No Fed exit anytime soon

By Robert Romano — All the economic babble cannot hide one simple fact; if inflation hits, the Federal Reserve may be powerless to use interest rates as a device to rein it in.  The central bank has sacrificed that policy tool in order to make sure the elite in the financial world did not have to pay the price for their follies over the past decades.

The primary reason higher interest rates will be unusable is because they will crush the federal government under a debt burden that cannot be refinanced, let alone be repaid. If rates get too high, it could set off a funding crisis and imperil the dollar’s status as the world’s reserve currency.

No exit

This all has implications for how the Fed might conduct an exit strategy from its ongoing quantitative easing programs, but it could mean that there really can be no exit from the current policy course. That is, not without potentially catastrophic consequences.

Already, the indications are that the easy money is here to stay. A recent Bloomberg News report stated, “The Fed may decide to hold the bonds on its balance sheet to maturity as part of a review of the exit strategy” it is considering from its current quantitative easing policy.

Currently the Fed projects a balance sheet expansion of $1.02 trillion a year: $540 billion of treasuries purchases and another $480 billion for mortgage-backed securities. This particular segment of the Fed’s program has only been in full effect since Dec. 2012.

Concerns have arisen that if interest rates, now very low, were to rise and then the Federal Reserve were to attempt to sell its assets, it would post major losses and become technically insolvent — being forced to print more capital to sustain itself. This would have severe political ramifications on Capitol Hill from those who would question why an insolvent bank should be allowed to run the nation’s monetary policy.

Instead, never selling the assets and holding the bonds to maturity as an “exit” strategy would, reports Bloomberg, allow “the Fed to avoid realizing losses on its bond holdings as interest rates climb.”

Which is to say, there would be no exit at all.

In addition, the Fed has promised to keep its near-zero percent interest rates in effect until “at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal”.

Official unemployment remains at 7.7 percent, and inflation came in at 2 percent for all of 2012, so there is no reason to expect the Fed to hike up the federal funds rate anytime soon.

The Fed is the only game in town

Plus, reports Edelweiss Holdings, the Federal Reserve has monetized nearly half of the $5.4 trillion of new credit outstanding — that is, all debts public and private — from the beginning of 2009 through 2012. During that time the central bank purchased some $2.35 trillion of securities.

Minus those purchases, and record deficit-spending by the federal government — gross federal government debt has increased by $6 trillion since the end of 2008 — credit outstanding nationwide would actually be contracting right now. And so would the economy.

That is because while government borrowing and Fed easing has been increasing, deleveraging forces (i.e. debt repayment and default) particularly in the financial sector due to the economic crisis has for the most part continued unabated. Since the end of 2008, the financial sector has shed some $3.27 trillion of debt, much of which has been dumped onto the Fed’s balance sheet.

Economy dependent on credit creation, not wealth creation

To put the data into perspective, from 1946 through 2008, credit outstanding nationwide grew at an average 8.3 percent annual rate like clockwork according to an Americans for Limited Government analysis of Federal Reserve data. That is, until the economy crashed amid the first credit contraction since 1946.

Since then, credit has only expanded an average 1.4 percent each year. In 2012, it grew by just 3.3 percent. It is picking up a little but nowhere near where it was throughout the postwar bubble.

That is because there is a direct correlation between credit expansion and economic growth, which in turn has consequences for unemployment, inflation, and other indicators.

When credit contracts or even slows down its expansion, as it has in recent years, the economy tends to follow suit.

This was true in 1946, 1949, 1954, 1974, 1975, 1980, 1982, 1991, 2008, and 2009. In all of those years, real Gross Domestic Product (GDP) contracted. And in each of those years, credit outstanding nationwide had either contracted or registered slower growth from the year prior.

In two years, 1947 and 1958, this was not true. The economy contracted but overall credit grew. Although to be fair, in both years financial sector credit slowed down significantly.

In 10 out of the 12 years in question, or 83.3 percent of the time, recessions were directly linked to an overall credit slowdown or outright contraction.  And in the two other years, they were linked to a financial sector credit slowdown. That is what one would call an extremely strong correlation.

Either way, it certainly explains the government’s recent spending and borrowing binge — if for no other reason than to offset nominal decreases of financial sector debt. It also explains why Bernanke dares not end quantitative easing any time soon. Certainly at least not until robust credit expansion resumes.

For, without more debt being added to bank balance sheets, based on the data, it appears highly unlikely the economy can grow and unemployment be significantly reduced.

Interest cannot be allowed to rise

As for the central bank’s so-called “exit” strategy, the real question may not be whether the Fed will ever sell its asset holdings, but when it might ever stop buying bonds. The economy remains sluggish, so it’s probably a safe bet that quantitative easing will continue for the foreseeable future.

But the Fed may be unable to even stop buying bonds. One thing holding interest rates down right now may be the Fed’s asset purchases itself, a recent U.S. Monetary Policy Forum study finds: “[T]he large scale purchases by the Federal Reserve may be one factor that has helped keep interest rates down up to this point.”

That means if new purchases, particularly of treasuries, were to suddenly stop, interest rates for government debt sold on the market would likely have to rise to attract buyers. For every percentage point interest on debt increases will cost taxpayers an extra $167 billion a year in gross interest payments.

By 2022, the national debt will likely total $25 trillion based on projections by the Office of Management and Budget. If interest rates were to normalize to their historical average of about 5 percent, interest owed will total $1.25 trillion a year.

By 2042, if nothing changes about the fiscal trajectory we are on, the debt could be as high as $100 trillion according to an Americans for Limited Government estimate. And if the U.S. Monetary Policy Forum study is to be believed, interest rates could be as high as 25 percent by that time.

That would mean interest owed on the debt would come to a whopping $25 trillion — every single year! Surely, even with Fed support, a funding crisis and default would follow.

Therefore interest rates can never be allowed to rise significantly.

No way out

And if one of the only things keeping rates low right now is Federal Reserve purchases of treasuries, then to prevent a default or a run on U.S. debt, it appears the government cannot afford for the central bank to ever stop those purchases.

In fact, since World War II, in 58 out of 68 years, or 85 percent of the time, the amount of treasuries held by the central bank has increased according to data from the Office of Management and Budget. So, based merely on a casual reading of history, it appears highly unlikely the central bank will ever stop monetizing the debt.

For all the aforementioned reasons, if and when inflation ever hits, the Federal Reserve will therefore be powerless to use the interest rate tools that Paul Volcker used to rein in rising prices in the early 1980s. The political pressure to avert default brought on by high rates will be too high.

As the chart below shows, there is a distinct correlation between rising inflation and interest rates.

One day in the not-so-distant future this catch-22 could come back to bite us all. That is, if fiscal authorities continue to whistle by the graveyard and fail to aggressively rein in spending and slow the growth of the national debt.

Because, if nothing changes, when inflation hits as it must eventually, our 2 percent interest rate will explode, making it impossible to ever balance the budget. Then, we’ll be cooked.

Robert Romano is the Senior Editor of Americans for Limited Government.

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