The Federal Reserve Is Driving A Car That's Out Of Fuel

by: Chris Wallendal CFA


Monetary policy was designed as a tool to guide the rate of economic growth while controlling inflation, but cannot of itself create real growth. Neither can capital alone.

While even "good" monetary policy cannot create real growth, bad monetary policy moves can certainly destroy progress and create bubbles. ZIRP and NIRP policies cripple banks rather than encourage lending.

Despite this, markets continue to react to every word central bankers utter because the flood of liquidity, while not creating economic growth, does inflate financial assets.

Deflation has replaced inflation as the worldwide "bogeyman", but maybe it's time to shine some light on this fear rather than blindly reacting to it.

Steering A Car That's Out Of Gas

If we think of capitalist world economies as cars, then central bankers are the drivers. Greenspan driving Using monetary policy tools (money supply, overnight rates, reserve requirements, and - most often - jawboning of expectations) to steer a course between inflation and economic contraction has been their historic role. And if the central bankers had a map, they certainly didn't tell where they were headed. The important thing was to keep everyone's confidence that they were watching the road ahead.

Importantly, it is not the monetary policy which actually moves the car forward. It is designed to be the steering, gas pedal, and brake. The fuel that propels the economy are productive resources, both tangible and intangible, such as labor, invention, innovation, raw materials, industrial machinery, factories, etc. In other words, it is putting the effort and inputs towards new or bigger products and services which create economic growth. That is the gas that we put in the economic tank. Unfortunately, the gas comes in waves and sometimes seems to be all used up, which is when monetary policy can help by steering to a downhill slope to keep things moving until the economy finds another gas station.

Necessary Is Not Sufficient

Note that I did not list capital as an input - and for a reason. As Mohamed El-Erian writes in The Only Game In Town: Central Banks, Instability, and Avoiding the Next Collapse,

...a significant part of the banking sector was no longer focused on its traditional role of serving the real economy - by mobilizing savings and channeling them in a cost-effective fashion to the most productive investment opportunities...No longer was the historic process of economic development characterized as just involving the various value-added stages of agriculture, industry, manufacturing, and services.

The point which we often forget in these days of "high finance" is that capital helps to allocate resources, but in and of itself is not what creates the goods and services we need. We use money to pay workers, but they build the houses while the cash just sits in the bank.

So we see that monetary policy doesn't create the real economy. But as the old song goes, "money makes the world go 'round". After all, if we had to barter without currency for every good and service we consume, most of us would have a hard time getting more than just some simple basic needs met each day. In logical terms, money is necessary - but not sufficient - to enable real economic growth.

That is the most basic and truly important function of currency - to facilitate trade. For this to develop into efficient systems, money had to be monopolized by each banking jurisdiction (it's not worth the paper it's printed on if anyone can just create it) and the monetary supply had to be controlled to provide enough to facilitate the total potential value of trade in the economy, but not so much that the currency became "cheap" and led to high inflation.

Putting these concepts together reveals what traders call a one-tail risk: getting monetary policy right creates the conditions for the real inputs to the real economy to grow with low inflation. But mess it up and the whole economy suffers, even if sufficient inputs are otherwise available. I hope central bankers are well-paid!

The transmission mechanism for said monetary policy is the commercial banking system under the central bank's supervision. Again, the basic and most important function of the banking system is not to create complex derivatives, quantitative trading strategies, and creative financing structures. The basic, easy to understand function of banks is to provide the fundamental service of matching savers' deposits to borrowers' loans. When this happens efficiently, monetary policy can be effective; lower rates and more money encourage businesses to expand, while higher rates and less money supply slows the growth rate.

The problem is that we got away from these basics by allowing hyper-inflation in the 1990's - 2000's:

US Inflation Rate Chart

US Inflation Rate data by YCharts

Don't see the hyper-inflation that I'm talking about? That's because it doesn't show up in the measured CPI. According to central banking history, Paul Volcker slew the inflation beast of the 1970's and 1980's. What I'm talking about is the hyper-inflation that caused the housing bubble, aided by unsupervised banks "lending" increasing amounts of money to homeowners. I put "lending" in quotations because the banks were not engaging in a typical lending transaction whereby they would issue loans as a multiple of deposits in our fractional reserve system and collect interest income on those outstanding mortgages. What they were doing is collecting origination fees and packaging and selling the underlying mortgages as mortgage-backed securities. Banks were incentivized by volume, not credit quality. That is what gave birth to such economically bizarre instruments as sub-prime, zero down, zero interest payment, no documentation, bullet maturity, and negative amortization loans.

This firehose of money thus created in the housing market created the bubble which nearly took down the financial system when it turned out that the underlying assumptions of the mortgage-backed securities did not anticipate the level of defaults that would eventually occur as a result of the overly aggressive, poor credit quality loans that were made. People quite simply could not earn enough to repay the loans as housing prices far outstripped the growth in personal income.

As I said, this was the result of poor bank supervision and the inability of regulators to keep up with the pace at which banks had departed from their basic function of matching deposits to loans. The response to the crashing financial system in 2007-2008 has been massive, unprecedented worldwide stimulus (i.e., more firehoses of money that made the first one look like a squirt gun) and zero interest rate policy ("ZIRP") and now negative interest rate policy ("NIRP"). The end results of these experiments in central banking are still to be seen, but have led to massive debt increases at the sovereign level, severe income challenges to savers and retirees, dislocations of markets, and an increase in the level of all risk assets even greater than what had happened in the housing market. A great example of this strange world we live in is that Italy can borrow more cheaply than the U.S. in ten year bonds. Explain that one to your kids.

As for healing the banking system and returning it to the basic function of deposits and lending, the low interest rate policy is crippling rather than nursing the damaged system. Think about it. In the normal course of banking, a spread called net interest margin ("NIM") is earned on the difference between what the bank pays depositors and what it earns on loans. Part of this spread compensates the bank for potential credit losses and the rest is available to grow the bank and/or reward its shareholders. How can this happen in a ZIRP, much less a NIRP, environment? My simple calculator can't come up with an answer to that. Savers don't have an incentive to deposit money with no return and banks have no incentive to lend with no ability to absorb credit losses and earn a NIM spread.

Bad News Is Good News

The one apparent effect of flooding the world with liquidity has been the inflation of financial assets. This is also not hard to understand. The Fed's multi-trillion expansion of its balance sheet, followed by central banks around the world buying financial assets from sovereign bonds to stocks and even commodities, has been a windfall for the owners of those financial assets and every new round of stimulus means more money for them. As I write this, the news just broke about a new record $500mm art purchase, not surprisingly by a hedge fund manager.

This is why we have entered into the also economically bizarre world of "bad news is good news" for the stock market. Any weak economic data creates a Pavlovian response in traders expecting their next treat.

Looking Under The Bed

There have been a number of analyses lately regarding negative interest rates and deflation. Having "conquered inflation", deflation is now the world's greatest fear and one justification for ZIRP and NIRP.

Calvin fears inflation

So let's shine some light on deflation fears. Deflation is a decrease in the general price level of goods and services which increases the real value of money over time, incentivizing people to save rather than spend, thus creating a drag on economic growth. Simply put, why buy a car today if it will be cheaper tomorrow? If too many consumers and businesses adopt this attitude, then it becomes a self-fulfilling downward spiral as weak demand leads to lower prices and more deflation.

Is that what the world is really facing? Commodity prices have obviously fallen, but isn't that ultimately a good thing? China's growth has slowed, but not yet gone negative as the country tries to transition to a consumer oriented economy, damping decades long demand for raw materials. In the normal course of business and progress in elevating worldwide standards of living, the things we buy do become cheaper. What few people realize is that measures of inflation are distorted and difficult to measure. The often cited CPI is adjusted more than the headlines let on. For example, say a car sells for $30,000 this year. Next year, the same car but one model year newer sells for the same $30,000 but includes a self-parking feature because that is what competition in the market requires the company to offer. Was there inflation, deflation, or stable pricing? According to the CPI adjustments, this is deflation because you are getting more for the same price.


The housing bubble caused a crisis felt around the world. The Federal Reserve was asleep at the wheel when this happened and is now trying unprecedented experiments, which have spread across the globe, to try to avoid the pain of the consequences. As a result, a far greater bubble has formed in financial asset prices and sovereign debt levels. In the process, the banking system has been cut off from the opportunity to return to its core function in allocating capital due to ultra-low or even negative rates. Given the interconnectedness of world economies, this has created a race to the bottom, justified by fears of deflation. Just as the official inflation numbers did not reflect the hyper-inflation caused by the housing bubble, the current low inflation numbers do not reflect the reality of shifting bubbles in the economy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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

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