God is a Capitalist

Thursday, February 26, 2015

Fed loses its mojo

The Dow hit another record high and the Japanese stock market rung the bell for a 15-year high this week following statements by Fed Chairman Janet Yellen before Congress that the she was losing patience. (Actually, she said the Fed would remove the word from its policy statement.) 

Both markets have been helped by the Big EZ's firing up its money presses. Much of the new issue of euros will swim the pond and dry out in the US stock market. Also, margin debt and debt by corps to buy back their own stocks are at record levels. 

But no matter how badly Jan would like to pull the trigger and kill her zero interest rate policy (ZIRP), she can’t raise rates for several reasons. First, everyone else in the world is printing faster than the Fed and causing the dollar to bulk up like a body builder on steroids. 90% of industrialized nations now have ZIRP. Any hint of a rate increase will cause the dollar to gain more weight and kill exports. 

Second, the economy isn't doing that well. Yes, unemployment is falling, but mainly because discouraged workers have been excluded from the count of unemployed. The labor force participation rate has not risen since the Great Recession. In fact, former Fed Chair Alan Greenspan said on CNBC recently that demand is very low, adding, 
The way I measure it, it's probably tantamount to what we saw in the later stages of the Great Depression.
The financial world has never seen such low interest rates like this in all of history because until recently the physical limits of gold and silver production prevented massive increases in money. Anyone who claims to know how this will shake out is crazy. But we have a couple of historical instances that are somewhat similar and could act as guides. Japan over the past 30 years has been stuck near ZIRP. As I wrote before here, that isn’t necessarily a bad thing. While it freaks out mainstream economists, the Japanese people have done well.

Another historical example is the recovery after the crash of 1929 in the US mentioned by Greenspan above. Though not ZIRP, interest rates were very low and the recovery was sluggish. Just as full recovery seemed possible, the bottom fell out and the economy crashed in 1937, even with very low interest rates. 

In the late 90's mainstream economists were proclaiming the death of the business cycle because they thought they understood the economy and the Fed could paper over any ditch in GDP that random shocks might dig. The recessions of 2001 and 2008 barely dented their hubris. I never thought I would see it but one of the top cheerleaders for printing money and inflation has admitted that monetary policy is not omnipotent. Scott Sumner wrote at Econlib,  
Demand stimulus can help reduce unemployment. It can also ease debt burdens. But that's pretty much all it can do. Unfortunately, many pundits are claiming that demand stimulus is some sort of magic potion, which can cure structural problems, boost productivity, increase labor force participation, etc. If we learned anything from the 1970s, it's that demand stimulus cannot solve supply-side problems.
Sumner is right. The ECB and IMF have also recognized that the problems in Japan, the Big EZ and the US are structural. Translated, that means they are micro problems, not macro. They are heavy regulations and high taxation. Micro issues, including the Ricardo Effect, will likely cause a recession soon, probably this year.   

Stock markets may continue to hit new records as central banks press on with ZIRP, but eventually the real, that is micro, economy will drag them down with it.

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