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VIDEOJames Bullard's Seven Faces of "The Peril"
Investors should understand how future Fed policy could impact the value of their savings and other assets.
After reading James Bullard’s 23-page paper on possible monetary responses to further economic shocks, we at Ciovacco Capital Management feel it's important for investors to gain a basic understanding of how future Fed policy could impact the value of an individual’s savings and other financial assets. The basic premise of Mr. Bullard’s work is as follows:
- Current Fed policy keeping interest rates low for an extended period may be causing the economy to fall into an undesirable steady state of low nominal interest rates and low inflation expectations.
- This undesirable steady state is similar to what sparked Japan’s lost decade.
- Current Fed policy reinforces a low expectation of future inflation, which in turn helps keep inflation at bay as market participants feel no compelling reason to take actions in preparation for future inflation. These actions might include investing, buying hard assets, or taking out a loan before interest rates go up.
- Keeping rates low for an extended period also creates a perception that “things must be bad; therefore, it's not a good time to hire, expand, or take risk."
- If there's no credible reason to believe policy or inflation rates are about to change, there's no impending event to prepare for future inflation.
- Rising inflation expectations can become a self-fulfilling prophecy as market participants begin to prepare for a future with higher inflation and higher interest rates.
- The best way to shock market participants out of the undesirable steady state is to begin a program of quantitative easing, where the Fed purchases US Treasuries.
- In order for quantitative easing to sufficiently increase future inflation expectations, market participants must believe the Fed will do "whatever it takes for as long as necessary" to obtain the objective of sufficiently positive inflation. This means the Fed must be willing to leave balance sheet expansion in place for as long as necessary to create expectations of higher future inflation by market participants (consumers, investors, companies, etc.). This reminds us of past "bazooka-like" policy moves, where policymakers would say, "You think we can't create positive inflation? Just watch."
Let’s start with quantitative easing, where the Federal Reserve buys Treasury bonds. Using a hypothetical example to illustrate the basic concepts, assume a typical American citizen has some Treasury bond certificates in a shoebox under her bed. If the Fed offers to buy those bonds, they will be exchanging paper money, not currently in circulation, for a bond certificate. After the transaction, the American citizen has newly printed money and the Fed now has a bond certificate. It's easy to see in this example the Fed has increased the money supply by buying the bonds. The Treasury bond represents an IOU from the US government. When the Fed buys bonds in the open market, it's like the government buying back its own IOU with newly created money. This is about as close to pure money-printing as it gets.
How is this policy any different from lowering interest rates or increasing bank reserves?
Lowering interest rates and flooding the banking system with cash has one major drawback: If the banks won’t issue loans or customers don't want to take out loans, the low rates and excess bank reserves do little to expand the supply of money in the real economy. Therefore, these policies can fall into the "pushing on a rope" category. Quantitative easing, or Fed purchases of Treasury bonds, injects cash directly into the real economy, which is a significant difference.
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