Investors have been begging the Federal Reserve to cut interest rates in hopes that further easy monetary policy will lead to much higher stock prices. After two quarter-percent rate cuts in the last two months, stock prices are lower than they were prior to the Fed cutting rates. Investors remain optimistic that the next rate cut will be the one that will send stock prices straight up, but the evidence shows that the rate cuts are not working.
The purpose of cutting the Federal Funds Rate, or the bank overnight lending rate, is to inject liquidity, or currency into the economy through the banking system. When borrowing costs fall, American consumers usually respond by borrowing currency to spend. As consumption increases due to an increase in borrowing, the economy expands a little bit faster.
A rate cut should inject approximately $60-70 billion dollars into the currency supply. Since the Fed cannot force the banks to lend, currency from a rate cut is unlikely to be found in the broad M2 Money Supply. Where the Fed’s handiwork can be seen is in the Monetary Base or the total amount of currency in circulation plus the currency held at commercial banks and in commercial bank reserves. The St. Louis Federal Reserve updates the Monetary Base on a biweekly basis.
In the two weeks following the Fed’s July 31st rate cut, the Monetary Base increased by $31.6 billion, far less than the $60-70 billion it should have increased. A month after the July rate cut, the Monetary Base fell -$31.5 billion from where it was right before the rate cut, which indicates the rate cut had no effect on the broad economy.
While the Fed called the July rate cut a mid-cycle adjustment, the data shows it had no effect. Keep in mind, the economy will enter a recession at some point regardless of how much the Fed cuts rates but it is important to know if the recent rate cuts are having a positive effect. The notion of a perpetual economic expansion is impossible to achieve in a cyclical world, but it has not stopped the Fed from trying.
Knowing the July rate cut was ineffective, the Fed was forced to cut rates at their September 18th meeting under the guise of another mid-cycle rate cut. To keep the public confused, some of the members Federal Open Market Committee (FOMC), who sets monetary policy for the Fed, did not support the rate cut and were not supportive of further rate cuts. The reason there was some dissent is that once the Fed acknowledges they are starting an easing cycle, the economic house of cards begins to fall.
One week before the second rate cut the St. Louis Federal Reserve updated its data on the Monetary Base. In the two weeks following September 11th, the Monetary Base fell by -$107 billion, which further substantiates that the Fed’s rate cuts are having no effect on the broad economy. The Monetary Base is currently at its lowest level since June 2013. The next FOMC meeting is scheduled for the end of October, and based on the direction of the Monetary Base, the Fed will likely cut rates again on October 30th.
The problem facing the Fed is they tightened monetary policy, which in a debt-based monetary system always leads to an economic slowdown or worse, recession. When the Fed tightens monetary policy they reduce the number of dollars in the global economy, as evident by the contraction in World Dollar Liquidity, which is the sum of the Monetary Base and the total amount of foreign-owned Treasury securities.
The number of dollars in the global economy is important, not just from a global trade perspective, but to support dollar-denominated asset prices. When there are fewer dollars in the global economy, asset prices, such as stocks and real estate prices, fall. In a debt-based economy, falling asset prices are a sign of disinflation or outright deflation depending on how severe the fall in prices is.
A contraction in the Monetary Base and World Dollar Liquidity are both symptoms of a dollar shortage, which was engineered by the Fed when they tightened monetary policy. The shortage of dollars was further evident when the New York Federal Reserve restarted overnight repo operations. A repo operation is when the Fed offers a short-term, usually overnight, collateralized loan for dollars. The only reason a bank would need a collateralized loan for dollars is that the bank or someone the bank is lending to is in need of dollars that the bank is unable to provide.
When the Fed started this mid-cycle adjustment that will turn into a full-fledged easing cycle, they had ten bullets in their monetary gun. The Federal Funds Rate was at two-and-a-half percent, giving the Fed ten quarter-percent cuts before the Federal Funds Rate is back at zero percent. From a monetary perspective, the Fed just wasted two rate cuts since they did not have any effect on the Monetary Base.
It is not surprising the Fed’s two rate cuts had no effect on the economy due to the lengthy monetary lags associated with monetary policy. The current monetary lags are estimated to be eighteen months in length, meaning changes to monetary policy today will not be felt by the broad economy until eighteen months from now. As the amount of government debt increases, so too does the length of the monetary lags.
Even though the two cuts did not lead to an increase in economic activity, they should show up in the Monetary Base. As an investor, it is very concerning when the Fed’s primary monetary tool is not working. This suggests that the Fed is going to be chasing deflation and forced to cut interest rates even more. It is entirely possible that future interest rate cuts will have no effect, which means the Fed may not have the tools to stop a deflationary crash when it occurs.
While the Fed’s primary role is to combat currency-printing inflation, a deflationary economic crash is their worst nightmare. The Fed will continue to cut rates even with asset prices near their all-time highs to stop the deflationary force that is starting to make its way through the global economy. The Fed will be forced to make further cuts to the Federal Funds Rate and restart Quantitative Easing to fix the deflationary problem they started by tightening monetary policy to destroy dollars out of fears of rising consumer price inflation.
Investors are hoping further rate cuts will send asset prices higher, but due to the long monetary lags, they will not, which is why asset prices are not responding to the two recent rate cuts. The biggest problem the Fed is facing is their own monetary lags from eighteen months ago. The economy is currently feeling the effects from April 2018 when the Fed increased the number of Treasuries and Mortgage-Backed Securities they were selling to $30 billion per month. The Fed did not stop tightening until July 2019, meaning the U.S. economy has yet to feel the effects of fifteen more months of increasingly tighter monetary policy.
From an investment standpoint, those holding risk assets such as stocks and real estate should see their values continue to fall over the next fifteen months. It is increasingly likely there will be a large, rapid move lower before the Fed is forced to cut the Federal Funds Rate to zero. Once interest rates are at zero, the asset prices will likely rebound for a short period before being crush again under the weight of the monetary lags. Assuming the eighteen-month lag is not extended by then, the U.S. economy will feel the end of the tightening cycle by January 2020.
The Fed has already begun easing, so the economy should start to bottom out before January 2020, depending on how much the Fed eases. To completely undo the monetary mess the Fed created, they will need to lower the Federal Fund Rate to zero percent and buy enough Treasury and Mortgage-Backed Securities to take the Monetary Base to new all-time highs. The expansion of the Fed’s balance sheet will not stop there since they will need to pump a massive amount of dollars into the global financial system to stabilize the global economy.
In the meantime, those holding defensive assets such as cash, U.S. Treasury bonds, fixed annuities or any other asset that is immune to the negative effects of tighter monetary policy, will have an unprecedented investment opportunity. During periods of disinflation or deflation, Treasury yields plummet and with the expectation, the Fed will take the Federal Funds Rate back to zero percent and restart Quantitative Easing, Treasury yields across the curve will be at or very close to zero percent, if not negative.
The opportunity for those holding Treasury bonds is that when interest rates fall, bond prices rise. The longer duration bonds an investor is willing to hold, the larger their return will be. For those with cash or fixed annuities, the opportunity will come to invest in risk assets when they are trading at significantly lower prices.
So far the Fed’s attempt to soften the global economic downturn has been a complete dud. They have wasted two of their ten monetary bullets and once they exhaust the rest, will be forced to restart Quantitative Easing on a large scale since the global economy is going to continue to deflate due to the contraction in World Dollar Liquidity. Investors who understand monetary policy and are positioned correctly are soon to experience the investment opportunity of their lifetime when the global economy enters a synchronized recession.
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