Outlook Worsened: Negative Rates from the Federal Reserve? Really?

Federal Reserve Janet Yellen
On 4 November 2015, Janet Yellen purported that the Federal Open Market Committee (FOMC) would be willing to lower the federal funds rate into negative territory if US economic conditions deteriorated further.

The United States faces many problems — a massive welfare state, complicated tax code, oversized government, over-regulated economy, and bloated education system. After a flurry of astigmatic regulation designed to promote home affordability created a $4 trillion housing bubble and ensuing financial crisis, most would hope that a nation as powerful as the US would finally get its act together. That pretence was simply false.

Since 16 December 2008, the FOMC has maintained a policy of 0% interest rates on federal funds, overnight funds traded between banks to maintain their deposits at the Fed. This was aimed to push interest rates far below Wicksellian (equilibrium) level and create another asset bubble. While this would result in another recession after a burst, the Fed has not been an organisation known to be concerned with long-term stability since the passage of the mandates set forth in the Federal Reserve Reform Act of 1977.

In addition, the FOMC maintained a policy of quantitative easing from 2008 to 2014. The policy  administered $3.5 trillion in asset purchases in the secondary market, with a goal of suppressing yields on government bonds to shift the allocations in investors’ portfolios to riskier assets such as stocks. Considering that the DJIA has more than doubled since the end of the financial crisis, QE clearly served its purpose in securities markets. In another respect, however, the program failed tremendously.

This current expansion is the slowest in the entire economic history of the United States. GDP growth has averaged 2.2% since the end of the financial crisis, far below the 1949-2007 long-term average of 3.25%. Wage growth is completely anaemic, with virtually no inflation-adjusted growth in the past six years. Government spending is approximately 40% of GDP and the country faces a regulatory burden of 12% of GDP. Despite all of these negative factors, both the Obama administration and Federal Reserve have attempted to convince the populace that the US economy is performing at an “optimal” level.

In recent months, however, many investors and consumers alike have started to discern the blatant attempts at misinformation. Equities markets are completely flat in 2015 so far and reports in consumer confidence are consistently falling. After the announcement that the US economy grew just 1.3% in the third quarter of 2015, the Federal Reserve itself began to shed its attitude of confidence and false optimism.

In the last FOMC meeting on 28 October, Narayana Kocherlakota, the President of the Federal Reserve Bank of Minneapolis, projected negative rates in the future. Many disregarded this as a deranged prediction from Kocherlakota, who is known for making erroneous statements on future monetary policy. On 4 November 2015, Janet Yellen, Chair of the Federal Reserve, claimed that the federal funds rates could be lowered to negative territory “if outlook worsened”. The radical fringe has suddenly become the voice of prophecy.

That same day, William C. Dudley, the President of the Federal Reserve Bank of New York, stated in an interview that “some of the experiences [in Europe] suggest maybe can we use negative interest rates and the costs aren’t as great as you anticipate,” referring to the disastrous negative interest rate policy set forth by the European Central Bank. Mario Draghi, the President of the European Central Bank, hinted that rates could be lowered further if the condition of Europe’s economic condition somehow gets even worse.

The harsh truth that has emerged since the end of the financial crisis is that expansionary monetary policy does not lead to higher economic growth in the sustainable sense. Expansion of the money supply and artificially lowering interest rates only serve to create an asset bubble, which is present in the US, Canada, and Europe. Negative interest rates will only make this conundrum even more difficult to rectify after the respective bubble bursts. Instead of focusing on short-term shortcuts that lead to economic malaise in the future, the West should begin fixing its long-term problems.

Dodd-Frank and the Status of Financial Regulation in Post-Crisis United States

WASHINGTON - JULY 21: U.S. President Barack Obama signs the Dodd-Frank Wall Street Reform and Consumer Protection Act at the Ronald Reagan Building July 21, 2010 in Washington, DC. The bill is the strongest financial reform legislation since the Great Depression and also creates a consumer protection bureau that oversees banks on mortgage lending and credit card practices. Also pictured (L-R) are Vice President Joe Biden, Speaker of the House Nancy Pelosi (D-CA), Senate Majority Leader Harry Reid (D-NV), Rep. Maxine Waters (D-CA), Sen. Chris Dodd (D-CT) and Rep. Barney Frank (D-MA). Photo by OwenDB/Black Star***
Barack Obama, depicted, signed the Dodd-Frank Wall Street Reform and Consumer Protection Act at the Ronald Reagan Building on 21 July 2010. Since its passage five years ago, the results have ranged from “massive disappointment” to “complete disaster”.

When nations misdiagnose the causes of a particular problem, the proposed solutions often lead to negative unintended consequences. The most famous example of this is the Great Depression, when a series of government programs aimed at stimulating aggregate demand turned a sharp market correction into a 17-year downturn. One can fast forward 70 years to find the same trend presenting itself once again. Overregulation of the mortgage industry starting in 1992,  implementation of Basel II reserve ratio requirements in 2004, and expansionary monetary policy from the Federal Reserve starting in 2001 all joined to produce a housing bubble sized at $10 trillion that popped in 2008, causing a contraction in US GDP by 4.3%.

A pragmatic policy maker views these causes and seeks to mitigate them in the future.  The Consumer Protection and Regulatory Enhancement Act, introduced by Spencer Bachus III and sponsored by many Republicans, sought to change the role of the Federal Reserve to focus on price stability and revoke the federal charters of Fannie Mae and Freddie Mac, government-sponsored enterprises which underwrote many subprime mortgages to enforce the aforementioned federal regulations. The proposal rectified two of the three major issues that caused the housing bubble in the first place. Unfortunately, the bill did not pass, as left-wing politicians saw the crisis as an opportunity to consolidate power in government. They blamed the crisis on “reckless deregulation”, when the opposite actually occurred.

Two prominent Senators, Chris Dodd and Barney Frank, introduced the Dodd-Frank Wall Street Reform and Consumer Protection Act on 2 December 2009, which currently serves as the largest government intervention in the financial industry since the Banking Act of 1933. The law radically changed the regulations for financial institutions and derivatives trading. While Dodd-Frank was implemented to increase market stability and minimise systemic risk, the result has been the opposite.

The most noticeable rule in the juggernaut among consumers is known as the Durbin amendment, which places price controls on the fee that retailers pay when customers utilise a debit card. This has triggered a shift in the cost to maintain payment card systems from retailers to consumers. Before the law was passed, 76% of all banking accounts were eligible for complimentary checking. Due to the rule, only 38% qualified in 2014. The Durbin amendment has contributed to a growing crisis of unbanked populations in the United States, with an estimated 10 million households resorting to costly checking cashing and payday loan facilities.

One agency created by the law is the Financial Stability Oversight Council (FSOC), which claims to implement regulation to decrease systemic risk in the market. In the FSOC’s 2015 Annual Report, the majority of the major risks outlined are the result of either Dodd-Frank itself or misinformed government policy. The most prominent delineation is the lack of “housing finance reform”. In a case of disturbing cognitive dissonance, the FSOC praises Fannie Mae and Freddie Mac for again providing affordable housing, however it also harshly criticises an increased level of mortgage industry risk. At the very least, the report does finally admit that the liquidity support programs dispersed in the Emergency Economic Stabilisation Act of 2008 has led to a rise in moral hazard. Other than that isolated statement, however, the FSOC has only created another burden in the finance industry without providing any actual benefit.

Another mess is the regulatory environment governing systemically important financial institutions (SIFIs). If a firm is found to be integral to the function of the US financial system (“too-big-to-fail”), then the FSOC will implement capital, leverage, and liquidity requirements. While originally intended for banks, the scope of the regulations has already expanded to include AIG, GE Capital, and Prudential Financial. To make matters even worse, the Council is also considering the inclusion of mutual fund firms such as BlackRock, Fidelity and PIMCO. These burdens have greatly increased inefficiency to the point that MetLife, another firm awaiting SIFI designation, has filed several lawsuits and GE Capital is in the process of a spinoff to decrease inhibiting levels of overhead.

The most important rule, and perhaps the most infamous, is the Volcker rule, which places a ban on proprietary trading by financial institutions. The rule is not just misguided. It will serve as a catalyst for the next financial crisis. Bank analysts and even some regulators have become increasingly concerned with a lack of liquidity in fixed-income asset markets, particularly that of corporate bonds. This has already resulted in a surge in market volatility, demonstrated by the upward trend of the the VIX over the past several months. This instability can quickly place global markets in a quagmire when the current US equity bubble bursts.

As stated in previous posts, the next financial crisis should be an opportunity for sound regulatory reform, not a window of cheap political gain. When it hits, regulators will first blame financial markets and demand more control over them. Based on this current set of laws, the United States will need to learn its lesson, as it clearly failed to do so after the 2000s housing bubble. The push for government consolidation of markets must be resisted and replaced with a policy that promotes long-term economic stability.

Overinflated and Bursting: Growth Prospects of the US, China, and Global Trade

The port of Singapore is the world's largest transshipment port. Global trade growth is projected to clock in at 3.2% in 2015, the worst performance since the Great Recession.
The port of Singapore, depicted, is the world’s largest transshipment port. Global trade growth is projected to clock in at 3.2% in 2015, the worst performance since the Great Recession.

The International Monetary Fund has again cut its forecast for global GDP growth in its World Economic Outlook, which is now only 3.1%, a decrease of 30 bps from 2014. This is during a time in which the vast majority of the world’s central banks have lowered their discount rate, with some even adopting NIRP. To complicate matters even more, the European Central Bank is in the process of massive quantitative easing program, while the Bank of Japan is anticipated to resume theirs towards the end of October.

This week global growth is based almost solely on asset bubbles created by the economic distortions of central banks. The Federal Reserve in the United States is perhaps the most infamous example, when it purchased $3.7 trillion in securities through open market operations in three rounds of QE from 2009 to 2014. Equity markets in the US are still in this bubble, albeit without quantitative easing, the bull market is beginning to reflect signs of subsiding.

The fundamentals of the US economy are disturbingly weak during this expansion, leaving many to wonder if the Federal Reserve will raise the federal funds rate in the next FOMC meeting. PCE is currently at 0.3% on an annualised basis, far below the level the Fed would consider optimal for raising rates. The latest BLS report was an abject disappointment with only 142,000 jobs added in September and labour force participation diving to a 38-year low of 62.4%. Considering these reports, it is unlikely that a rate hike will occur, however if it does, it will most likely be a small 25 bps, which could place this current bubble in jeopardy.

Projections from the IMF report peg US GDP growth at 2.6% in 2014. This will be strenuously difficult to achieve, as the latest data from the Federal Reserve Bank of Atlanta’s GDPNow index nowcast third quarter growth at 0.9% annualised, combined with 0.6% in Q1 and 3.9% in Q2.

A large feature of the WEO focuses on the state of the Chinese economy. The nation recently underwent the correction of a bubble in the equity market, which quickly prompted liquidity support and trading restrictions from the People’s Bank of China and China Securities Regulatory Commission, respectively. Despite these measures, the Shanghai Composite rests at just over 3,000 at 6 October market closing, equal to the trough evident in late August. Li Keqiang stated on 10 September that the PBOC will not begin a quantitative easing program, which signifies that the Communist Party has finally obtained an elementary level of competence. Due to this burst and subsequent slowdown, the report projects Chinese GDP to grow at under 7% in 2015, the rate long regarded as a technical support.

The highlight of the WEO also the most depressing inclusion. Global trade, which is less affected by myopic actions of central banks, is predicted to grow at only 3.4% in 2015. This level is the lowest seen since the end of the financial crisis of 2008-09 and is unconventionally low during an economic expansion. Global trade has grown significantly faster than other components of the world economy due to increasing levels of globalisation. Growth rates this low reflect that GDP growth is propped up only by central banks.

Despite the plead of many economists, global central banks have continued easing their monetary policy, the only exception being the Reserve Bank of India, and have produced asset bubbles combined with economic stagnation as a result. Many problems facing the world economy, ranging from overregulation to high welfare spending to a lack of property rights, will not be rectified, as the motives for reform are greatly inhibited by the constant cycles promulgated by central banks. While another financial crisis is not the most desirable outcome, it is the only way to restore the proper function of price discovery and create a pathway for policy reform, both from central bank and government.

ECB Goes All In with QE

On 5 March 2015, European Central Bank President Mario Draghi announced a €1 trillion quantitative easing program, allocating €60 billion in monthly security purchases until September 2016.
On 5 March 2015, European Central Bank President Mario Draghi announced a €1 trillion quantitative easing program, allocating €60 billion in monthly security purchases until September 2016.

After deciding earlier this morning to keep the discount rate at a record low 0.05%, Mario Draghi, the President of the European Central Bank, announced a quantitative easing programs of sovereign treasury notes, mortgage-backed securities, and covered bonds. The QE program will begin on 9 March with €60 billion of asset purchases until September 2016, totaling €1 trillion ($1.1 trillion). The program will purchase bonds with a negative coupon as long as the rate is not below the ECB’s deposit rate, which is -0.2%, but will not buy more than a 25% share of a bond issue to prevent the ECB from having a blocking majority in case of debt restructuring.

While this sort of economic stimulus failed in the United States with the Federal Reserve’s $3.5 trillion program, the ECB believes that expanding the money supply to increase the Harmonised Index of Consumer Prices, the Eurozone’s inflation indicator, will spur economic growth to a “prosperous level”, which Draghi describes as 1.5% annual GDP growth.

Even though the new 1.5% growth projection for 2015 is abysmal at best, it isn’t certain that the European Union will even achieve that. China, the EU’s largest trading partner, has lowered its GDP growth forecast to 7% for 2015 amid fears of a real estate bubble burst. Additionally, the possibility of a “Grexit”, or Greek exit from the Eurozone, would send Europe into an economic spiral, undermining the viability of the Euro. As stated in previous articles, none of the major problems facing the EU, such as inefficient state-owned enterprises, high tax rates, excessive regulation, and insolvent pension systems, are being rectified by national governments or the EU at-large. As a result, it should not surprise many that the region has difficulty achieving 1.5% growth despite €60 billion a month of asset purchases.

Perhaps the most depressing part of the ECB meeting earlier today were the HICP projections. While the 2015 inflation forecast was lowered to 0% from 0.7% in the December 2014 report, the 2016 forecast was raised from 1.3% to 1.5%. Why did these trends so in opposite directions? Draghi and other members of the ECB’s Executive Board are hoping that “an increase in oil prices will raise inflation to a sustainable level”. The ECB is betting the entire QE program on the prediction that OPEC’s hesitance to cut production will collapse the US shale industry, which can avoid default and liquidation despite a negative cash flow due to extra liquidity in global markets due to QE.

This leaves the question: has the European Central Bank turned into a complete joke? In the same QE announcement, the central bank said that its intention is to be market-neutral, with the hope of creating as little “distortion” as possible. If the ECB would abide by their own claims, the state of the European economy would be nearing a “prosperous level”.

Tsipras, Varoufakis, and the Schäublegang: Pension Crisis Edition

Varoufakis and Schäuble met on 27 February to negotiate a bailout extension for Greece, a nation that already has 360 billion Euros in debt.
Yanis Varoufakis and Wolfgang Schäuble, the finance ministers of Greece and Germany, respectively, met on 27 February to negotiate a bailout extension for Greece, which already has 240 billion euros in debt.

Another day, another chapter in the ongoing Greek debt crisis. While Greece’s T-bill action earlier today was a success, the yield on Greek treasury securities reached an 11-month high of 2.97%, compared to 2.75% on the last auction in February. Another issue of contention is that 262.5 million euros were non-competitive bids, mostly comprised of funds from Greek Social Security accounts.

Concerns over a Greek exit from the Eurozone (so-called “Grexit”) peaked in late February during the Troika-Greek debt negotiation showdown. Yanis Varoufakis, the finance minister of Greece, eventually struck a deal with the Eurogroup. Many in the Bundestag were hesitant to pass the bailout extension, while many in Greece were angry at the SYRIZA Party for reneging on pre-election promises. Despite the opposition in Germany to the extension, German finance minister Wolfgang Schäuble pleaded that “we Germans should do everything possible to keep Europe together as much as we can.” Greece’s exit for the euro could cause major problems for other Eurozone members by undermining the credibility of the euro.

In the past month, many issues have rose from changes in bailout programs between the Troika and Greek government. Since 2010, the European Central Bank has accepted Greek junk bonds and related securities as collateral from banks to assist refinancing operations as long as the Greek government continues fiscal reform and austerity measures. This program ended on 4 February 2015, causing disarray and worry within the Greek banking system. To quell concerns, the ECB extended to scope of its Emergency Liquidity Assistance program to Greek banks to 65 billion euros. The last tranche of bailout from the ECB of 7.2 billion euros requires that Greece meet new budgetary requirements before the assistance is paid out.

The current crisis in Greece originates from poor government policy over the past several decades. A stringent regulatory structure discourages business formation and investment. While this is a major problem across the Western world, it contributes massive weight to Greek economic malaise. Inefficient state-owned enterprises produce poor services whilst adding to budgetary deficits. Conflicting laws in the country’s legal system discourages business production through ill-conceived prosecutions. High taxes on the wealthy have encouraged capital flight and tax evasion, reducing Greek tax receipts.

In order to expiate the debt crisis situation, Greece needs to adopt a hands-off approach to economic management through privatization, deregulation, and a streamlined tax and legal system. Tsipras and Parliament cannot pay off the 240 billion euros in government debt through tax hikes or penalties. The Greek economy needs a period of economic prosperity in order to extend Treasury reserves. While this goal seems impossible at the moment, many nations, such as Vietnam and India, have utilized successful economic reform to their advantage.

NASDAQ 5,000: Are We In Another Bubble?

The NASDAQ 5000 has increased exponentially since the trough of the Great Recession despite low economic growth, leading to the consensus that Fed policy has created another asset bubble.
The NASDAQ Composite has increased exponentially since the trough of the Great Recession despite low economic growth, leading to the consensus that Fed policy has created another asset bubble. Many bull market economists dispute this view, mirroring thoughts during the height of the dot-com bubble.

Given the poor economic performance of the United States in recent years, it surprises many that the NASDAQ Composite has nearly returned to its highs during the dot-com era, which was the longest economic expansion in US history. This regained milestone also poses another question: is the US economy currently experiencing a market bubble?

The March 1991 to March 2001 economic expansion was the longest and largest of any in United States history. US GDP grew at above 4% annually in 1997 (4.5%), 1998 (4.5%), 1999 (4.8%), and 2000 (4.1%). The NASDAQ Composite reached an intraday high of 5132.52 on 10 March 2000, before diving to 1108.49 on 18 October 2002. The combination of the failure of FCC-mandated CLECs, burst of the dot-com bubble, and a flurry of accounting scandals (Tyco, WorldCom, Enron) weighed heavily on the technology-dominated index.

It should not shock many that the US’s economic performance is more dismal than during the dot-com boom. GDP growth was 2.4% in 2014, and has never reached above 3% since the Great Recession. Despite this, the massive accumulation of corporate debt in recent years (especially in the technology sector) mirrors the same trend during the financial crisis. Overvaluations and high price-to-earnings ratios concern many economists.

Peter Schiff, CEO of Euro Pacific Capital, voiced that Uber’s latest $41 billion “valuation is absurd. And there’s a lot of companies like Uber that are sporting these billion-dollar market caps.”  Wild overvaluations are not the only symptom of the current bubble. There’s been a major move to more speculative investments due to low interest rates. This is evidenced by the recent rise in stock buybacks that public companies have facilitated. After accounting for inflation, many savings accounts, certificates of deposit, and Treasury securities generate negative real returns. This will later end in financial capitulation, or flight to quality, as traders will be forced to expunge riskier assets from their portfolio after the bubble bursts.

The Federal Reserve’s $3.7 trillion quantitate easing program was aimed to stimulate investment after the Great Recession by purchasing bank debt, mortgage-backed securities, and Treasury notes. QE has clearly pushed up asset prices above equilibrium levels, causing massive amounts of malinvestment in the economy. The Fed’s only option is to facilitate a discount rate increase within the next year, thus bursting the current bubble.

Economic conditions revolve less around timing of interest rate increases than Fed response to the ensuing financial crisis due to cash flow management difficulties that arise from an increase in debt service costs, among other results aforementioned. My worry is that the FOMC will use the downturn to begin QE4, creating another asset bubble. Poor policy by the Fed in recent years has made many reconsider the central bank’s role in the economy, for better or worse. Perhaps optimal monetary policy will one day set the stage for solid, real economic growth.

Restructuring the Fed

Jerome Powell speaking at an FOMC meeting
Jerome Powell, the only Republican governor on the Federal Reserve Board, has rightly claimed that a Fed audit would be “in violent conflict with the facts”.

Spearheaded by financial reformers such as Rand Paul, the movement to audit the Federal Reserve’s conduct has grown in recent years. One current proposal would subject the Fed’s monetary policy to Government Accountability Office audits. While this is aimed to prevent the creation of asset bubbles that we’ve seen from late-Greenspan, Bernanke, and Yellen, it poses additional problems for the US’s financial system.

Jerome Powell, the only Republican currently serving as a Federal Reserve Board governor, gave a speech on 9 February, expressing worry that an audit would produce “substantial risk of political interference”. Considering the atrocious left-wing, expansionary movement the Fed has made since Greenspan’s exit (QE and ZIRP), further politicization of central bank policy should be avoided at all costs. Powell added that Fed policy is most effective when “rendered independent of influence by elected officials”.

This false panacea does nothing to solve the structural problems that the Fed faces. Dallas Fed Chairman Richard Fisher argued that the Fed was “audited out the Wazoo”. While his statement isn’t entirely accurate as outside institutions have no direct control over the Fed’s open market operations, some truth lies in the claim. The Federal Reserve Reform Act of 1977 forced the central bank to “promote maximum employment, production, and price stability”, establishing direct policy objectives  for the first time. Since then, interest rate policy has become unstable in order to achieve these goals, often causing financial crises.

Aside from the poor policy decisions, which can only be repaired through the appointment of rational governors to the FRB, many structural problems exist within the Federal Reserve System. Many market analysts believe that too much power rests with the New York Fed. Assets and transfer volume are fragmented throughout each of the system’s 12 regional banks. Decreasing the number of banks to six (New York, Dallas, San Francisco, Saint Louis, Atlanta, and Chicago) would concentrate these indicators and decrease the relative power of the New York Fed. After the unsightly burden that Dodd-Frank placed on smaller financial institutions, a reduced number of regional banks could redirect their conduct to verifying the transactions of the largest holding companies, which are typically based in the six aforementioned cities.

To further inhibit the political implications placed on the Fed, the Presidents of the six regional banks should be given permanent Federal Open Market Committee voting power. Consolidation of the regional banks and new power in the FOMC will dramatically increase efficiency of the Federal Reserve System’s objectives. The new voting seats also bring a variety of views, notably that of Saint Louis Fed President James Bullard, who warned that failure to increase the federal funds rate would create “some risk” and other options would be “resolved in a violent way”.

Those that advocate abolition of the Federal Reserve fail to realize two key points. When a country has a nationalized currency, like the United States, a central bank is needed to ensure the limited stability of the currency. Combined with a fractional reserve banking system, a central bank provides liquidity to financial institutions.  Privatization of the world’s currencies is the best option of reform, however this is politically impossible for at least the next two decades. In the meantime, the Federal Reserve needs to be operating in the most efficient manner in order to ensure proper function of financial markets.