“If you give a man a gun he can rob a bank; if you give man a bank he can rob the world.”
Last week, Jerome Powell, the chair of the Federal Reserve, announced at the Kansas City Fed’s annual Jackson Hole policy symposium, a major shift in how the central bank guides the economy, signaling it will continue to make job growth a focus and will not raise interest rates to guard against coming inflation. To emphasize the importance of a strong labor market the Fed will tolerate inflation past their 2 percent target. This could lead to long periods of low interest rates for mortgages and business loans to foster strong demand and a hope of a solid job market.
The Fed’s announcement signifies a critical change in how the central bank tries to achieve their twin goals of maximum employment and stable inflation. The Fed is now recognizing that too low inflation is now the problem and it will slow down any efforts to guard against inflation running too high. This seems like a subtle shift especially given the high employment levels of the pandemic era, however this really does signify a significant change and could indicate that Mr. Powell sees more problems ahead if inflation expectations continue below their 2 percent objective.
The Fed Has No Effect On Inflation
Something that I thought was surprising after the 2008 crisis was that even though interest rates had hit all time low levels, inflation continued to go down. Common economic thought was that low interest rates will eventually lead to higher inflation and that the Fed’s job would then be to raise interest rates to stop inflation from rising to high. Well what happen? The Banks happened. They refused to lend the money. Think about that period, during the housing boom Banks we more than eager to lend money to anyone and often were committing criminal loan fraud in many cases, i.e. remember your waiter telling you how she just bought 3 rental properties, worth more than your home. Now think about how hard is was to get a home loan after the financial crisis. The reason inflation went down after 2008 was the banks, who were still trying to clean up their balance sheets and didn’t want to lend money unless you had excellent credit. So essentially the banks’ were de-leveraging the US economy and the supply of money contracted leading to lower inflation also known as deflation. That’s why I say the Fed has no effect on inflation, only the banks and to some degree the government can truly create inflation, which I’ll describe later.
‘Show Me The Money’
“We will continue to use these powers forcefully, proactively, and aggressively until we are confident that we are solidly on the road to recovery. I would stress these are lending powers, not spending powers. “
– Jerome Powell, April 9th 2020 Federal Reserve Speech
So here we are, facing another economic crisis that could be worse than the financial crisis or even The Great Depression. As I mentioned before, The Fed has done their part, they lowered the Federal funds rate to zero, they even purchased individual corporate bonds and etfs to keep the corporate debt market from exploding. However in order for economic growth (spending) to occur we need the banks to start lending money at these low rates. The lending would need to happen at the main street level (small businesses) and not just at the corporate. All corporations have done lately is take out loans (issue bonds) to buy back their stock. One of the negative consequences of the financial crisis, is that banks have gotten out of the loan business, even mortgages. There is just too much risk to holding debt on their books, so if it’s not a loan that they can securitize and then sell to another entity or the government, they probably won’t do it. Rarely does the small business owner approach his or her local bank to ask for business a loan, and of the 11 trillion mortgage debt market Fannie and Freddie own about 7 trillion. The banks are just servicers. There lies the dilemma, the Fed wants to promote higher wages, more spending and higher prices, but they need the banks to do their part and lend money for actual spending to occur.
There is another way that we get spending to happen in the economy and that’s when the government spends money or gives money to people or organizations to spend. The government has already done some heavy lifting with the 2.2 Trillion Cares Act, which put money directly into the hands of individuals and businesses, and that money ultimately gets spent back into the economy. For the most part, this was necessary to prevent a collapse of the economy due to the coronavirus, however unless the government plans to do this type of stimulus package continuously then it’s likely not going to be enough to sufficiently move the economy in the right direction.
It Ain’t Over Til It’s Over
Many in the financial news would like to announce that we’ve already experienced an economic recovery and sight the fact that we’ve posted new stock market highs as evidence. That is far from the case and the bond market and current market for interest rates are telling you that this is far from over. It is my belief that interest rates will continue to fall, the stock market will go through waves of volatility, and economically we will be fighting a deflationary not inflationary battle for years to come. All the Fed is doing by announcing they won’t stand in the way of rising inflation is really telling to the world that they have just fired the biggest round of economic ammunition in history, they are effectively out of bullets, but they won’t stand in the way of whoever wants to fire the next round of bullets. It’s now up to the Banks and The Government.