When novice pilots are learning how to land an airplane they practice what are known as touch and goes. When pilots practice touch and goes they let the wheels of their aircraft barely make contact with the runway. They never fully land. Instead, they pull back on the stick and climb away. For the past 25 years, the Fed has been conducting touch and goes with the U.S. economy.
A look back at Fed policy bears this out. In 1981, the Fed began a 25-year policy of easing (lower interest rates), lowering the Fed Funds rate from an inflation busting high of 20% to an eventual affective 0.00% in 2009. One would think that the Fed Funds rate fluctuated a lot during that time and although that is correct, the chart looks more like a downward stair case than a typical peak and valley formation. The Fed rarely raised the Fed Funds rates back to (or even close to) to rates seen during the prior tightening cycle (in some cases not even to rates seen as neutral.
Let’s look at the history of Fed Funds rates since 1981. We will leave out the punitively-high rates of the early 80s. Let’s begin in the late 1980s when rates were somewhat “normal”.
February 1988 (peak of rate cycle) Fed Funds 9.75%
February 1991 (approximately half way point) 6.25%
September 1992 bottom of rate same rate cycle) 3.00%
Here is the next cycle:
May 2000 (peak of rate cycle) 6.00%.
June 2003 (bottom of cycle (1.00%). Stayed at 1.00% until June 2004.
June 2006 (Peak of rate cycle) 5.25%
December 2008 (bottom of rate cycle) 0.00% to 0.25%)
Can you see the problem? The Fed never landed the economy. It merely conducted a series of touch and goes. This created what we now know to be a dangerous dynamic. Ever lower rates made refinancing and the use of home equity for spending drive growth beyond structural limits and pushed home prices high as more people could afford homes due to lower rates and little in the way of core inflation. We all began to view ever rising home prices, cheap loans and buying whatever we wished to as normal. It wasn’t. The Fed kept the economy in the air for over 20-years, never letting it refuel (correct). Now it is out of fuel.
What is needed to refuel the U.S. economy? Asset price correction, but that sets up another dangerous dynamic, especially when the stigma of walking away from contractual obligations, such as mortgages, is all but gone. Home prices, auto prices and wages in those and related industries rose to levels which are unsustainable. However, asset prices ad incomes must reset to fundamental levels.
The Fed’s solution is to cause inflation and weaken the dollar. In theory this could help. It may have kept us out of a depression thus far, but inflationary and dollar-weakening policies can only have limited benefits when borrowing is constrained, wages cannot rise (cost of leaving raises would make it easier for Americans to pay their mortgages as they are repaying debt created with dollars which are more valuable than the dollars which they are paying), and increased U.S. exports have only a limited benefit due to the relatively small portion of manufacturing in the overall economy (efficient businesses needs few new workers).
Much has been made of the “new normal” of slow growth. Current growth is not the “new normal” no more than the booms of the mid 1980s – 2006 was normal. Once we go through several more years of slow growth and falling home prices growth and employment will level off somewhere between the boom years and today’s bust. What does this mean in numbers? Although no one can say for sure, growth leveling off between 2.00% and 3.00% and unemployment between 7.00% and 8.00% could be where the economy improves to following another several years of pain.
The Fed can slow this correction, but cannot prevent it beaus the Fed has cyclical tools and today’s problems are structural.
Disclosure: No positions