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The Zero Bound Dilemma
10/08/2004 12:00 am EST
What would the Fed do if rates fell to zero? In tackling this question, John Mauldin, as always, epitomizes the concept of thinking "outside the box." His commentary does not suggest an easy answer, but offers a thought-provoking, conceptual analysis
"A battle plan, we are told, seldom survives contact with the enemy. Nonetheless, military leaders throughout the world wisely persist in making plans they know will be changed time and time again once the battle starts. Contingency plans are made for all sorts of events, whether likely or unlikely, on the off chance that when something goes wrong (and Murphy assures us it will) that there will be a plan to deal with the next crisis. So it is that we consider the battle plans of the Fed to combat that most serious of monetary enemies, the Zero Bound Dilemma. What would happen if interest rates went to zero? Let me start with what may appear as heresy. I am not going to deal with whether or not a Fed policy of lowering rates or providing stimulus is appropriate. For our purposes, it is irrelevant. The Fed is not going to listen. We are going to explore what I think they will actually do.
"When armies are gathering, smart people move away from the battlefield. If the Fed decides to use its arsenal to fight deflation on some future economic battlefield, you do not want your investments to be at ground zero. Arguing about dialectic materialism or whatever the current political nonsense is does little good when there are bullets in the air. Likewise, debating theoretical economics might make us feel good, but it will not protect your retirement portfolio.
"Let's start with a summary of recent Fed policy and where we are today. Inflation as of late 2003, early 2004 had fallen about as low as it could go without being too close to deflation. Recessions are by definition deflationary, and having one in the current low-inflation environment would probably lead to outright deflation and bring up thoughts of Japan. The Fed repeatedly referred to ‘an unwelcome fall in inflation’ in the meeting summaries as a possible risk to the economy. Remember, those words were used only last year.
"Low interest rates were clearly a major stimulus to the economic recovery. The recession of 2001 would have been much deeper without aggressive Fed action combined with Bush's repeated tax cuts. The lowest mortgage rates in 40 years led to a booming housing market as more people could afford to buy first-time homes, and more people could afford to move up to larger and newer homes. In addition, mortgage refinancing allowed consumers to lower their mortgage payments as well as take money out of their home equity for other purchases. If interest rates (and especially mortgage rates) were to rise significantly in a fragile recovery that is largely stimulus driven, the recovery could be aborted before it has time to develop a firm foundation in business spending. Thus Fed policy was to keep rates lower for a longer period than in any previous recovery.
"But what would happen next? What happens when it is time to raise rates (and/or the market does it for you) or if business spending (the third leg of the economy) is not prepared to pick up the slack from slowing housing and consumer sectors? What does the Fed do then and what are the likely results of its actions? As I wrote early this year in Bull's Eye Investing, ‘The members of the Federal Reserve are genetically programmed, deep within their economic DNA, to fight recessions with all the tools available, and especially a deflationary recession that might develop. They do not believe that it will make things worse.... They will risk a little inflation in order to drive a stake through the heart of the deflationary vampire. The belief (or hope) at the Fed is that with enough stimulus we can work through the hangover of the 1990s (debt, deflation, excess capacity, dollar bubbles, trade deficits, etc.). Rather than one very big recession that hits the reset button on the economic imbalances created during the 1990s, the Fed hopes to slowly deal with them one by one by growing our way out of the problems, stimulating demand every time we slip nearer to deflation and/or recession.’
"Now, fast forward to today. The Fed is slowly raising rates. The market seems to think they will raise rates to 2% by the end of the year. Some think they will then stop and wait to see if the coast is clear before they raise rates again. By coast is clear, they mean that the economy is still doing fine and job creation is proceeding apace. Full employment is a congressional mandate the Fed is supposed to work on. Others think they will keep right on going as they work to keep inflation from coming back, another sometimes-conflicting congressional mandate of the Fed. A 2% Fed funds rate is not even keeping up with inflation. Such rates represent a negative real interest rate, and will ultimately result in inflation. The thinking is that they will raise rates until they are at least at the level of inflation, and tack on a few points for good measure.
"I think there may be a third way to look at the current situation. Let's look at what happened as the last recession started. Inflation was still above 3.3% in 2000 prior to the start of the recession. In 2001, the Fed had 6.75% fed fund rates, so they had plenty of room to lower rates to try and provide stimulus to the economy. In 2001, the government budget was in surplus and we were actually lowering government spending. There was budgetary room for significant tax cuts to work in tandem with lower rates to maintain consumer spending. Additionally, Bush and Congress sent billions in direct payments not once but twice to consumers. To top it off, the Fed was able to talk long-term mortgage rates down to their lowest level in 40 years. This kept the housing market alive but also lowered consumer costs as millions refinanced. Homeowners also pulled out billions as they refinanced their homes.
"It was a perfect storm of stimulus. It produced what I called the Steroid Economy. GDP went to a rate of over 8%. Slowly employment began to creep back up. Unemployment is now down to 5.4%. Let's make no mistake. Without all this stimulus, and coming off the bursting of the largest investment bubble in history, not to mention the severe shock of September 11, we would have entered into a ‘soft depression’. Without such aggressive policies we would have slipped into deflation. Unemployment would have gone to 8% or higher. A difficult worldwide recession would have resulted as the engine of the American consumer would have lost its fuel. But the point is that we did have the stimulus and it did work. You can argue that we merely postponed the pain, but others would argue that it was simply minimized. In any event, that is an argument for another day. All that is history and at this moment we need to think about the future.
"Now let's look at the question ‘What would happen if the US economy were to go into recession early (or even the middle of) next year?’ There would be trouble in River City, that's what. First, inflation is still less than 3%. Using the measure that the Fed prefers, the GDP deflator, it may be less than 2%. (Because it isn't based on a fixed basket of goods and services, the GDP deflator has an advantage over the consumer price index (CPI). Changes in consumption patterns or the introduction of new goods and services are automatically reflected in the deflator.) Interest rates are obviously already low. There is no room for future tax cuts of any significance. Even if mortgage rates were to drop back to close to 5%, much of the boom from refinancing has already happened. In short, there are few ‘standard policy’ means to try and jump-start an economy.
"If we were to soften into a recession in early 2005 (an event which is not all that likely, but we are talking hypothetically here), we would soon be talking of deflation. Two percent inflation is not a sufficient buffer from a deflationary recession when interest rates are only 2%, at least from a central banker's viewpoint. The Fed is on a course to increase rates as fast as possible while also allowing inflation to rise more than one would normally think. They need to re-load their guns. But they cannot risk the economy getting soft at this point, as the only ‘weapons’ they would have would be lowering rates to zero. The ‘real’ stimulus that one would get at the Zero-Bound is not all that much more than 1%. So perhaps (and this is what I think) the Fed will go slowly, but they will keep going longer than we now think, perhaps pausing here and there, letting a little inflation pressure build, because they do not in fact want to experiment with ‘non-standard policy alternatives.’
"The best outcome, and what is the current ‘plan,’ is one where businesses start to invest and spend their cash horde (cash to debt ratios of US businesses are at cycle highs), employment drops below 5%, and consumer spending continues to modestly grow. Hopefully long-term rates don't rise that much and therefore housing keeps rocking along. The Fed can continue to raise rates, we get a little ‘buffer’ inflation and things are back to normal. The longer we go without a recession, the higher that rates go, the sooner the Fed can return to its comfortable role of inflation fighter. The next recession comes along and the Fed is ready to make it a short, brief affair. Hey, it could happen.
"However, no battle plan survives contact with the enemy. As noted above, the best outcome would be for a long period of economic stability as the world resets. But such periods are the exception and not the rule, so let's look at the contingency plans. In such a situation, the immediate goal would be to lower long-term rates and thus mortgage rates, and to keep lowering them until the economy finds ‘traction.’ How to do that? Let's remember that last year the Fed ‘jaw-boned’ rates down. Simply hinting that they would use non-standard policies, coupled with the words ‘a considerable period of time,’ drove mortgage rates to their lowest level in four decades.
"But what about if talk is not enough? Then, the Fed could actually set the rate for the ten-year treasury, offering to buy from all comers at a lower fixed rate for a period of time. In such an environment, the unintended consequences will be huge. The dollar could (and probably would) come under great pressure. The result might (and I think would) be that we end up with our old friend stagflation. But that is a story for later …."
Editor’s Note: The Stock Trader's Almanac recently named John Mauldin’s Bull's Eye Investing as one of the Year's Top Investment Books in their upcoming 2005 edition. James Altucher writes, " I don't always agree with him on everything but this is a must-read for the investment professional and individual investors."