The Fed's Dangerous Game: A Fourth Round of Stimulus in a Single Growth Cycle
The longer the signals in capital markets go haywire under the influence of “monetary stimulus,” the bigger is the cumulative economic cost. That is one big reason why this fourth Fed stimulus — in the present already-longest (but lowest-growth) of super-long business cycles — is so dangerous.
True, there is nothing new about the Fed imparting stimulus well into a business cycle expansion with the intention of combating a threat of recession. Think of 1927, 1962, 1967, 1985, 1988, 1995, and 1998.
This time, though, we've seen it four times (2010/11, 2012/13, 2016/17, 2019) in a single cycle. That is a record. Normally, a jump in recorded goods and services inflation, or concerns about rampant speculation, have trumped the inclination to stimulate after one — or at most two — episodes of stimulus.
Also we should recognize that the length of time during which capital-market signaling remains haywire, is only one of several variables determining the overall economic cost of monetary “stimulus.” But it is a very important one.
Haywire signaling is not just a matter of interest rates being artificially low. Alongside this there is extensive mis-pricing of risk capital. Some of this is related to the flourishing of speculative hypotheses freed from the normal constraints (operative under sound money) of rational cynicism. Enterprises at the center of such stories enjoy super-favorable conditions for raising capital.
There are also the giant carry trades into high-yielding debt, long-maturity bonds, high-interest currencies, and illiquid assets, driven by some combination of hunger for yield and super-confidence in trend extrapolation. In consequence, premiums for credit risk, currency risk, illiquidity, and term risk, are artificially low. Meanwhile a boom in financial engineering — the camouflaging of leverage to produce high momentum gains — adds to the overall distortion of market signals.
Crucially, the length of time over which capital-market signaling has been haywire does not neatly coincide with the business cycle. Rather, it may extend into the previous cycle — and beyond — if it is a long time since there has been any sustained period of non-stimulus. This consideration is a rationale for the hypothesis of the long financial cycle — stretching well beyond one business cycle — as hypothesized in research at the Bank for International Settlements.
Accordingly, in the course of a long financial cycle upswing, there could be a recession which briefly shrinks the speculative froth across a range of asset markets. But there would be no extended period of monetary normality (absence of stimulus) during which signaling again became efficient.
For example, think of the business cycle expansion of 2003–2007. In fact, monetary stimulus was already over by late 2005. How could such a short monetary inflation have had such devastating results in terms of Crash and Great Recession? At least part of the answer is the long period during the previous cycle in which prices had also been haywire. This period includes most of the years from 1993–2000. The 2001–2002 economic downturn was mild and the subsequent stimulus (2003–2005) was radical.
The same point about the duration of haywire stretching into the previous business cycle can be made for the asset inflation (coupled with goods inflation) of 1971–1973. Only an exceptionally mild recession and short effective monetary tightening in 1969 (and earlier a brief “credit squeeze” in 1965) interrupted the Fed stimuli during the long cyclical upswing to that date. Earlier in the twentieth century, the shortness of the 1920 recession (though severe) and the power of the subsequent Fed stimulus meant there was no substantial respite from capital market mis-signaling. This dated back to the start of the Great Asset Inflation in 1915–2016 (ignited by vast Fed purchases of gold from Britain and France during the period of neutrality).
Length of time during which capital-market signaling remains haywire is crucial to the amount of overall mal-investment which occurs and the ultimate cumulative economic cost. We also should consider the severity of the mis-signaling. This depends in part on a range of idiosyncratic factors which determine the power and growth of speculative storytelling.
Of course, mis-signaling in capital markets, as measured by duration and extent, is not the only source of economic cost from prolonged asset inflation. There are also the incidental mistakes, sometimes very big, which the Fed makes during the periods of economic slowdown or recession, which interrupt or succeed the asset inflation.
Relevant history here includes the over-tight monetary policy of late 1928 and first three quarters of 1929 as the Fed fought excess speculation on Wall Street. The Fed was blithely unaware of the gathering recession from the autumn of ’28 in Germany, then the world’s number two economy, and the chief destination of vast speculative waves of loan capital. In modern times, we can take the Bernanke Fed’s tight money policies through 2006–2007 driven by concern about CPI inflation above target when asset and credit inflation was already cooling.
In measuring the cumulative economic cost of price-signal malfunctioning in capital markets and coincidental Fed mistakes, it is not just a matter of assessing the severity of the Crash and Recession which marks the end stage of the cycle under review. Costs accrue over a long period of time and might be huge even when these events seem mild. Mal-investment means that the growth of economic prosperity can suffer over decades, especially if, subsequently, capital-market pricing remains haywire and the invisible hands suffer from paralysis.
This has likely been the case with cumulative mal-investment in the first two decades of the present century — helping to explain why growth in overall prosperity has been so meager. Looking into the future there could well be growing evidence of bloated investment (relative to what would happen under sound money) in often negative-sum-game digital technology. This is driven in part by speculative narratives of present or future monopoly power.
In this context, the fourth Fed stimulus is especially dangerous. It is still possible this will be a failed stimulus. Asset inflations tend to burn themselves out. Growing mal-investment, and speculative narratives which become tired, become reflected in slower business earnings growth. Pessimism then becomes apparent in weakness in some particular asset markets, downgrades of credits (as collateral values fall) and at some stage a panic for the exit from crowded carry and other trades. These endogenous forces may be gathering strength and capable of over-powering the “Powell put.”
Take, however, the alternative scenario: where the Powell Fed’s stimulus is indeed effective in producing another growth-cycle upturn which starts well ahead of Election Day. A new momentum of mal-investment around the globe is to fear — along with related fantastic boom time for the financial engineers. There would be chat in the media that the business cycle is dead due to the skill of the data-dependent Fed in administering ever-ready stimulus.
Like the townsfolk in Gogol’s Government Inspector, markets would fete the mysterious disappearance of the recession danger which visited in 2019, even attributing the escape from a new hard regime as due to their representatives’ skill. Later it would turn out that the visitor was an artful impostor and the real inspector (recession and crash) arrives with no notice.