The US Federal Reserve has been preparing the public for their intentions to start a very gradual disengagement from their monetary stimulus policies for months. When it came to pull the trigger, they got cold feet and surprised the markets. The markets have been trading in anticipation of the "tapering" for all these months, thinking that it makes sense to start disengaging and returning to a more normal Fed policy. It is obvious that the Federal Reserve board members themselves thought it was normal for them to start the gradual disengagement process in response to normalized conditions, right up to the point when they actually had to go through with it. At that point, they decided that things were not all that normal after all.
Things may not be back to normal yet but surely, it will happen soon. This is the wishful thinking induced logic that seems to dominate a field in which people should know better than to allow emotional considerations to overrule cold consideration of facts. Yet it happens within the ranks of the investors, whether they are investing their own money or other people's savings. It even happened within the ranks of Federal Reserve policymakers, who it seems to me, are choosing to look at the wrong data when thinking that they can now consider disengaging from current stimulative policies. Almost everyone is waiting for a return to the pre 2008 world, so we can expect many more attempts to get back to it. I want to offer some reasons why we will not, based on a review of fundamental economic changes that have taken place in past years and the last few decades.
This is not the first time I am arguing that monetary policy will continue to remain stimulative for a long time to come. I pointed out this specific oil price reason why Fed policy will continue down the current road almost two months ago in a previous article (link). The current oil price range is needed in order to prevent a global production decline. We often forget that shale oil and deep water field developments on which we are increasingly dependent on would not have been feasible without the current crude oil price level. The economy can only tolerate this price level as long as the loss of family income compared to a decade or more ago, when oil prices were five times cheaper, is compensated for. The average US household saw a rise in gasoline costs of 136% (link) A rise in wages to compensate would have been nice, but it has not happened. Per-capita income growth has been flat for almost a decade and a half.
The only way to compensate is to maintain a low interest rate environment so households can service their debts at a cheaper rate. To simplify it, households now pay more in energy directly and indirectly, while they pay less interest on debt. It should not take much complex analysis to understand that households with stagnated incomes and increased energy bills will not be able to shoulder a greater interest rate burden.
Consumer willingness to pile on more debt is on the decline.
More than two thirds of the US economy is dependent on consumer spending. Economic growth is impossible at this point without the participation of the consumer. Consumer income, however, has largely been stagnant for more than a decade now and in the absence of continued expansion of household debt, real growth is simply not possible. It is hoped of course that somehow economic growth will somehow get back to levels where the 1% will continue to get richer while the middle class can still expand, but that will not happen. At this point, after the IMF the World Bank and many other institutions made predictions of lower global economic growth for the next few decades compared with previous decades, one would think perhaps it is time to accept the new reality. We should at least wake up after six years past the 2008 crisis, where we see that those predictions are right, or perhaps even somewhat too optimistic and realize that we will not be back to the pre 2008 world ever. The 1945 to 2008 period will go down in history as one of great stability and growth in global prosperity. For some parts of the world, growth in prosperity will continue where the baseline is still low. The developed world, however, is the first place where this change is already being felt in the form of economic stagnation.
In parts of the European Union, youth unemployment rates are in the 50% range. In the United States, it is significantly lower, but college graduate unemployment and under-employment is also in the 50% range here as well. Well-paid stable jobs are increasingly things that unachievable dreams are made of for young people who are just entering the workforce and do not necessarily have very prominent connections in society to pull some strings for them. Commission based or low paid service jobs are increasingly the norm. Even those who manage to squeeze into a better career are faced with increased job security worries. It should not come as a surprise then that a recent survey has found that the new "American dream" these days consists increasingly of the goal of achieving debt-free status, which came in as the second most popular option, just behind retirement at the age of 65. The age group that was the most likely to choose the option of being debt free was the 18-24 year olds, which should not come as a great surprise given the poor job prospects for those starting out in life lately. Owning a home was a distant third most favorite option for the general public, which is a clear cultural shift, with serious implications for our economic structure.
Note: The US youth age group is considered to be everyone between the ages of 15-24.
With all indications pointing to consumers not being able or willing to take on more debt, even at current low interest levels, should anyone be contemplating gradually pushing interest rates higher? The fact that everyone expected the Federal Reserve to act this month on starting the process of easing off the monetary stimulus shows us that most people are not in tune to the current reality. This should be surprising given that the data I am referring to is very common knowledge. As I already stated, however, we seem to be caught in a collective mentality that is greatly influenced by emotion rather than facts. The expectation of imminent action on behalf of the Federal Reserve to start tightening continues to dominate and it is in fact something we should expect to see happen soon, because I believe that even the members of the Federal Reserve board are caught in the same mindset as those who are trading based on expectations of Fed actions. The question is whether we should expect that once the Fed takes this course of action, it would also be sustained.
Government needs cheap credit.
The CBO projects that for 2013, the Federal government deficit will come in at 4% of GDP, which is a great improvement on the 10% deficit recorded in 2009. They also project future deficits for the next decade to remain under 4% until 2023, so it may seem that government is now on a sustainable fiscal path and there is no further need to help on the monetary side. This assumption is flawed on two counts. The first one is a little bit of optimism on the part of the CBO, because I believe they are underestimating the likelihood of another great recession happening before 2023. They are also underestimating the drag effect on the economy caused by a cultural shift in the US consumer, which it seems no one is willing to acknowledge to be taking place. In the absence of consumer debt driven growth, government debt will inevitably need to go on an expanding path in order to keep growth going.
The other flaw comes from not paying enough attention to the change that took place during the 2008-12 period, in the US debt/GDP ratio. Debt held by the public in 2007 was just 36% of GDP, while now it is over 75% and even under the CBO scenario, which I believe to be very optimistic, the ratio will stay above 70% for the foreseeable future. The cost of servicing the debt at much higher rates of interest is simply not something that the US government can deal with, aside from perhaps servicing the debt through higher deficits, which would take us right down the unsustainable and growing debt to GDP ratio path. Raising taxes or more deep cuts would most likely have the same growing debt to GDP ratio effect, due to the effects of slowing growth rates. Any which way we look at it, the government needs the current cheap credit environment to remain in place.
The three factors I mentioned are the ones that make it impossible for the Federal Reserve to start the disengagement process from their stimulus programs and maintain their policy of "tapering" because there is just no way for the economy to deal with the consequences. There are also other factors that may not be of such grave consequence as to make it impossible to end the stimulus programs, but will cause some significant pain nonetheless. If the Federal Reserve backs off its policy of monetary stimulus, the US dollar could appreciate to the point where US exports would become uncompetitive, given that major competitors such as the EU and Japan are not likely to follow suit and start raising rates any time soon.
Since the Federal Reserve announced its intention to ease off the monetary stimulus programs gradually, starting in the month of September of this year, interest rates shot up as investors turned more sour on bonds. As it turns out, there was no reason to be this sour, because the Fed members changed their minds and decided to hold off on their "tapering." The consensus is still that the beginning of the exit process is imminent and eventually they will start, because even the members of the Fed council are eager to get back to normal. Eagerness alone will not be enough to maintain course, however, because the right conditions to allow for the end of monetary stimulus are not there. This is something people should keep in mind whether they are in the market for a house, or are actively invested in bonds. Even though many will seek to end it, the era of low interest rates will not be ended through policy decisions. It will only end once inflation will start to threaten, which should not be for a while yet.