Most mainstream analysts praise the programs implemented by the Federal Reserve during the last several years under the leadership of Chairman Ben Bernanke. Many believe that the historic amount of monetary stimulus injected into our economy has helped it to heal following the severe recession in 2008. Unfortunately, the reality of the situation is that the structural deficiencies that plunged our economy into the worst recession since the Great Depression still exist. Instead of addressing the underlying problems, the Federal Reserve has chosen to provide superficial, short-term fixes in an attempt to create the appearance of substantive economic recovery. However, until the excessive debt problem is addressed in a meaningful way, our economy will continue to struggle, experiencing substandard growth and remaining vulnerable to shocks. Additionally, the short-term fixes applied by the Federal Reserve have significant unpleasant consequences that will also need to be addressed. Fund manager John Hussman discussed those consequences in his latest weekly commentary and we have reprinted an excerpt below.
Government intervention in the U.S. economy is approaching the point where probable long-term costs exceed short-term benefits - straining to maintain the pace of extraordinary fiscal and monetary measures that have repeatedly nudged the U.S. economy from the border between new recession and tepid growth for three years. U.S. Treasury debt now exceeds 105% of GDP (publicly held debt approaching 75% of GDP). Meanwhile, the Federal Reserve has expanded the monetary base to more than 18% of GDP (18 cents per dollar of nominal GDP), where a century of U.S. economic history indicates that a normalization to Treasury bill yields of just 2% could not tolerate more than 9 cents of monetary base per dollar of GDP without inflation.
The federal government continues to run a deficit of about 7% of GDP, which the $85 billion sequester would reduce to about 6.5% under the unlikely assumption that economic activity and revenues don't contract somewhat. Current Federal Reserve policy absorbs about $45 billion per month in new government debt as part of QEternity, but even the Fed continues this policy indefinitely, U.S. publicly held debt is still likely to expand by several percent annually assuming no recession occurs. Any eventual normalization of Fed policy would dump Treasuries back into public hands (or require public purchases of new debt in the event the Fed decides to let the holdings "roll off" as they mature). Massive policy responses, directed toward ineffective ends, are scarcely better than no policy response at all.
To offer a visual picture of where monetary policy stands at present, the chart below depicts the current situation, as well as data points since 1929. As of last week, the U.S. monetary base stands at a record 18 cents per dollar of nominal GDP. The last time the monetary base reached even 17 cents per dollar of nominal GDP was in the early 1940's. The Fed did not reverse this with subsequent restraint. Instead, consumer prices nearly doubled by 1952. At present, a normalization of short-term interest rates to even 2% could not be achieved without cutting the Fed's balance sheet by more than half. Alternatively, the Fed could wait for nominal GDP to double and "catch up" to the present level of base money, which would take about 14 years, assuming 5% nominal GDP growth.
Of course, 5% nominal growth would likely make it inappropriate to hold short-term interest rates below 2% for another 14 years. So either the Fed will reverse its present course, or we will experience unacceptable inflation, or we will experience persistently weak growth like Japan has experienced since 1999, when it decided to take Bernanke's advice to pursue quantitative easing. My guess is that we will experience unacceptable inflation, beginning in the back-half of this decade.
Because of the strong relationship between the size of the monetary base (per dollar of nominal GDP) and short-term interest rates, it appears likely that short-term interest rates will be suppressed by Fed policy for some time, until Fed policy normalizes or inflation accelerates. The Fed is now leveraged 55-to-1 against its own capital. With an estimated duration of about 8 years on $3 trillion of bond holdings, every 100 basis point move in long-term interest rates can be expected to alter the value of the Fed's holdings by about $240 billion - roughly four times the amount of capital reported on the Fed's consolidated balance sheet.
Ultimately, the normalization of the Fed's balance sheet - outside of weak economic conditions - is likely to press long-term interest rates markedly higher. This would be particularly true in the event that inflation accelerates and forces that attempt to normalize, which we expect in the back-half of this decade. As a result, the next economic recovery will very likely be associated first with a significant steepening of the yield curve, and only later by an inversion as the Fed scrambles to tighten. But in my view, the time to expect higher interest rates is not now.
I continue to expect that the course to the next economic recovery is likely to be punctuated by a global recession that is already underway in the rest of the developed world. At best, U.S. participation in that downturn has been kicked down the road for a quarter or two by QEternity. It also remains possible the final revised data will indicate that the U.S. entered a recession sometime in the third-quarter of last year. Meanwhile, immediate inflation risks do not appear pressing (despite the increase in longer-term inflation expectations), and the overwhelming negative sentiment toward bonds seems likely to be replaced by a flight to Treasuries as a safe haven. The same should not be assumed for corporate or high-yield debt, where yields have plumbed historic lows and current risk premiums appear barely sufficient to cover actuarial default risks.
By varying the amount of monetary base relative to nominal GDP, the Fed has very tight control over short-term Treasury yields and some control over the long-term yields that reflect expectations of the future course of short-term rates. But quantitative easing has also had an effect in suppressing risk premiums in securities that have much less dependence on the course of short-term rates - particularly junk rated debt, corporate debt, and stocks. The apparent blind faith in an automatic link between Fed easing and diagonally rising prices is not supported by the data, however much an uncorrected rally makes it seem otherwise.
The present syndrome of overvalued, overbought, overbullish, rising-yield conditions is the same basic environment that concerned us in 2007, and in 2000 (as well as May 2011, just before the market experienced a near-20% swoon). While the Fed continues its policy of quantitative easing, that policy is fully recognized and investors now fully rely upon its continuation. It is also an element of common knowledge that "everything will be fine until the Fed reverses course," at which point everybody will presumably be able to sell to nobody. Unfortunately, the support for such complete confidence in Fed policy is vastly overstated.