Federal Reserve Should Stay in its Lane!
This is the first of what I hope will be a weekly feature following a break for the Holidays. Rather than repeat the latest economic development, or analyze a recent Jerome Powell press conference, I plan to examine whether policy measures make sense and are consistent with economic theory. And if they are not, I shall discuss what the negative macroeconomic fallout may be. This first edition covers US Federal Reserve policy and how deviation from theoretical principles has resulted in distortions in markets and in the overall economy.
It all began with the central bank’s response to the Great Financial Crisis.
Having lowered the Federal Funds rate to near-zero by the end of 2008, Chairman Ben Bernanke and his colleagues were out of ammunition – or, at least that is what economic theory would suggest. However, the central bankers, in their collective wisdom, decided that increasing the balance sheet of the monetary institution was analogous to a reduction in interest rates in stimulating the economy. What happened? Annual growth in real gross domestic product was about a percentage point lower in the subsequent decade than during the first seven years of the 21st century. Wages rose barely in excess of inflation, and income inequality worsened. On the other hand, asset prices surged and equity prices soared.
Your income is low and, to supplement it, you depend mainly on bank interest income rather than stock market returns? Better luck next time! As our central bankers made up their monetary theory as they went along, post-2008 developments caused distortions that are still with us today.
A new opportunity for Fed activism came about with this year’s pandemic-caused recession. Not content even with a return to near-zero interest rates and a massive increase in its assets – both the steps undertaken after the 2008 crisis – the central bank entered new territory in 2020. Among the measures, it decided to purchase corporate bonds to support their prices. On May 12, it initiated purchases of exchange-traded funds (ETFs), in essence, raising the prices of securities included in the funds relative to those that were left out.
It is important to note that Fed action during the pandemic crisis went far beyond its traditional “Lender of Last Resort” role. Rather than come to the temporary rescue of one, or a few, enterprises, the new initiatives involved a broad-based entry into the private credit market. In doing so, the Fed distorted market prices because investors could no longer make decisions to buy and sell based on traditional criteria. Are there “fallen angels” – companies that fell to non-investment grade status – due to the covid crisis? No problem, the Fed will buy those bonds with freshly minted dollar bills!
Why allow the Federal Reserve to perform a task that would be the natural prerogative of the US Treasury? By disguising fiscal policy as a monetary measure, Treasury borrowings that would have otherwise increased yields can now be financed by new money creation. Indeed, this is one of the reasons why Treasury yields have continued to remain as low as they have been. Low bond yields have also resulted in a $2.5 trillion corporate borrowing binge in 2020, faster than profit growth, as discussed in this Financial Times article.
Private capital flows based on risk – return evaluation should not be replaced by investments resulting from government decisions. In addition to increasing the risk of political cronyism, such moves are likely to deter private investments. Which company will you invest in – a well-managed company with good earnings prospects, or one that the Fed is likely to favor?
These issues were especially relevant last weekend because it is the US Treasury’s refusal to continue to allow some Federal Reserve lending programs that had held up authorization of the much-needed $900 billion stimulus program, with assistance to the unemployed a key component. A compromise was reached, and aid will soon flow, but only at the cost having the Fed perform functions that will continue to affect market pricing and result in misallocation of resources.
Some food for thought as the Biden administration prepares to assume office, and the recession continues into 2021.
Dr. Komal Sri-Kumar
President, Sri-Kumar Global Strategies, Inc.
December 22, 2020
Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities. Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.
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