Monetary policy and Main Street


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A detailed look at the economic disadvantages of monetary policy implemented by the Federal Reserve Bank.

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Monetary policy and Main Street

  1. 1. Published by Moneycation™ Newsletter: December 2013 Monetary policy and Main Street It is no secret Federal Reserve monetary policy has passed over long-term economic stability for a shortterm economic fix originally intended to kickstart Main Street's economy. Central bank officials reason that by stimulating Main Street via Wall Street, the economy is better off in the long run. However, if using metrics such as wage growth, job creation, labor participation and corporate revenues as a percent of global market share, then monetary policy seems less sure footed and more swaggered. The central bank claims it has been seeking to maintain its dual mandate of inflation control and employment, but has contributed to the devaluation of the dollar, which is just as bad as price inflation and with little job creation success. Econometric equations, no matter how elaborate and sophisticated, are just as capable of weaving fabricated quantitative justification for an elitist economic status quo as statistical samples and political rhetoric are riddled with fallacy. The fact of the matter is economics is not science, therefore no amount of mathematical reasoning is completely accurate in terms of determining how a particular policy affects a whole economy's performance. Investment banker Jeremy Grantham put it this way in GMO LLCs quarterly letter: “Economics is a very soft science but it has delusions of hardness or what has been called physics envy. One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed introduced rigor into economics, it unfortunately also brought mortis.” To be fair, at least the wealthy are getting richer, which is slightly better than no one getting wealthier. In effect, loose monetary policy has been a windfall for Wall Street, but not necessarily Main Street. Even a Stockhouse interview with ex-fed official Andrew Huszar admit to this in the following quote “While there had been only trivial relief for Main Street, the U.S. central bank's bond purchases had been an absolute coup for Wall Street. The banks hadn't just benefited from the lower cost of making loans. They'd also enjoyed huge capital gains on the rising values of their securities holdings and fat commissions from brokering most of the Fed's QE transactions. Wall Street had experienced its most profitable year ever in 2009, and 2010 was starting off in much the same way.”
  2. 2. Huszar goes on to say the monetary steroids applied via mass asset purchases and quantitative easing lowered the incentive and pressure for Congress. Thus, the economic problems that caused the Great Recession have not actually been dealt with despite the Dodd Frank Act, regulator lawsuits and more pressure on financial institutions to maintain and raise capital reserve requirements. “As for the rest of America, good luck. Because QE was relentlessly pumping money into the financial markets during the past five years, it killed the urgency for Washington to confront a real crisis: that of a structurally unsound U.S. economy.” With hundreds of billions of dollars being pumped into the U.S. economy by the Federal Reserve Bank, one might think monetary policy's capacity to stimulate the economy would be massive. After all, the federal slowdown of October 2013 only cost a fraction of the Fed's quantitative easing program, yet its effects were far reaching. Moreover, according to Standard & Poor's rating agency, the federal government partial shutdown that began in late September 2013 removed $24 billion from the economy and .06% of gross domestic product in the fourth fiscal quarter. Yet, the Federal Reserve Bank's “quantitative easing” also known as U.S. debt monetization has been creating $85 billion per month to purchase U.S. Treasury debt and mortgage backed securities. Another fear is that monetary policy is becoming increasingly ineffective for Main Street. This is evident in the chart below where GDP rose for decades while household income remained flat. Now it seems that monetary policy can't even grow the GDP as GDP per capita has not surpassed its peak in 2007. In other words, despite trillions of dollars of stimulus and near zero percent interest rates, household income has continued to decline and GDP per capita has remained flat for seven years. U.S. gross domestic product vs. median household income Image license: US-PD
  3. 3. Congressional testimony On November 14, 2013, The Federal Reserve Chair nominee Janet Yellen answered questions about the impact of monetary policy on Main St. and one of her answers is that the broad focus of policy is to generally benefit all Americans through a “ripple effect” rather than a “trickle down effect”. She also stated that current policy has to make use of alternatives due to a lack of scope in traditional approaches to economic regulation. Her testimony to Congress did not seem inspiring or encouraging due to a lack of detailed examples of just how a macro-focused policy benefits a wide swathe of individual Americans. In other words, just because there is a wealth effect doesn't really mean the ripples through Main St. could not be waves. Yellen herself stated low rates do harm savers who are not necessarily home or stock owners. In addition, according to Senator Schumer (D-NY), middle-class incomes are declining, which doesn't point to a very effective monetary policy indeed. It seems quite possible the Federal Reserve Bank has an agenda other than lowering unemployment and keeping inflation in check. Summary points of the testimony are below: • Accounting Standards: Effects of changes • FSOC metric: Transparency for non-bank institutions • One size fits all policy for smaller financial institutions too onerous • P/E ratios don't suggest bubble; Equity Risk Premium doesn't indicate bubble • Volcker rule: Maintain integrity of investor protection “firewall” • 27 lower rate votes by Yellen, 0 rate increases • Diminish volatility in financial markets via “communication” • Low rate deference to Congressional mandate • Monetary policy as response to weak fiscal policy and tapering Senator Corker addressed the failure or lack of effectiveness of the trickle down effect. Low rates have helped asset prices such as stocks and home prices, which according to Yellen is broadly beneficial. However, as Senator Corker alluded to, home and stock ownership is elitist as not everyone owns these assets. Additionally, Yellen also stated the Federal Government has no business in influencing the stock market. This seems to indicate that the Fed is relying on indirect economic impact than direct impact. Nevertheless, according to following quote from the Option Queen newsletter, the Fed's metrics are all wrong: “An additional unspoken concern is with the measurement of price to earnings ratios (PE). With interest rates near zero, the PE calculations are out of whack because no accommodation for a low interest rate environment is being made. It is our belief that given a fed perpetuated environment of ongoing abnormally low interest rates, PE should be adjusted to reflect the resulting artificially low cost of money, especially if compared with times when the cost of money was much higher. If that measurement were made today, we believe that PEs would not reflect a cheap market, but one that is getting somewhat frothy.”
  4. 4. Questionable policy This opening anecdote points to the difference between monetary policy's influence on Wall Street vs. Main Street or mainstream America. Main street, it seems, is more sensitive to less money being withdrawn from fiscal policy than it is to more money being used to help Wall Street. In other words, and on first note, monetary policy is questionable in its ability to actually help Americans, which it is intended to do. The primary beneficiaries of monetary policy are not the majority of Americans because the wealth effect being generated by the Federal Reserve Bank is not increasing loan activity, isn't encouraging employers to hire more and does not benefit individuals and households that do not own equity via stock markets. Dollar devaluation The problem of dollar devaluation is evident over time. For example, for $1,000 to have the same intrinsic worth as it did in 1971 it would now have to equal $5,517.00 in 2011 dollars according to the U.S. Bureau of Labor Statistics. Now suppose someone put $1,000.00 into a Treasury Bond in 1971 at a 5 percent interest rate and also pays income tax of 28 percent after redemption. That $1,000.00 bond would now be worth $5,470.89 according to the U.S. Treasury. The problem is that is even less than the amount of money required to maintain the value from 1971, $46.11 less to be exact. Conclusion, anything lower than 5 percent is insufficient to build suitable retirement due to inflation. It is for this reason, specific investments such as Treasury Inflation Protection Securities or TIPS are bought to provide inflation protection. Money supply To illustrate the failure of monetary policy's attempt to boost the U.S. economy that the majority rely on to earn a living one need not look far. A look at the U.S. money supply in the graph below illustrates this. M1 is one of three measures of money supply and accounts for the sum of total currency in circulation and transaction deposits and has climbed over $80 billion in just a few short years. M2 is the sum of M1 with savings deposits and retail money market mutual funds per The Federal Reserve Board. The value of M2 is surpassing $10 trillion. In effect, by authorizing the creation of so much money, the central bank is devaluing the dollar and its purchasing power. What is evident in both these charts is that the U.S. money supply has grown a little short of exponentially in the recent past.
  5. 5. Image source:
  6. 6. This money creation trend cannot continue without negative consequence to the economy. It also reflects just how bad the underlying economy actually is because if the economy were healthy, that much liquidity floating around would lead to substantial inflation. So what if the economy does not improve enough? Will money supply continue it's upward climb? The answer is quite possibly and potentially without inflationary consequences. Economic asset “bubbles” Loose monetary policy stimulates asset bubbles because price trends attract capital and become a money magnet, both nationally and internationally. When investors spot a bubble with room to expand, that represents opportunity provided the exit out of the bubble prior to its bursting is orderly and well calculated. The growth created by asset bubbles serves as a stimulus for economic expansion, and expansion that may otherwise be impossible to attain with more practical, but stable economic policies. To illustrate further, as with large companies, developed countries with large economies like the U.S. have to grow GDP in the hundreds of billions to expand at a rate that can support increased hiring and substantiate significant capital investment into industrial research, business development, and government sponsored programs. The need for economic bubbles suggests it is quite possible the U.S. has reached its economic apex where continued economic expansion at a consistent rate higher than 1-2% is difficult, and possibly even unsustainable. Despite the negative effects of bubbles they are also economic catalysts. Bubbles attract investment capital from foreign countries, create wealth and fuel investments spawned by the increase in asset values. Without bubbles, financial and economic stasis would be more likely, and although that is more stable, it also has less near-term economic benefit. For example, consider an economy without asset inflation, and with GDP growth that remains steady at 1-2%. Such an economy may only keep up with population growth and currency purchasing power, and does necessarily increase or decrease in size. A bubble stimulated economy may grow 3-5% for several years straight. Moreover, according to Department of Commerce GDP data, U.S. GDP grew an average of 3.82% each year between 1992-2000. That is year over year data as well meaning 3.82% compounded over the previous year's growth. Although in the 1990s the bubble was actually based in real technological innovation, a reasonable interest rate environment existed and inflation was actually kept in check by tightening the creation of U.S. currency per the CATO Institute This bubble was conceivably caused by over-exuberant investors rather than loose monetary policy. This is not the case with the equity bubble believed to have been formed with the help of the central bank's current policy of quantitative easing. The contrast between industry led asset inflation versus monetary policy led price rises is striking. Even after the tech bubble of the 1990s had burst, annual GDP did not decline below 1%, a relatively small price to pay for a bubble that created a lot of jobs, attracted a lot of foreign capital, and generated massive revenue. The housing bubble that burst in 2008 was not as healthy and was fueled by inaccurate derivatives valuations, loose lending policies and a surge of speculative real estate purchases and construction. Interest rates were also much lower in the mid-2000s than the
  7. 7. 1990s. Yet this led to a four year average GDP growth of 2.95%, low unemployment and large corporate, foreign and individual investments. Without this bubble, economic growth may have only averaged 1-2%, and a recession still might have occurred afterward. The current economic climate is clearly not healthy and amounts to kicking the can down the road in exchange for short-term growth. Government spending is out out of control with an excess of hundreds of billions of dollars each year at the fiscal level, and a cumulative spending pattern in the trillions of dollars at the monetary level. The big credit card in the sky is losing a strong credit utilization ratio, which in turn lowers national credibility and raises the cost of national debt via government security yields. The first domino of economic decline, and possibly more have been tipped and the clues are evident everywhere. Low labor force participation, declining corporate revenue, hemorrhaging government debt, chronic currency devaluation and rising precious metal prices are just a few of the clues. The magnitude of monetary policy is huge, and when the time comes for the Federal Reserve Bank to seel its multi-trillion dollar stake in U.S. Treasuries and mortgage backed securities, the results could be massive. The reason a selling of Fed assets is co influential is because of the massive value they hold,. Moreover, under the law of supply and demand, a rising supply lowers asset values and raises yields on Treasuries. In terms of interest rates, if the economy suddenly grows at a fast rate, tightening access to capital and interest rates on borrowed funds would not necessarily be performed fast enough to prevent a corresponding sharp rise in inflation. The result could be economic whiplash as inflation rises alongside a money supply that can't easily be shrunk. Debt monetization The term debt monetization is disliked by the Federal Reserve Bank because it describes the less economically and socially palatable side of economic stimulus. By buying U.S. Treasury securities, the central bank is financing the federal government's overspending and earning interest on it. This is a pattern that cannot continue indefinitely despite the banks statement that it will continue quantitative easing for as long as necessary. The fact is, as long as necessary is not economically feasible because of the risk of inflation and to economic growth. Interest rates versus financial regulations The Dodd-Frank Act, originally created to overcome risks associated with banking de-regulation acts as a damper on monetary policy such as low interest rates. This is because stricter capital requirements for banks and tighter loan application procedures make it more difficult to purchase a home despite historically low mortgage interest rates facilitated by the Federal Reserve Bank. Nevertheless, financial institutions have pushed back against the legislation by lobbying for delays and exemptions. Another key component of the Dodd-Frank Act is the Volcker Rule. This rule curbs financial institutions freedom within securities markets and will be voted on by regulators this month. Furthermore, The Volcker Rule prevents banks from trading in financial securities for their own benefit rather than that of their clients per the New York Times. To be clear, this rule is a fiscal
  8. 8. regulation and not a monetary one, meaning it is not necessarily implemented in conjunction with the goals of monetary policy, but may counteract some of the effects of monetary for better or for worse. Despite the conflict between monetary policy and fiscal regulations, the traditional belief is that investment rises when commercial interest rates are low. This has been the case to an extent, but the resulting investments have not included extensive rehiring, Instead corporations have used cheap money to implement stock buyback programs, and finance capital expenditures on equipment that improves efficiency. In other words, companies are using the money to get richer and not necessarily to expand. Concluding thoughts At best monetary policy has kept the U.S. economy afloat until something better happens. A federal sequester, persistent annual fiscal deficits, continual above average unemployment and declining corporate revenues do not indicate something better has actually happened. Thanks to the Federal Reserve Bank, a business friendly environment and macro-economy has been maintained, but businesses aren't exactly gaining market share and increasing their competitive positioning on a global scale as the U.S. share of global GDP is also shrinking while the population continues to rise. Mainstream Americans have little to show from monetary policy other than retirement plans that have risen due to increases in the valuation of high-risk assets. Those rises in equity valuations will not continue indefinitely and are also a stop-gap until the economy improves in a substantial enough way to benefit Main Street. Sources: 1. “MarketWatch”; Shutdown has taken $24 billion out of the economy; S&P; Steve Goldstein; October 16, 2013. 2. “U.S. Treasury”; Growth Calculator 3. “Bureau of Labor Statistics”; Inflation Calculator 4. “WikiCommons”; Money Creation; Akokkone; February 17, 2012. 5. “WikiCommons”; Components of US money supply; Autopilot, December 12, 2010. 6. “Federal Reserve Board”; What is money supply? Is it important? 7. “Zero Hedge”; Charting The Fed's Across The Board Fail; “Tyler Durden”; October 18, 2013. 8. “Zero Hedge”; Lacy Hunt Warns Federal Reserve Policy Failures Are Mounting; October 18, 2013. 9. “Zero Hedge”; Things That Make You Go Hmmm...Like the Freaking Fed; “Tyler Durden”; October 18, 2013. 10. “Zero Hedge”; Ron Paul Knows The Longer QE Lasts, The Worse It Will End; “Tyler Durden”; October 19, 2013. 11. “Department of Commerce”; GDP data; Bureau of Economic Analysis 12. “CATO Institute”; Greenspan's Monetary Policy In Retrospect, Discretion Or Rules?; David R. Henderson and Jeffry Rogers Hummel. 13. “Business Insider”: Central Bankers Have Gone Wild, And The World Is In Code Red; John Mauldin; October 27, 2013. 14. “Federal Reserve Board”; Does the Fed get audited? 15. “Bloomberg”; Fed Bubble Agonistes Persists As Zero Rates Prompt Debate; Craig Torres and Caroline Salas Gage October 28, 2013. 16. “Moneycation”; Impacts and purpose of Federal Reserve Monetary Policy; “A.W. Berry & Best Accounting Schools, July 25, 2012. 17. “Zero Hedge”; Fromer Fed Quantiative Easer Confesses, Apologizes: “I Can Only Say: I Am Sorry, America”; Andrew Huszar; October 12, 2013. 18. “Zero Hedge”; You Are Here; “Tyler Durden; November 11, 2013. 19. “Moneycation”; What the Federal Reserve Bank's Debt Monetization Means For You; “A.W. Berry”; September 13, 2012. 20. “Stockhouse”; U.S. Federal Reserve Official Apologizes. Goldman Sees More Downside For Gold; Clif Droke;
  9. 9. November 15, 2013. 21. “Option Queen”: Archive For October 2013; J.A. Schwartz-Market Analytics. 22. Federal Reserve Board”; Does Monetary Policy Affect Stock Prices And Treasury Yields? An Error Correction And Simultaneous Equation Approach J. Benson Durham; Division Of Monetary Affairs; Board Of Governors Of The Federal Reserve System. 23. “GMO LLC Quarterly Letter”; Ignoble Prizes And Appointments; Jeremy Grantham; November 2013. 24. “New York Times”; Volcker Rule On Bank Risk Approaches Its Final Edits; Ben Protess; December 3. 2013.
  10. 10. November 15, 2013. 21. “Option Queen”: Archive For October 2013; J.A. Schwartz-Market Analytics. 22. Federal Reserve Board”; Does Monetary Policy Affect Stock Prices And Treasury Yields? An Error Correction And Simultaneous Equation Approach J. Benson Durham; Division Of Monetary Affairs; Board Of Governors Of The Federal Reserve System. 23. “GMO LLC Quarterly Letter”; Ignoble Prizes And Appointments; Jeremy Grantham; November 2013. 24. “New York Times”; Volcker Rule On Bank Risk Approaches Its Final Edits; Ben Protess; December 3. 2013.