Why The Next Recession Will Hurt More

As comedian Jim Gaffigan tweeted, "That fiscal cliff sounds even worse than one of those Clif bars." Opinions on all-natural energy bars aside, it's clear that the fiscal cliff doesn't look good for the economy in the short term. There's something worse, though, that affects the ability of the country to fend off future recessions. Because the current Federal Reserve policy could make any future recession less like falling off a cliff and more like falling down an up escalator, where the country will find it hard to stop tumbling, stand up, and reach prosperity.

The current Fed policy
Right now, the federal funds rate, which is what banks charge each other for overnight loans of their reserves held at the Fed, is 0.16%. The Fed originally set this target rate of 0% to 0.25% back in December 2008 on its way down from a high of 5.25% beginning in mid-2006. This is called ZIRP, or zero interest rate policy. As you can see, the federal funds rate has never been lower, especially for this long of a period:

The Federal Reserve changes the federal funds rate to achieve its goal of low inflation and maximum unemployment. As the Cleveland Fed explains, "Higher interest rates (all other things the same) raise the cost of borrowing and tend to reduce loan and investment activity, whereas lower interest rates (all other things the same) reduce the cost of borrowing and tend to increase loan and investment activity."

So when the economy needed a little pick-me-up during the last recession, it lowered rates to near-zero. But the economy wasn't responding to near-zero interest rates as quickly or with as much gusto as the Fed wanted, so the central bank implemented some creative policies that were previously used in Japan: quantitative easing. As the Cleveland Fed writes, "some policies aim at lowering long-term interest rates through purchases of longer-term Treasury securities, agency debt, and mortgage-backed securities."

Now, the federal funds rate still remains near zero, and the Fed recently reached deeper into its unconventional playbook and announced a program of unlimited quantitative easing, which some call "QE infinity," on top of the previous rounds of QE1 and QE2. Where do these policies lead?

Japan's path
Japan implemented similar plans in an attempt to recover from its own property bubble in the early 1990s. Since 1995, Japan's central bank has kept its discount rate below 1%. Since 1996, the iShares MSCI Japan Index  (NYSEMKT: EWJ  ) has returned an astonishing loss of more than 40%.

While Japan's demographics, culture, and economy differ greatly from the U.S., our similar central bank actions make it possible that we are following in its path. In terms of indexes, that path does not look prosperous. Recently, however, it seems that a stronger economy and stabler housing prices might mark our departure from following Japan's poor equity performance. Since the Federal Reserve lowered rates in Dec. 2008, the S&P 500  (INDEX: ^GSPC  ) is up more than 60%, the Dow Jones Industrial Average (INDEX: ^DJI  ) has risen more than 50%, and the Nasdaq Composite (INDEX: ^IXIC  ) has nearly doubled.

Teetering on the edge
While there seems to be a strengthening recovery, near-zero rates have put us in a precarious situation. 

The zero-bound rate takes away the traditional tactic to help stabilize unemployment and inflation. And the Federal Reserve forecast in September that rates will remain zero-bound until 2015 -- a year longer than its previous forecast of 2014. Pushing a rate increase further into the future will force the Fed to continue using unconventional tactics.

Other unconventional tactics include allowing the federal funds rate to go negative -- meaning borrowers would be paid to take money. The New York Fed warns, "If interest rates go negative, we may see an epochal outburst of socially unproductive -- even if individually beneficial -- financial innovation." And more financial innovation is not what will help grow a stable economy.

It may also be difficult for the Fed to ever raise rates to regain its primary tool. If rates go unchanged until 2015, it will mark seven years of zero-bound rates. If growth never appears strong enough for the economy to stomach a rise in rates, the Fed may find itself trapped like the Bank of Japan.

Finally, some fear a liquidity trap. This means that any new monetary policy won't be effective because new money will be held onto in hopes of higher rates in the future. Banks and spenders want to hold onto their money to keep it liquid instead of taking the risk of investing in business.

Should the fiscal cliff, or any other event, push the U.S. into a situation where it needs stimulus, the Federal Reserve doesn't have its main policy tool to tinker with the economy, and it will have to rely on more complicated and likely less understood practices.

Even if policy prevents an easy way out of future recessions, there are still companies that will return value to shareholders no matter the overall economy. In our free report "3 Stocks That Will Help You Retire Rich," we name stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

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  • Report this Comment On November 08, 2012, at 2:17 PM, SOCOMhead wrote:

    Great discussion. Nice delve into ways the Fed try to massage the math. You remark how the Fed's tool bag seem to work less and less and now they have disappeared and they still don't work. I think it is funny that the Fed keeps trying the same thing over and over and they are not getting the same undesired result (unless the desired result is actually greater wealth concentration in a smaller group of elites coupled with lowered purchasing power for all).

    But let's look only at the math which never lies.

    GDP = C + I + G + (x - i)

    That is, GDP = Consumption + Investment + Government Spending + Net Exports

    Note that this alleged "measurement" is inherently flawed, however, because it is a nominal value.

    That is, if we have 10,000 units of credit and currency in the system and we add 1,000 units through deficit spending, GDP increases even though from the common man's perspective who is not a recipient of the government largess he actually saw his economic prosperity in real terms decline!

    But even the recipient of the largess did not see an actual gain, although one was reported -- he saw "status quo." That is, he saw "more" but each unit of currency and credit bought less, and those more-or-less cancel out.

    To "fix" the fiscal cliff you must stop deficit spending, one way or another. And there is no free lunch -- if you increase taxes then either "C" (consumption) or "I" (investment) must decline since the money to pay the taxes has to come from one of those two categories. If you cut government spending then GDP decreases by the exact amount that "G" is decreased.

    This math shows exactly how much the next recession should hurt and you are right that it will be more.

    The fed just gooses/allows the deficit spending through its foolish policies, and indeed the whole of current government believes that if the government stops deficit spending that personal savings will be impossible (they argue that Deficit Spending is what allows personal savings to happen in the first place).

  • Report this Comment On November 09, 2012, at 9:14 AM, dakeyras wrote:

    "The Federal Reserve changes the federal funds rate to achieve its goal of low inflation and maximum unemployment."

    I hope that this is a typo and that you meant maximum employment. Though if not, it does appear that the Fed is being somewhat effective.

  • Report this Comment On November 09, 2012, at 1:50 PM, foolisle wrote:

    Does the Cleveland Fed explain how higher interest rates focus capital into more reliable, more productive and less risky avenues.

  • Report this Comment On November 16, 2012, at 12:26 PM, JZeigler wrote:

    I am a new retiree.... not by choice I might add. Look... I saved and lived within my means for 30 plus years. I can survive this on a Walmart budget while I try to find some part time work. Someone tell Ben that I am mad as hell and I am not going to take this anymore. He needs to allow interest rates their market level so I can earn enough with my money (read hard damn work for thirty years) to purchase a car or live my life at a level that actually gives a younger person a job. I had a job and if no one was buying anything I never would have been able to have a job and save. What did I do to earn the wrath of the Gov and the Fed?? What did Americans do to get their own Fed to rob them?

  • Report this Comment On November 16, 2012, at 2:24 PM, JeffMLittle wrote:

    It is a myth that the FED controls interest rates. The fed controls the base money supply, but interest rates are based on both the base and the multiplier, so the best the fed can do is smooth out impacts on the economy caused by the multiplier.

    In turn the multiplier is a function of distribution of wealth. When money is being spent rapidly, you have a high multiplier, whereas when money is being spent slowly the apparent amount of money in the economy shrinks unless you increase the base enough to cover.

    Since the number of dollars you add to the economy for every dollar by which you expand the base decreases when the money multiplier, as the multiplier decreases, so does the fed's ability to fight economic issues.

    But what causes the multiplier? Several factors go into it. Consumer credit scores play a big part. Housing and stock prices play a big part because they allow debt/asset financing of consumption. The most important factor, though, is the ratio of wages to revenues, and the closely related percentage of dollars falling within the "radius of consumption" as I call it.

    As a metaphor, consider a skater who is spinning with his arms out. The hands have a relatively large contribution to angular momentum, but a very small contribution to rotation speed. If you pull in the arms within a very narrow radius, then angular momentum stays the same, but rotation speed goes up. Similarly, if dollars fall into the pocket of a billionaire, they have pretty much zero contribution to the money multiplier, whereas if you take the same dollars and put them in the hands of someone making 200k a year, then the dollars have a decent chance of being spent as long as some innovator can come up with a product that is appealing enough. This act of pulling dollars in from the billionaire level and distributing them within the radius of consumption causes the economy to move faster from a consumption point of view. Now remember, I am not talking policy or fairness; I am talking physics.

    Of course this is an oversimplification because you can't look at demand side economics without considering supply side economics any more than you can look at supply side economics without looking at demand side economics. It is possible that the dollar in the billionaires pocket is doing good work by creating capital.

    This is the framework for discussing the yin and the yang of consumption and production, or as I put it sometimes, the ratio of the number of dollars chasing tacos vs the number of dollars chasing taco bells. This relationship has two extremes.

    If this ratio gets really high then you need the billionaires to have dollars because there is a huge amount of ROI that you can have if you can only find the I. The process of turning I into ROI builds new factories, trains new skillsets, pushes the education boundaries, etc. In this case, there are a lot of individuals running around with consumption dollars, and anybody who has excess production capability has a high chance of bumping into one of them, so incremental production grows the economy fast while incremental consumption only has a small possible impact.

    If the ratio of dollars chasing tacos to dollars chasing taco bells gets very low, on the other hand, you see people with capital dollars getting more and more desperate to loan or invest. Interest rates head toward 0 for safe loans. Lending standards tend to drop and as long as prices keep rising, you get more and more bad loans accumulating in the marketplace. Stocks and bonds stop being reverse correlated and start being directly correlated as the importance of money sloshing around to fill all holes starts to outweigh the importance of flight toward or from risk. Trade imbalances become exaggerated as capital flow trends become self-reinforcing and strong or weak dollars start to have massive impacts on infrastructure location.

    By the way, as a side note, if you were paying close attention, then the second category could very easily be labeled everything that has been going wrong in America since 1980. Another way of looking at this second category is, if you throw extra dollars at capital, they can either be productive dollars that will be used to build new factories, or they can be purely inflationary dollars that increases prices with no underlying improvement reflected in the physical economy. In other words, rather than just having one blanket term for inflation, it would be better to say that monetary inflation can either contribute to price inflation, economic expansion, or asset inflation, and only a well balanced economy can funnel that efficiently into economic expansion.

    Unfortunately, there is a large crowd of economic commentators that don't understand the difference between consumer price inflation and asset inflation or don't realize that if you are experiencing one you are safe from the other in the same way that an overweight person can stop worrying about starvation, so we have a big job of education in front of us to get fully on the right track.

    The good news is we are having a lot of the same economic problems we were having before FDR took over and almost tripled the economy in 12 years. That 12 year period by itself grew the economy more after inflation than all the Republican presidents of the last century combined (48 years). If we really deal with the wealth inequality issue while maintaining a strong education base, a strong research base, a strong technology base, and creating a strong energy base, then we really do have the potential to enter a new golden age (through much the same route as we entered the last golden age).

  • Report this Comment On November 16, 2012, at 2:39 PM, gene132 wrote:

    Frankly, Obama will try more of the same "stimulus" that has gotten us a "real" unemployment rate of 15%. By that time, the debt will be so enormous that 80-90 cents of every tax dollar will go toward interest payments. Only this time, it will be harder to borrow money from China, Japan, etc.

    Of course, maybe Obama is right-we can spend our way to prosperity.

  • Report this Comment On November 16, 2012, at 5:53 PM, West7354 wrote:

    Why no mention of the 16 trillion deficit which limits the ability of congress to do pump priming & stimulus spending?

  • Report this Comment On November 17, 2012, at 12:04 AM, JeffMLittle wrote:

    A couple responses to other posters:

    SOCOMhead - additional government spending will first of all be real spending in the sense that real work is done and real value is created. The effect you are talking about, where the recipient in turn is only causing an increase in the number of dollars chasing the same goods is a red herring because if you have a windfall of 10% extra consumer dollars, a) there is no reason to treat it differently because it comes from government spending, and b) there is no a priori expectation as to whether the dollars would contribute to consumer inflation, asset inflation, or economic growth. If there is a ton of consumer dollars, but no-one is able to borrow money to build factories that will make stuff, then the extra consumer dollars just turn into consumer inflation. If there are a ton of capital dollars, but consumers don't have any money, then the extra dollars just turn into asset inflation without creating any new factories or jobs. If there are some free capital dollars and some free consumer dollars, then the capital dollars can increase investment while the consumer dollars provide return on that investment and the economy is able to grow.

    foolisle - the fed couldn't support high interest rates if it wanted to. The underlying math gives a growth rate associated with high interest rates corresponding to large negative values like we saw in the Great Depression. We have to increase interest rates organically, by sopping up some of the massive capital market liquidity that pushes stock prices to the moon, real estate prices to the moon, and interest rates on loans to near zero. To give you an idea, the last time Interest rates were stuck near zero in the US was the period around 1929, and in 1932, congress raised the top tax bracket by 150%, from 25% to 63%. The results? Growth rate went from more than 10% down to more than 10% up in a matter of about 18 months.

    JZeigler - Not only were people able to buy what each other made in the old days, it went so far that we went through a unique period when a lot of people lived in 1 income households in the new deal era. The key statistic is the ratio of wages to revenues. If wages are low compared with revenues, then the only thing making up the difference are asset growth, loans, and decrease in middle class wealth. If wages stay high compared with revenues, then things like asset growth can translate into support for a high growth rate assuming that production can match it (which has seldom been a problem in American history). Wages grew with increased production steadily from 1945 to 1970. Then between 1970 and today, wages were flat while we kept producing more and more. If the average person making 50k a year were paid the same based on their value creation that the middle class was making in 1970, then they would be making over 80k a year. Plus the growth rate would have been faster to boot. I am betting that missing 30k a year could come in pretty handy.

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