging and losing value—they can now claim those deductions all at once, freeing current cash. Firms will invest and borrow at higher interest rates to seize this discounted cost of capital and, in doing so, incentivize household savings.
Though the GOP presents healthcare reform as a necessary step toward Trump’s tax plan, the timeframes of these policies differ widely and suggest a reversal in order. The tax plan’s immediacy favors the gridlock of American politics, in which the GOP has stalled beyond Obamacare’s repeal. It also fits the Fed’s narrative of interest rate normalization—perhaps too well to be plausible, or incidental.
Markets have priced the odds of a December rate hike at 75%. By increasing rates, the Fed will directly reduce the economy’s money supply, borrowing, and growth, despite the US’s first monthly decline in jobs since 2010. Such a backdrop steepens the “worst case” scenario of current monetary policy and asks how much money we can afford to pull from the American economy.
That said, the Fed’s support of higher risk-free rates would buoy risky corporate rates even higher. In doing so, the Fed may be coercing households to save more, to sacrifice a temporary slowdown for a future system flush with diverse savings—instead of just theirs—as well as tax advantaged investment.
For a compromise so substantial, the Fed’s conviction to raise rates seems rather recent. Such haste may have resulted from Trump’s looming replacement of Fed Chair Janet Yellen; he’s set to decide by month’s end. Though the President hasn’t ruled out Yellen’s reappointment, his shortlist of candidates features many lead-footed inflation fighters who’ve spurned the Fed’s past indecisiveness.
As such, the last decisions of Yellen’s term may intend to show the president that she can play ball. By feigning her dedication to raising rates today, she can secure her position and moderate her stance later on. As opposed to newcomers who may be naive of the scale of quantitative tightening, Yellen may better adapt to its high-risk developments once the operation is underway.
The president’s past selection blunders may have also inspired this nudge. The strength of the Federal Reserve is its impartiality from political influence and, though Yellen may have fallen victim to such interests of late, cronyism between a President and Chair could lead the Fed to ignore rampant overexpansion. A replacement, reminiscent of Trump’s other nepotistic selections, may one day prioritze the administration’s short-term approval over sustainable risk management.
Nonetheless, even impartial monetary policy has its reputation of costly errors. In 2011, the European Central Bank raised interest rates in fear of runaway inflation—owing much to Germany’s historic episodes—and held their benchmark above zero for three years longer than the Fed did. ECB chief Jean-Claude Trichet had unsuspectingly slowed the European economy during its deepest stagnation since the 1930’s. Europe’s recovery, in turn, was postponed even longer than three years.
In Trichet’s case, optimism was wrong. Households hadn’t regained enough confidence to save and thus couldn’t benefit off of the borrowers Trichet had pained by lifting interest rates. By failing to recognize the impairment of equilibrium-seeking mechanisms, which typically offset central bank impacts, the ECB unilaterally hurt companies and governments. Not only were there less and less savings for them to borrow, but they also had to pay more on what they already had. Bonds across Europe’s economy imploded, and consumers’ savings receded further and so on.
If today is such a trap, then no tax cut will persuade consumers and households to share the government’s savings. Rather, by selling government bonds into an unfavorable market, the Fed risks devaluing American debt. As today’s risk-free benchmark across global markets, treasury bonds stand to lose years of gains before risk is priced back in. Even those who have saved these past two years, if others don’t answer the bell, will face losses having done so.
To add insult, less saving also sparks stock market selloffs. The very formula used to calculate stock prices inputs interest rates in its denominator. If our savings drop enough and rates go up, the S&P 500’s recent records can only go up in smoke.
No matter the blood that follows—and oh, blood matters—the Fed’s got a really, really hard problem on its hands. Unless households buy the bonds the Fed will sell, Janet Yellen will have made a mistake. Unless Trump’s tax cut incentivizes companies to borrow at higher rates, the next Fed Chair will never have the chance to make a mistake. And unless the Fed has modeled these variables, we’ve already made a mistake—a mistake bound to hurt the United States’ debt and equity.
As the first officials to ever face such a problem, this era’s Fed Chairs cannot expect the best case. But if they don’t respect the worst case, memories of the way up will fade only a tenth of the way down. And if politics has any hand in our discretion, our way down will steepen until there’s no cash left to stand on. And then, maybe we’ll realize how quickly $4.5 trillion can disappear.