What The Fed Has Wrought

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Includes: AGG, BAC, BND, C, GM, IEF, IVV, JPM, LQD, QQQ, SPY, TLT, VTI
by: Roman Chuyan, CFA

Summary

After back-stopping the financial crisis in 2008, the Fed continued its emergency easing for longer than anyone expected.

Most economists believe that there is no harm to the real economy from the Fed's continued easing.

Not so - these policies have major negative economic effect of misallocating business investment into financial assets rather than real assets, which has reduced long-term productivity and economic growth.

The Federal Reserve provided unprecedented monetary stimulus in response to the U.S. financial crisis. It dropped its short-term Fed Funds target rate to zero, and provided unprecedented liquidity as part of quantitative easing programs starting in September of 2008. These emergency policies were coordinated with other major central banks (though I will focus on the U.S. in this article).

What did the Fed's policies achieve? In the short term, they served as emergency backstop to failing financial system. In the long term, they were intended to continue to provide support until the real economy caught up. In this article, I argue that these policies have major negative economic effect of misallocating business investment into financial assets rather than real assets, which has reduced long-term productivity and economic growth.

Emergency Back-Stop

In September of 2008, the Fed served as the lender of last resort to the financial system that was failing. Recall that after the collapse of Lehman Brothers in 2008, a "run on a bank" was happening on entire U.S. financial system, including the largest financial institutions such as Merrill Lynch [Fed-brokered acquisition by Bank of America (NYSE:BAC)], while Citigroup (NYSE:C), JPMorgan (NYSE:JPM) and others were recapitalized by the Fed and Treasury. As consequence, major industrial companies started to fail too, one of which was General Motors (NYSE:GM). We ought to give credit where it's due: if not for decisive actions that month by the Fed led by then-Chairman Ben Bernanke, it's very likely that the economy would have sunk into a deep and long depression. In the short term, the Fed's emergency policies back-stopped the financial crisis and prevented it from growing into an economic crisis that could have been much like the 1930's.

Fed Policies and the S&P 500, 10 Years Click to enlarge

The New Normal

U.S. financial markets normalized by 2009, and total profits of U.S. corporations represented in the S&P 500 (NYSEARCA:SPY) index rebounded strongly and surpassed their 2007 peak in 2011. Despite all this, the Fed continued providing the same emergency stimulus. It continues to holds record $4.5 trillion of assets on its balance sheet, and just started raising the target rate from zero to 0.25% in December (see chart above).

The Fed's monetary stimulus has been the only public policy in place since the financial crisis - "the only game in town" as Mohamed El-Erian put it [1]. While the Fed has been aiming for the real economy to attain a "liftoff," or "escape velocity," the other major effect of these policies was boosting financial asset prices - bonds, stocks, real estate, etc. The real economy, however, failed to accelerate from its "new-normal" real growth of around 2%.

The above facts are well known. Most observers recognize that asset prices are elevated - and some criticize the Fed fiercely for supporting asset bubbles (though one is ill-advised to bet against the Fed). But at the same time, most economists believe that there is no harm in the Fed being patient and keeping the emergency stimulus in place while waiting for the economy to "liftoff."

Long-Term Effect

Not so, in my view - there is major harm done to our economy. The Fed's emergency policies that continued for seven years (instead of a year or two) had a major economic "side effect." They contributed to reduction in private business investment - corporations invested in financial markets (share buybacks) rather than investing in growing their businesses. Lowed business investment reduces productivity growth, which is major component of sustained economic growth.

Private business investment is considered to be the primary driver of subsequent gains in productivity, which in turn drive sustainable economic growth. These investments include new technologies, advanced processes, infrastructure, equipment, and workforce training - which then yield long-term benefits for the companies and create growth and jobs in the economy.

Through its actions (stepping in at the least sign of volatility) and words (recall "considerable period of time," "lower for longer," and "patient" language), the Fed created significant moral hazard - the "Bernanke-Yellen-Draghi put" on financial markets. Expectations firmed that financial asset and returns would continue to be elevated. At the same time, real economic growth has settled in a low 2% range (with the Fed's stimulus, mind you).

Source: FactSet

Corporate treasurers and CFOs invest their companies' cash based on expected returns on investment, as they should. Cheap borrowing at record-low interest rates and confidence in continued stock markets gains boosted expected returns from share buybacks. At the same time, investing in growth projects carried low expected returns due to low economic growth. Share buybacks in the last three years have been close to pre-crisis peak in 2007 (see chart above).

Sources: Noah Smith/ BloombergView, data from Federal Reserve

As you can see in the chart above, the trend in net private investment as a share of GDP started to falter in the 1990's. It plunged during the Great Recession, and the recent rebound took it just above the lows reached during previous recessions.

Of course, I am simplifying the situation by focusing on one factor. In reality, several other factors also influenced a downshift in economic growth in the 21st century, including:

  • growing economic inequality which hampers aggregate demand,
  • unwise open-trade policies, as has been the focus of political debate lately, and
  • "financialization" of the economy, according to Satyajit Das [2] - the replacement of industrial activity with financial products and services. One might argue that the Fed, under the leadership of then-Chairman Alan Greenspan, failed to contain (if not contributed to) this financialization.

As you can see below, productivity growth has slowed since 2006, other than a rebound in 2010 which didn't last. The employed share of US population has been slow to recover from the crisis and only now is approaching 60%, the same as in 1985.

Total Labor Productivity, 1970 - Present Click to enlarge

Source: OECD via Federal Reserve Economic Data Repository (NASDAQ:FRED)

Civilian Employment-To-Population Ratio, 1970 - Present Click to enlarge

Sources: Bureau of Labor Statistics via FRED

How Will This End?

Designed to be back-stop severe financial crisis, central bank emergency monetary policies are not only ineffective in stimulating the real economy, they actually degrade it in the long run. The ECB and the BoJ took these policies a step further than the Fed by implementing negative interest rates - and their economies are doing much worse than the US. If the US economy deteriorates, the Fed is prepared to do more of the same, and is evaluating negative rates, as former Fed Chairman Ben Bernanke's described here.

How will this end? As Mohamed El-Erian put it in his book [1]:

There is some limit beyond which it becomes totally unreasonable to divorce highly elevated asset prices from sluggish fundamentals.

The uncomfortable idea that central banks' monetary policies are becoming ineffective has already begun to draw increasing attention in the market. El-Erian argues that we are approaching a "T-junction," with good and bad outcomes equally likely. But I think we will take the downward-bound road. The question is when - I will try to cover this in a follow-up article - please stay tuned. Meantime, it is prudent to reduce exposure to assets that are elevated as a result of the Fed's policies - equities (SPY, IVV, QQQ, VTI, etc.) and long-term bonds (AGG, BND, IEF, LQD, TLT, etc.)

References

1. Mohamed A. El-Erian (2016). The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse. Random House Publishing Group.

2. Satyajit Das (2016) The Age of Stagnation: Why Perpetual Growth is Unattainable and the Global Economy is in Peril. Prometheus Books.

Disclosure: I am/we are short SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.