Could The Fed's Balance Shrinking Actually Stimulate The Economy?

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by: D. H. Taylor

Summary

The Fed is raising interest rates and will continue to do so through the year.

Higher interest rates are going to draw in funds from around the world, pushing up Treasury prices, muting interest rate yields.

This, to the chagrin of central banks around the world as they counter the flows of funds outward towards the United States.

The yield curve is flattening. I have been doing some research on an article and have gotten some good input from a fellow Seeking Alpha contributor, Michael Roat. The concern is that the yield curve is signaling a future weakness in the economy. But, I wonder if the yield curve even matters at this junction. My rationale is simple: The yield curve is reactionary; The current yield curve is past tense. What everyone should be looking at is the consumer, after all the consumer is 73% of the driving force of the economy. Then, you can figure out what will happen with the yield curve. In the meantime, I think the slew of articles that I have been running in to, from respectable news sources, are trying to push on a string to determine the future of the United States economy.

First, I ran into a contrarian article today that thought the flat yield curve, with rising short term rates, may actually fuel this economy. I found the thesis dubious. But, there were some aspects that made me think. The idea is that the rising short term rates would draw in funds into the United States; higher yields would favor investments in the U.S. This would drive up the dollar's value and the money market funds would be pushed higher.

The higher dollar theory I thought was interesting. With a higher dollar, inputs goods could be purchased at more competitive prices. But, over half of all goods purchased in the United States through imports are intermediate goods, not direct consumer goods. The United States also takes these intermediate goods, completes a packaged good, such as an automobile, and then will sell that vehicle overseas. Because the US dollar has increased via the funds moving into the country, the goods sold by the United States would increase.

But, keep in mind one thing: The USD Index is dropping. So, while I found the concept interesting and could see a better terms of trade side of the equation, it is negated by the fact that the short-term interest rates are higher in the United States already, yet the USD Index is moving lower and I expect that trend to continue.
My biggest concern with the Fed's moves are that the consumer is not healthy enough for interest rates to move too high, too quick. But, at the same time, that first article was on to something in the sense that higher interest rates do have the potential to draw in more money from abroad. This is an idea I have had in the back of my mind for some time.

Let us look at a hypothetical example to see what I am thinking of. If all of a sudden the yield on the United States Treasury 10-year bond, the benchmark of the industry, shot up to a healthy 5.00%, whereas the rest of the industrialized world had interest rates at a not-so-healthy 2.00%, where would you invest? Or, for that matter, every other individual in the world, where would they invest? Ostensibly, you would want to invest in the place with the highest yield in the world, and, in this scenario, that is the United States.

But, while the Federal Reserve is busy letting their bond investments roll over, the rest of the world would be moving money into the United States. This would do two things. First, the USD Index would head right back up because of the money flowing into the U.S. But, all of that new demand would push up the price of bonds and keep interest rates mostly lower.

However, all of that money just left one country for America. That begs to question, what just happened to their respective interest rates as all of that money just sold off those bonds in order to gain better yield in the United States?

This would certainly push the Bank of Japan, the European Central Bank and the Swiss National Bank to continue with their respective quantitative easing programs just to maintain a set interest rate target in those economic regions.

Keep in mind 2004's "Conundrum" that Greenspan fretted over. The Chairman was in the process of raising short term interest rates but the high demand levels of yield kept the longer end of the curve on the low end. It may be that the current Fed is going to have to deal with another kind of conundrum.

Given this, I almost get the sense that the Federal Reserve will pull off shrinking its balance sheet, that is, up until a certain point. I still defer to the consumer and what is happening there.

I always start with the consumer and the health of their expenditures to see where the economy is headed. For the consumer, increases in incomes translate into increases in expenditures. Sometimes the growth in expenditures are fueled by loans.

In the case of the current economic landscape, the rate of growth in lending is drying up.
If the economy was in a bubble and the Fed were to shrink its balance sheet, interest rates would move higher. But, the United States is not in a bubble. There are individuals all over the world who would invest in the United States.

The process of shrinking the balance sheet for the Fed does involve banks having to set aside funds simply because the Fed is reversing the process it started after the financial crisis. Banks are going to have a tough time lending in that environment where they are trying to set aside capital that was used by the Fed now that the Fed is transferring the paper back to the bank. Loans will shrink, that is, up until a certain point.

That shrinking is going to push interest rates higher… up until a certain point. That point is when investors from around the world, and, even inside the United States, start chasing after higher yield. That rush of money into the United States will mean that banks will be flush with cash.

It is almost as if shrinking the balance sheet will stimulate the economy simply because of the rush of money into the United States. That is exactly what the first article I quoted on this article stated.

However, as I alluded to, this will end up being a beggar-thy-neighbor policy. The central banks from around the world will be busy, that is for sure.

If the Fed really wants to stimulate the United States economy, they are going to have to raise interest rates. And, that may be the only time in history when that sentence was typed.

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.