The Federal Open Market Committee, in its latest meeting Wednesday, reiterated the same message to spellbound investors that’s been in place the last eight years: The Fed is committed to maintaining a massive balance sheet through bond buying, but someday that balance sheet and near-zero interest rates will revert to normal levels.
That someday is the most powerful single risk investors have faced since 2008 — not overregulation, not higher taxes, not foreign competition. It explains why the recovery has been so slow: the economy is in a liquidity trap. The Fed holds the power to sell back onto the market the $3 trillion in Treasury and mortgage-backed securities it acquired during and since the financial crisis through quantitative easing. It can start on that “in 15 minutes,” as now former Fed Chairman Ben Bernanke once told “60 Minutes.”
Until then, investors have had to remain liquid enough to absorb the Fed’s selloff, or risk a bond market collapse should the Fed be forced to unload at big losses. The $3 trillion in new money created by the Fed through its balance sheet expansion has been funneled into stocks, bonds, and hard assets like gold and cash rather than riskier, illiquid investments in small businesses and entrepreneurs that generate the highest returns. Those liquid investments better match the Fed’s portfolio of super-safe, long-dated debt.
Economist David Malpass, an adviser to the presidential transition team of Donald Trump, calculated that from 2010-2015, credit to the government and corporations grew by 37 percent and 32 percent, respectively, but credit to small businesses and households grew just 6 percent. Small borrowers, the lifeblood of the economy, have been left behind in favor of large and safe recipients of capital.
As money has been sidelined from high-growth activity, conditions have deteriorated. Gross domestic product won’t expand past 2 percent a year. Annual productivity growth since 2009 is just half a percentage point after clocking in at 2.5 percent per year the prior two decades. The labor participation rate has declined by 5 percentage points, well below the aging-related decline that demographers projected. Velocity – the number of times the money supply is used in one year – typically rises during expansions. In this one it’s at its lowest level in the more than 50 years of Fed record-keeping.
This situation is alarming but not shocking. Research on liquidity traps finds that temporary monetary injections by the central bank do not translate into economic growth. People make economic decisions based on permanent expectations and therefore discount transitory conditions, including the size of the money supply. The fact that inflation has not surged – to hawkish Fed critics’ surprise – even though the monetary base has quadrupled demonstrates this.
What can the Fed do now to get the economy out of the liquidity trap it created?
Fed Chair Janet Yellen and her colleagues indicated at the Jackson Hole conference that they could make the balance sheet size permanent. Bernanke, who participated at Jackson Hole for the first time since stepping down from the Fed, afterward on his blog prodded Yellen and company to take up this Never Normalize route.
But making the massive balance sheet permanent would likely trigger an outcome Bernanke doesn’t acknowledge: high inflation. The money supply would inundate the entire economy, rather than just single sectors like stocks, and put enormous pressure on consumer prices. Yellen, like many of her contemporaries, is a believer in the Phillips Curve and its logic that economic growth requires inflation.
Full article: The Fed Has the Economy in a Liquidity Trap (Morning Consult)