The Federal Reserve Bank of the United States which is the American equivalent of a central bank, has been the major driver of artificial economic growth not only at home but around the globe. The historic low interest rates that have been in place since 2008, have created a distortion in the domestic economy that in turn has created bubbles in certain sectors. The same can be said internationally where the overabundance of American dollars has had a similar effect in various markets.
Massive rounds of quantitative easing that officially ended last autumn, has also led to disruptions in normal economic growth and decline. It is like the Federal Reserve (Fed) has now taken it up as part of their policy, a repeal of the normal business cycle.
Traditionally, the role of the Fed has been to manage the rate of inflation. In other words keep it tamed. This has been true for the century that the bank has existed . In more recent times, keeping a lower pace of unemployment has become one of the new responsibilities of the institution. In its present configuration the role has vastly expanded, to where it has become ever more involved in the financial and economic well being of the nation.
The vast expansion in the money supply and exceptionally low interest rates has resulted in a partial recovery of the real estate market in parts of the country and an overheated stock market. The overvaluation of the markets have a direct correlation with the easy availability of money and extraordinarily low rates of interest, over an extended period of time.
The collapse of more traditional methods of investing have left just two sectors where one may see some success. That would be the stock market and to a lesser extent, real estate in select markets. Everything else provides such low rates of return, that they have mostly fallen out of favor by the majority of investors.
By trying to forestall or mitigate an economic downturn, the Fed has helped to create a bubble not only in the stock market, but with a number of companies and institutions that will have a huge impact, once the economy finally does slide into recession. The slow down in real estate has already begun and will soon be followed by a major correction in the stock market, that could be as little as a few months away.
Then the economy will stall and the recession will arrive shortly after. The Fed will have little room for maneuver, since the standard remedy for contractions in economic growth is lower interest rates. Although this scenario of even lower rates is possible, it would soon lead to nonsensical monetary policy. That is zero rates or as is the case in nations like Denmark and Sweden, actual negative rates of interest.
Even the mention of higher interest rates makes the market swoon each time. The linguistics of what is being said by the Fed chair (Janet Yellen) is carefully studied when she speaks publicly. Hence the controversy over the word patient. When she spoke earlier this month she did not use the word, but was quick to point out that by removing it, the Fed had not become impatient. Higher interest rates are necessary not only to return investing back to a more normal environment, but also to have some tools available when the economy really begins to sour. Perhaps, it is already too late for this prospect.
The Fed will not be able to return to quantitative easing on a massive scale in the near future. Even with a new recession the further expansion of the money supply could well usher in an era of hyperinflation. Using fiscal policy as a remedy with a massive stimulus, is also unlikely given the already almost unmanageable national debt. Already in excess of 18 trillion USD (United States Dollar) it exceeds the total GDP (Gross Domestic Product) of the country.
The budget deficit will already be rising fast enough, as government revenues plunge in response to the plummeting GDP. In fact, the only way that the United States can ever hope to stay ahead the debt monster, given the present political climate, is to grow far faster than it has in the last 6 years.
So one must wonder what arrows are still left in the quiver? What will the Fed be able to do, to lessen the pain of the recession? There will be a strong political incentive to provide at least some kind of relief, when unemployment and business bankruptcies start rising in a contracting market.
The present monetary policy of gradually returning to more normal marketplace conditions, is indeed a walk on a tightrope. Move too fast and there will be serious market volatility and a rapid deflation in asset prices. Maintaining the present equilibrium will become increasingly difficult, as the time for adjustments runs out. The bull market is now over 6 years old and is already living beyond the normal life expectancy, if one is to use history as a guide. We are now experiencing the 4th longest bull market since the late 1940’s.
The same is true for the present economic recovery, which is most likely heading for its own twilight. It began in June 2009 and although it has been much more sluggish than previous upswings in the business cycle, it is still moving from the 5th to the 4th longest recovery since the end of the Second World War. At 70 months, only the tech boom of the 1990’s, the boom of the 1960’s, the Reagan boom of the 1980’s, and the housing boom of the early 2000’s have lasted longer. The present recovery is about to pass the length of time, that has been associated with the last boom in real estate that ended in 2007 and 2008.
Internationally, the Federal Reserve has flooded world markets with USD to the tune of trillions. As the reserve currency of global trade and finance, it has permitted the United States the option of exporting the problems of debt and slower growth to a certain extent. As many commodities are priced in American dollars, it will eventually create an inflationary effect as there are now more dollars in circulation.
Since the United States still possesses the largest economy in the world and the largest military by far, much of the world will still continue to accept USD. This is gradually changing as nations and groups of countries begin to form alternate arrangements, to move beyond the American dollar and those institutions that support it.
Hence, developments such as the founding of the AIIB (Asian Infrastructure Investment Bank) which is to be based in China, are occurring over the objections of the United States. Charter members are to include American allied nations like France, Germany, Italy, South Korea and the United Kingdom. This will be in addition to nations as diverse as Russia, India, Kazakhstan, Tajikistan, New Zealand, Singapore and Uzbekistan.
The Fed is increasingly mired down with financing the enormous and growing fiscal and trade deficits of the United States. The balance sheet at over $4.5 trillion USD is an tremendous amount of debt. At the beginning of Great Recession in December 2007, the Fed held just $700 billion USD. This has grown to the present total by the end of 2014. It will be difficult to move this huge sum through the economy, even one as large as the United States at $17.7 trillion GDP.
The addiction to debt that is displayed by the American government, will continue to hamstring the Fed in dealing with the declining influence of American financial power and prestige abroad. Increasingly, more nations in the world will find ways to circumvent the present reliance on the United States dollar. Unless the United States decides to change course and gets its fiscal house in order, the Fed will continue to lose the ability to influence events and therefore maintain American hegemony in international finance. Under the present circumstances and ongoing global events, the central bank of the United States is truly becoming a lion in winter.