Federal Reserve’s Kashkari Wants 6-Week Lockdown
I often wonder what the modern world and economy would look like without the Federal Reserve’s interference in free markets?
The central bank is constantly meddling with interest rates and, although most don’t fully understand what they do, I think it’s fair to simplify their policies as follows: they seek to influence behavior. That means all of us, and it’s all done under the guise of promoting full employment and stable pricing (their statutory objectives).
In the early 1980’s, Paul Volcker’s Fed jacked up interest rates to stem runaway inflation. It worked, but not without consequences as it caused a very deep painful recession. Nonetheless, it is often cited as an example where the central bank’s action was necessary and good for the economy; the inflationary spiral of the prior 10 years did end.
To fully render judgment on what happened though, I’d suggest looking back a bit further. Many believe the inflation Volcker sought to kill was a direct result of the Fed’s “easy” monetary policies in the 1970s.
Although it is universally acknowledged Volcker did the right thing, you could say his action simply corrected the Fed’s own mistakes. I’ll let you be the judge.
What’s remembered is his success. People have come to believe the Fed must take an active role in the economy and the market, and that’s what they have done.
For example, the Fed’s Chairman, Alan Greenspan is remembered for commenting on the stock market during the dot.com boom. He stated in 1987 that the then-current stock market’s valuation reflected “irrational exuberance” on the part of investors. Stock fell briefly, but ultimately kept rising another 3-years.
The Fed Chair eventually took it upon himself to vociferously fight what he believed were excessive animal spirits on Wall Street. Ultimately, he pricked the stock bubble with six straight interest rate hikes. But one has to ask, what does an expensive stock market have to do with the Fed’s role in creating stable pricing or full employment?
Greenspan, of course, had his logic. I’ll leave it to you to wade through it.
This also began the rollercoaster ride for interest rates that we still ride today.
Neel Kashkari, President of the Minneapolis Federal Reserve Bank, noted in a Federal Reserve paper dated May 17, 2017 that utilizing interest rates to combat asset price bubbles could have adverse unintended consequences.
A statement I would characterize as “overstating the obvious.”
After popping the dot.com bubble, the Fed found itself in a bit of a predicament. Stock prices fell but kept falling; the economy went into recession. They found themselves needing to support stock prices and to do so, they began slashing interest rates.
The immediate effect was a success, the stock market stopped falling, but they failed to move interest rates back up after things stabilized. Persistently low interest rates started influencing behavior. Consumers began a massive mortgage refinance wave, the Fed held rates steady. Money for real estate purchases became cheap and easy to secure; real estate prices started to soar, and the bubble began inflating.
When the real estate bubble burst the Fed slashed rates again, now to even lower levels. This time, they sought to support the value of fixed assets like homes.
These now very low rates started influencing other markets. Investors began questioning the returns offered by traditionally safe investments like bonds. Most were accustomed to earning 6% to 8% interest rates on investment-grade bonds and were now looking at rates under 4%.
Fixed-income investors began looking elsewhere for income. Low-interest-rate policy began affecting values in a host of other asset classes.
When housing prices stabilized in 2012, and the reason for the latest round of low rates evaporated, the Fed did not reverse policy. We have lived with that policy, excepting a short period late in 2018, ever since.
Why not just leave rates alone? Why not let natural market forces determine the rate of interest, the value of assets, and take care of pricing bubbles? I think the record since the early 70’s (and we could easily go back to the early 1930’s) has been the Fed’s actions have caused as much trouble and the problems they were set to fix.
So here we sit in the midst of another crisis, and we find the Federal Reserve again fiddling with interest rates. In March they slashed interest rates to zero, yet another new level, and stepped into the fixed income market as a buyer. Again, they sought to do what they could to support asset markets.
In tandem with the Fed’s action, Congress opened its purse. Phase 1 of the CARES Act came to a total of $2.2 trillion dollars. Phase 2, if and when passed, will add to that total. Some are worried the spending is getting out of control. Others, like Kashkari, feel otherwise.
In an op-ed piece co-written by Kashkari and Michael Osterholm, Kashkari makes the case for instituting a 6-week lockdown to contain the virus. He states that the virus must be under control for the economy to recover. In his view, a lockdown is the only way that happens.
What I thought was more interesting in the article was Kashkari’s observation that the personal savings rate had increased to 20% from 8% since January. Such an increase in savings is rare during an economic downturn and affords Congress the opportunity for doing more.
It may be counterintuitive to those worried about the national debt, but it shouldn’t be. A higher savings rate means that America can finance its own debt instead of relying on foreign investors.
If Congress fails to assist (i.e. pass more stimulus), Kashkari argues that there will be a trickle-down impact that will make the downturn worse. Bankruptcies will rise, and the recovery will be slower. He argues for bold policy action.
Our position is that although action by the government may be needed, as investors we have to stay alert to both the direct impact of the actions and the unintended consequences. It’s always the latter effects that have the greatest lingering impact on the markets. For that reason, they are more important to watch.
At least that’s always been the case in the past.
To discuss how we can help you do the same, give me a call.