The Fed’s Crazy Game of Chicken
As Peter Schiff put it in his most recent podcast, Jerome Powell blinked.
In a surprising about-face, the Federal Reserve Chair hinted that interest rates are “just below” neutral, leading to speculation that the central bank might be close to ending its tightening cycle. Peter said the Fed has basically been playing a game of chicken with the markets.
And the way the game of chicken goes is the markets keep moving lower and the Fed keeps talking about how great the economy is and how many rate hikes are coming in the future and somebody his to flinch. Somebody has to blink. It’s like you have these two automobiles driving toward each other and there’s going to be a major crash unless somebody turns the wheel. And it seems like it was Jerome Powell that turned the wheel first and in fact was chicken.”
Stock markets swooned at the prospect of a continuing supply of monetary heroin. Of course, as Peter said, this was precisely the point.
As much as the Fed wants to pretend they don’t care about the stock market and they’re not worried about the stock market, they absolutely care about the stock market. They are worried tremendously about a weakening stock market. Remember, the goal of quantitative easing was to lift the stock market — to create a wealth effect. And it was the stock market-created wealth that was going to drive consumption and the economy. And it wasn’t just the stock market. It was the real estate market. So, the Fed is worried about all asset prices, not just the stock market. Clearly, the real estate market is in even more trouble than the stock market, but both of these markets were headed lower and I think that is what really prompted the Fed to blink — to swerve in the game of chicken.”
This underscores just how much influence the Federal Reserve has on the US economy. We tend to focus on government policy — things like taxes, regulation and government spending. Of course, these policies have a major influence. But it pales in comparison to the power of the central bank.
President Trump has been pressuring Powell to stop pushing interest rates higher. The president has repeatedly characterized the Fed as a problem. And as economist Thorsten Polleit pointed out, Trump is right.
But what is the solution?
Polleit explains the role the Federal Reserve has in this crazy game of economic chicken and what to do about it.
The following by Dr. Polleit was originally published on the Mises Wire. The views expressed are his own and do not necessarily reflect the views of Peter Schiff or SchiffGold.
“I think we have much more of a Fed problem than we have a problem with anyone else”, said US President Donald J. Trump on 20 November 2018. While the press, mainstream economists, and bankers cry wolf, the US President hits the nail on its head: The Fed is the source of significant economic and political trouble. By issuing US dollar out of thin air, it sets into motion unsustainable booms, which sooner or later turn into bust.
What is more, the Fed, expanding the US dollar quantity through credit expansion, nurtures the “deep state”: Providing it with the financial means to buy voter consent; to increase its impact on all walks of peoples’ lives; to make possible its aggressive military adventures on a world-wide scale; and to keep alive and kicking its monetary system – that couldn’t survive without an ever deeper state.
Viewed from this perspective, is it not good news that the Fed wants to tighten its policy further? Well, the truth is that Fed interest rate changes do not and cannot solve any problems caused by the Fed’s meddling with interest rates in the first place. By its very nature, monetary policy inevitably creates economic distortions – which appear in the build-up and bursting of speculative frenzies and the notorious boom and bust cycles.
By reviewing how the Fed has been setting interest rates in the past, you might get the impression that things have become ever more problematic. Just consider Figure 1, which shows annual US nominal GDP growth and the Federal Funds Rate in percent. Eyeballing these two series suggests that the Fed has set its interest rates more or less in line with nominal GDP growth.
The “Interest Rate Gap”
Mainstream economists would not find any fault with such an interest rate setting. They would argue that the central bank should, in principle, increase its interest rate if and when economic growth accelerates, and it should lower borrowing costs once GDP expansion loses steam. (A formalized version of this viewpoint has been made popular by the concept of “Taylor interest rate rules.”)
The really interesting finding, however, comes out in Figure 2: It shows the difference between annual nominal GDP growth and the Fed’s main interest rate in percentage points. Moreover, as we can see, this time series has been drifting upwards: from cycle to cycle, the Fed has allowed the gap between nominal GDP growth and its main refinancing rate to widen. In other words: It appears that the Fed’s policy has become increasingly expansionary.
In this context, we have to remind ourselves what artificial lowering of the market interest rate — and this is what the gap between nominal GDP growth and the Fed’s main refinancing rate represents — does to the economy. For instance, it inflates asset prices. In the case of stocks, expected future profits are discounted with a lower interest rate, thereby increasing their present value and thus stock prices.
Pretty much the same happens with real estate prices. As asset prices go up on the markets, their value as collateral in credit transactions also rises. Borrowing on the part of asset holders becomes economically more attractive. Lenders, encouraged by collateral gaining in value, ease their lending standards. As a result, rising asset prices set into motion a borrowing and lending spree.
Furthermore, artificially suppressed market interest rates encourage consumption at the expense of savings. The economy is then living beyond its means. Initially, output and employment increase. Sooner or later, however, it becomes evident that the “boom” is unsustainable, and that it (other things being equal) inevitably has to turn into “bust”.
To fend off the bust, the central bank prevents the artificially lowered interest rate from rising. In fact, to keep the boom going, the central bank has to push the market interest rate to ever lower levels. This is actually what the Fed has been doing for decades: It has set into motion a boom through pushing down market interest rates, and in times of crises, it has lowered borrowing costs even further.
Once the economy recovered, the Fed has raised interest rates, but only very hesitantly. This may explain why the gap between nominal GDP growth and the Fed’s key interest rate has grown so substantially over time. With the Federal Funds Rate currently standing in a band of between 2.00 and 2.25 percent, Figure 1 b would suggest that the Fed’s rate hiking spree might be pretty close to an end.
What Should — and Can — Be Done
But as noted earlier, this would by no means bring the problems caused by Fed monetary policy to an end. But what should and could be done? Let us conclude this article with what Murray N. Rothbard has to say about the Fed, the problems it creates, and how an economically sound solution would look like:
The American economy has suffered from chronic inflation, and from destructive booms and busts, because that inflation has been invariably generated by the Fed itself. That role, in fact, is the very purpose of its existence: to cartelize the private commercial banks, and to help them inflate money and credit together, pumping in reserves to the banks, and bailing them out if they get into trouble. When the Fed was imposed upon the public by the cartel of big banks and their hired economists, they told us that the Fed was needed to provide needed stability to the economic system. After the Fed was founded, during the 1920s, the Establishment economists and bankers proclaimed that the American economy was now in a marvelous New Era, an era in which the Fed, employing its modern scientific tools, would stabilize the monetary system and eliminate any future business cycles. The result: it is undeniable that, ever since the Fed was visited upon us in 1914, our inflations have been more intense, and our depressions far deeper, than ever before.
There is only one way to eliminate chronic inflation, as well as the booms and busts brought by that system of inflationary credit: and that is to eliminate the counterfeiting that constitutes and creates that inflation. And the only way to do that is to abolish legalized counterfeiting: that is, to abolish the Federal Reserve System, and return to the gold standard, to a monetary system where a market-produced metal, such as gold, serves as the standard money, and not paper tickets printed by the Federal Reserve.”
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