The Good, the Bad and the Ugly of Federal Reserve Rescues
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Rescues by the Federal Reserve and aggressive monetary policies have helped stock and bond investors, but the degree of money printing will be paid for by future generations.
The Federal Reserve (Fed) rescued the economy from total collapse in 2008. Now it’s stepping up again to rescue victims of the current pandemic. The Fed is our hero, but before we order that Superman cape, we need to be aware that there are costs that we all will pay for those rescues. Ambulances do not show up for free. As shown in the following picture, the Fed rescued us from recessions, but the money printing will lead to inflation.
It’s complicated, and many will not agree with my concerns, which is good – let’s discuss.
2008 financial crisis
Due to the housing loan crisis, the gears of the economy locked up heading to a total collapse in 2008. The Fed came to the rescue with quantitative easing (QE) that pumped $4 trillion into the economy and created the longest bull market ever in stocks. We had a quick recovery from a recession and market crash.
In addition to the catastrophic loss of human life, the COVID-19 pandemic has crippled many industries and put millions out of work. People are struggling to buy groceries and pay their bills. Enter the federal government with $3 trillion of relief in 2020 and another $3 trillion coming in 2021, most of it in “helicopter money” sent to almost everyone. This humanitarian relief is much needed; that’s the “good.”
The Fed has manipulated short-term interest rates to their lowest levels ever. This has increased stock prices and made borrowing attractive, especially for share buy-backs and home mortgages. What could go wrong?Source: 361 Capital
2008 financial crisis
The “solution” to the 2008 crisis had its roots in modern monetary theory (MMT) that advocates aggressive fiscal and monetary policies to grease the economy but cautions that those efforts need to be reversed if and when inflation builds. The reversal mechanism is taxes. Do you think there’s political will for large tax increases?
QE has caused inflation, but not in the traditional manner that shows up in the consumer price index (CPI). Instead, we’ve had what some call “asset-price inflation” in stock and bond prices. The impact on bond prices is direct since most of the QE money went to suppress interest rates. Bond sellers then bought stocks, inflating stock prices.
Some believe that the checks issued by the Treasury are merely a refund of our taxes, and that the government is sending us our own money, but that’s not true. COVID relief money is brand new money, although it’s not “minted” in the ordinary way. It’s created out of thin air. The Treasury issues debt that in the past has been purchased by investors, but most of those new issues are not being bought by investors; they’re being “purchased” by the Fed. This is how money is “printed.”
Much of the COVID relief money will be spent on goods and services or to pay down debt, rather than stocks and bonds. This will move the CPI needle. The needle is already moving. Are your meals getting more expensive?
Low interest rates are good for borrowers but not lenders. Consequently, this is a horrible time for our 78 million baby boomers who are in or near retirement because they cannot invest safely and get a decent return on their investments. They’re being driven to take more risk than they should at this critical time in their lives.
2008 financial crisis
QE has created a stock market bubble that some say is the biggest ever. Every measure of value, like price/earnings ratio, is at or near historic highs. When bubbles inflate, bullish investors insist “it’s different this time.” That’s true; interest rates have never been lower. The reduction in interest rates has increased stock prices by 50% because future earnings are discounted at a lower rate, but stock prices have increased by more than 300%. Interest rates can’t go much lower, so the bump is all already baked in – there’s nothing left.
The following shows that Warren Buffett’s bubble indicator is at 275% of normal, an all-time high.
QE has also exacerbated the great wealth divide in the U.S., leading to social unrest and a plea to move to socialism.
No one knows how much money printing is too much, or what will happen when that limit is breached. But adding $6 trillion in relief to $4 trillion in QE is testing the limits of trust in fiat money. That $10 trillion is about half of our GDP. The unfortunate reality is that the Fed is past the point where it could have stopped printing; it must continue to print until something breaks. The common belief (hope?) is that this break will take a long time.
Fiat (paper) money only works if we all agree to honor it; otherwise, it’s just pieces of paper. The dollar was debased in 1971 when it was taken off of the gold standard and replaced by “In God We Trust.” Concerns about fiat money surfaced in 2020 when gold prices increased 25% and bitcoin skyrocketed 300%.
If you’re going to borrow a lot of money, you’ll want to pay the lowest interest rate possible, so the Fed is creating money using ZIRP – zero interest rate policy. The Fed is controlling the short end of the yield curve, letting investors price long-term Treasurys. At the time of this writing, 10-year U.S. Treasurys yield 0.92% and are rated AA+ by S&P. By comparison, Chinese governments yield 3.32% and have an A+ rating, and if you move down to a BB- rating you can earn 8.77% in South African sovereign bonds. Yields increase with lower quality, but you don’t have to lower quality much.
The Fed might discover that it can’t suppress interest rates forever. In the fourth quarter 2018 we got a hint of what happens when the Fed stops easing; stock markets plunge. Can the Fed ease forever?
When interest rates rise, as they should, the system collapses.
- Stock prices plunge because future earnings are discounted at higher rates.
- Interest payments on the debt take away from other government programs, like welfare and military
- Inflation is likely because trillions have already been printed and more is likely to be printed to monetize the debt
We all want to believe that our government is doing the right thing, but I fear that politicians are more interested in themselves and their re-election than the long-term consequences of their decisions. Money printing is a stop-gap measure that will have serious long-term consequences, probably on our children and our children’s children. This isn’t over.
Please see How to Minimize the Impact of Inflation, Recessions, and Stock Market Crashes for some thoughts on protecting yourself.