The Damage Caused By the Fed's Zero Interest Rate Policy (ZIRP)

Accounting for various inflation measures, the target and daily effective Fed Funds interest rate has been negative since 2009. The Fed has reiterated this so-called "zero interest rate policy" or ZIRP, indefinitely, and additionally has tied further monetary easing measures via bond and asset purchases not only to inflation, but to unemployment, regardless of the lack of evidence that such monetary measures positively affect growth leading to less unemployment. Rates on Treasury Inflation Protected Securities (TIPS) recently hit a record low yield to maturity of -1.496% on 4-year, 4-month issues, forcing the obvious question: Who would buy these things? Evidently, investors are willing to accept getting paid back less than the principal loan at maturity on the expectation that regular payments tied to the government's understated consumer price index (CPI) inflation measure will make up for the negative yield to maturity over the life of the loan - the auction was relatively strong, with a 2.7 bid-to-cover. The likely outcome is that investors will barely break even or lose money, given that inflation and risk will be running higher than expected or as sold to investors.

Creditors and savers lose money in this ZIRP environment, while debtors gain. That has been the goal of the Fed all along, to manipulate the cost of money so as to provide a bailout to all of those debtors, deleveraging or not. The accepted term for this ruse is appropriate: Financial Repression. What the Fed does not admit to is that this practice has significantly skewed the risk-reward for investors willing to lend money, and has created systemic risks tied to the interest rate markets. Both of these side effects have an impact on private investment, and by extension, real economic growth. On a basic level, investors willing to lend money want to see the level of risk tied to the potential reward, as set by market pricing, not as manipulated by a cartel. If that reward has a manipulated ceiling, or has a higher than expected probability of losses (negative reward) due to interest rate dislocations, defaults or other risks not priced in, then investors will shy away from taking any risk at all: they simply will hoard their capital and not lend. We've seen strong evidence of that in the last 3-4 years, as a result of an accommodative Fed feeding overextended debtors looking for a cushy reprieve from the housing and credit market bubbles the Fed helped to create.

Much talk has been made recently about how and when the Fed will proceed to raise interest rates and unwind its growing balance sheet of Treasury and Agency (MBS) securities, bought to keep interest rates artificially low for government borrowing, public mortgage financing and debtor refinancing. Existentially, there is a threat that interest rates could rise without a Fed change in ZIRP: the interest rate markets could dislocate rates higher to more accurately reflect risks. The danger is that dislocation could be severe and lead to significant losses in bonds and in interest rate sensitive securities and derivatives, including currencies. It has been my conviction that the Fed has not quantified this "Black Swan" event or series of events. The severity is potentially very high given the collaterized nature of Treasury and Agency securities within the global financial system, including the repurchase agreement (repo) markets. Rated securities used as accepted collateral experiencing significant sharp losses will have a systemic effect across the system. Critics answer this existential threat by stating that the Fed could simply flood the system with liquidity (printed money), in the magnitude and durations needed to restore stability. This is a fallacy; as I have pointed out in other essays, the Fed is an endogenous (not exogenous) entity, not unlike a large hedge fund, and the belief that it could perpetually print money to save its "system" is as wrong-headed as believing in perpetual motion machines. Trust is not infinite, and Federal Reserve Notes and Treasurys carry risks tied to trust.

Creditors and savers (investors) held hostage by the financial repression of ZIRP have little wiggle room other than to continue to push for changes in the powers carried by the Federal Reserve. Those powers are sold to all of us as a common good, when in fact it has led to an involuntary wealth redistribution scheme, a tax meant to benefit government and politically recruited debtors, with a leveler outcome of stagnant or negative real growth. At its worst, these powers have throttled systemic risks and will continue to do so, instead of unshackling markets and investors to allow for markets to set price levels and risk-reward curves based on supply and demand, and not on politically-motivated cartel manipulations.

 

National Debts, Debt Monetization and Inflation

This last week marked the 40th anniversary of Nixon's move to break up the international gold standard, set by the Bretton Woods Agreement among 44 nations in 1944. The move represented a post WWII culmination of a U.S. balance of payments crisis, including a run on U.S. gold reserves that would trigger an insolvency event:

"Recently the markets had panicked. Great Britain had tried to redeem $3 billion for American gold. So large were the official dollar debts in the hands of foreign authorities that America's gold stock would be insufficient to meet the swelling official demand for American gold at the convertibility price of $35 per ounce." [1]

This insolvency event was chiefly driven by the unbalanced fiscal spending of the Johnson administration (e.g. the "Great Society" welfare state and other profligate spending), Nixon's inability to deal with rising deficits, and the growing shift of the U.S. from a creditor to a debtor nation, with a trade deficit that would likewise increase in coming years.

While Bretton Woods was a flawed international monetary system in many respects - imposing currency pegs and encouraging intervention by monetary "authorities" such as the IMF - the decision to make the dollar the reserve currency backed by gold was among the positive aspects that supported the growth of the U.S. as a net creditor nation.

It is worthwhile to review what has happened since Nixon declared a fiat end to the gold standard, allowing the dollar to float. By removing the restrictions of a dollar-to-gold conversion, debt monetization by monetary authorities (in particular the Federal Reserve) could ensue without check, under pretense of the "full faith and credit" of the sovereign.

The figure at the top depicts the geometric growth of the U.S. national debt, the broad M3 money supply metric, and price inflation as represented by the original Consumer Price Index (CPI) calculated before 1984 [2,3], resulting in an 82% decline in the purchasing power of the dollar. Such national debt growth does not take into account the 'unfunded' liabilities faced by the U.S. government through Medicare, Medicaid and Social Security programs, which exceed $100T.

Keynesians and Post-Keynesians have misguidedly supported deficit financing and debt monetization to stimulate aggregate demand and to prevent deflationary or disinflationary relief during debt deleveraging cycles. When will they wake up to the damage caused by such fiscal and monetary policies, chief among them financial instabilities that occur due to the unsustainability of perilously high debt loads, the understated risks due to artificially low interest rates, and the growing lack of confidence in the dollar?

[1] "The Nixon Shock Heard 'Round the World," Lewis E. Lehrman, WSJ, August 15, 2011.
[2] Graph is taken from "Modern Monetary Madness and King George III," May 8, 2011. 
[3] The pre-1984 CPI is tracked by ShadowStats.com HERE.

Japan's New Inflation

A few weeks ago Japan reported rising inflation, with the CPI gaining 0.3% and 0.6% YoY in March and April, after years of negative monthly CPI data. The headlines from major news outlets were indeed amusing: "Japan beats deflation for the first time in two years (BBC)," "Japan Ends 25 Months of Deflation in Victory Marred by Quake-Led Recession (Bloomberg)," and my personal favorite, "Why inflation is great news for Japan." Oh wait - that latter title is recycled from a myriad of similar news reports when inflation last surfaced in Japan in 2007/2008.

According to business/economic news media and Keynesians alike, inflation for Japan is good, while deflation is an anathema. Inflation means rising consumption, demand, loan growth and ultimately output, while deflation means falling consumption, demand, credit contraction and deleveraging, and ultimately falling output. Except the dynamics aren't that simple and settled.

Japan's persistent YoY deflation since 1995 is arguably the result of years of debt deleveraging from the '80s real estate and stock market boom-then-bust, but it is also the result of rising production and productivity [1], which has a positive effect on lowering overall consumer price levels, even when demand is increasing. One might call this "good deflation." Also overlooked is the fact that Japan's deflation was "low and stable," especially during the period 1998-2007, when the average annual YoY CPI deflation was -0.23% with a standard deviation of 0.49%. I find it contradictory that the bulk of economists (especially those residing at central banks) think that low and stable inflation is good (the "Great Moderation"), while apparently low and stable deflation is bad.

What Japan's experience with inflation proves is that rising prices can happen with falling output and productivity, or stagflation, a dirty word to garden-variety Keynesians. With the Yen recently strengthening against most major currencies, the Bank of Japan is limited in what it can do to weaken its currency, which in the past has been achieved though a plethora of quantitative easing measures. Japan has little choice but to continue to delever and fight off any potentially persistent high rates of inflation, should it arise.

[1] Japanese industrial production and labor productivity rose steadily from 1998-2007, aside from a break in the increase during the 2001 recession. CPI and production/productivity data for Japan were sourced from HERE.