5 February 2019

By Alex Karidis

It was only a couple of weeks ago that the Chairman of the Federal Reserve gave his scheduled press conference following the Federal Open Market Committee’s (FOMC), meeting. As was broadly anticipated by the markets, the Fed decided to take a “wait-and-see” approach to the overall economy and thus the committee’s actions regarding interest rates and the Fed’s balance sheet. The stance on being patient was most welcomed by market participants. It is the opinion of The Kapital News that the market is akin to a drug addict and the Fed – the drug dealer.

            Only a couple of months ago, the major indices of the US markets entered correction territory as defined by a 10% decline. This was then followed by a further decline that put these indices in bear market territory or reaching a 20% decline. Well it should have came as no surprise that the addicts, coming down from their highs, would throw a tantrum, a hissy-fit, whatever you want to say, to get the attention of their dealer – they sure succeeded! Not only did the Fed come under pressure from the markets, but also from President Trump. There were immediate calls for the Fed to reverse course or at least stop what they’re currently doing. So, what is or was the Fed doing?

            For well over a year, the Fed has been discussing increasing the Effective Federal Funds Rate from its extreme policy of low interest rates coupled with quantitative easing (QE). This interest rate is used by banks for overnight lending purposes. Banks with excess reserves will lend money to banks in need of additional liquidity in order to satisfy their daily reserve requirements. This rate has been zero-bound since 2008 during the financial crisis. This also went by the term ZIRP or Zero Interest Rate Policy for those “in-the-know.” It has gradually been increasing and we stress the word gradually, for the past couple of years. It currently stands at 2.27%. Even though the Fed has been broadcasting for some time now that it intended to “normalize” interest rates as well as to continue to reduce the size of its balance sheet – the markets declined rapidly during Q4 of 2018.

            This now raises serious questions for the broader economy at large and the financial markets. What credibility does the Fed have? Will the Fed do a 180 and cut rates and embark on a new leg of QE? If the economy is so vibrant, then why do minute interest rate increases of 25 basis points negatively shock the markets and economy? If the economy is so strong, then why is the Federal government running near $1 trillion deficits? These questions need to be asked and they need to be answered!

            With respect to their credibility – it is the opinion of this author that they have NONE!!! We’re supposed to believe that a team of 200 PhD economists at the Fed, in addition to any analyst the Fed wants input from, that they all got it wrong?! They broadcast that the economy is doing well and thus it is appropriate to increase rates and continue with their balance sheet run-off and then BAM, markets decline, the economy is now not so vibrant, and the global economy is suddenly slowing. They didn’t see this coming?! What the hell are they looking at?! Or does it become more of a question between who does the Fed work for, which leads to the title of this article.

            During his press conference, Chairman Powell made it clear that the Fed works for the American people. This commentary simply asks, What Americans, Mr. Powell? In our recent podcast, A Stock Market Divided Cannot Stand, we stated that the Fed is not helping Americans who are attempting to save. With low interest rates, savers are not earning any interest on what savings they may have. This has been true for a decade of significantly flawed monetary policy. Economies are not built on the backs of over extended consumers and over leveraged banks and corporations, but rather on the savings and investments of market participants. We continued with older Americans and how many of them live on fixed-incomes, and in some instances, a very-fixed income. The mechanics of QE is by definition an inflation generating process. Once this liquidity makes its way through the economy, the effects of this inflation (money-printing) are felt. This has adverse effects, especially on older Americans on fixed incomes as their cost of living outstrips their rise in income – should they even experience an increase to their incomes.

Their policies of ZIRP and QE are fundamentally flawed for middle income and lower income Americans. Yet how have these policies faired for the wealthy, corporations, banks, and the government? Well you guessed it – they have done extremely well! The markets have reached new all-time highs and given the wait-and-see stance by the Fed, they may make even greater highs this year. The wealthy who own the majority of financial assets – stocks, bonds, real estate, have seen tremendous gains to their portfolios and net worth. This author does not demonize success, for he is an ardent proponent of free market capitalism. Yet, money printing is not capitalism! Therefore, these gains to the wealthy, the corporations, and the banks have come at the expense of middle- and lower-income Americans. Corporations have used this funny-money to engage in financial engineering never seen. One such activity relates to share buybacks. The amount of share buybacks has gone to increase earnings artificially as opposed to organically, since some of this activity has occurred due to access to cheap money. The same holds true for the increasing of dividends and leveraged loans, which are loans that will be used to pay-off other loans. Many of these financial gimmicks can translate into higher stock prices – and they have. This then translates into higher compensation for C-suite executives as their earnings may be tied to stock price performance. Starting to get the picture?

Now onto how the government benefits. The US government’s stated national debt is nearing $22 trillion. This does not include the unfunded liabilities that increase this number several times. If one were to look at the amount the US pays on interest payments alone, which is over $300 billion per annum, one must then ask, how much longer can this be sustained? Well, so long as the Fed keeps interest rates low and/or returns to another round of QE, which is the Fed purchasing Treasuries, then Uncle Sam may be able to keep this charade going. However, if the Fed were truly concerned with macro-events, then they should be ringing the alarm bells telling Congress and the President that this is unsustainable and public finances must be dealt with. They do not do this because this would require someone to be an adult in the room and to stand up and be a true leader. We do not have such leaders in our current government nor have we for many years. The problem this creates is two-fold. First, it continues to kick the proverbial can down the road and thus these problems will only get worse and that much more difficult to resolve. Secondly, there does not appear to be any concern that interest rates may take on a mind of their own. In other words, markets may look at the financial health of the federal budget, or lack thereof, and say, in order to lend money to Uncle Sam, we’re going to need a higher return. Therefore, despite the efforts by the Fed, they may one day soon fall on deaf ears. When one looks at Treasury rates, especially the 10-year Treasury, it must be understood that many other rates, such as mortgages are closely linked. If rates were to rise either by decree from the Fed, or worse by the market, the downstream effects will make 2008-2009 look like a walk in the park. If rates remain low and/or the Fed should do a 180 and lower rates and/or embark on a new round of QE, these problems will only get pushed further down the road. Once these debts come due, this too will make 2008-2009 look like a walk in the park. Damned if we do and damned if we don’t – great going Fed.

We have done this to ourselves. Living beyond our means and not holding ourselves and our political leaders accountable has serious and significant costs. Soon, we’ll all be paying the price one way or the other. A return to free market capitalism is the solution, yet the common voices and the loudest voices call for policies quite the contrary. The United States should have the best economy in absolute terms, not in relative terms – the best-looking girl at the dance isn’t good enough. It’s time to wake up and demand change or we’ll be awoken from a nightmare only to realize, we’re not dreaming.