The major central banks have slashed interest rates to 0% to curb the economic fallout from the Coronavirus pandemic. As the Federal Reserve, the Bank of Canada, and the European Central Bank embrace unprecedented quantitative easing, who in the world is even thinking about tightening monetary policy and raising rates to their historical averages? The Eccles Building has fired off the big guns to contain the financial crisis, which appears to be working – for the moment. Now that the Fed has shown its hand to the economic deities and market gods, the only tool it has left to utilize during the current or next downturn is a negative-interest-rate policy (NIRP). But what happens when the central bank unleashes the tsunami of price inflation? Will it be the 1980s all over again?
A Tall Order
It is August 1979. The Baltimore Orioles are the best team in baseball, Moonraker becomes one of the worst James Bond films, and Ronald Reagan is set to announce his candidacy for president. Also, in a story that would land in Section F, Page 15 of The New York Times, Paul Volcker has become head of the most powerful institution on the planet: the Federal Reserve System.
During the expansive agenda of the 1960s and 1970s, Chairmen William Martin and Arthur Burns printed vast sums of dollars to cure anemic economic growth and cover the cost of the guns and butter of the previous 20 years. On day one, cigar-smoking Tall Man Volcker dealt with double-digit inflation and unemployment and a printing press working overtime to stimulate the economy. What did he do? What any sensible man would: He took a baseball bat to the printing press so he could jack up interest rates and curtail rampant price inflation. The result was a miracle: falling inflation and joblessness and a rejuvenated economy.
This is the same situation the next Fed chair will need to contend with as he or she is dealt the impossible task of fighting inflation and spurring growth. Perhaps the next Fed chair will need to remedy stagflation or reverse the Japanification of the U.S. economy. It will be no small feat.
The Great Inflation
The U.S. central bank has taken unprecedented action in its fight against COVID-19. Unlimited quantitative easing, corporate bond-buying, and 0% interest rates are now the new norm. With these new measures, the Fed now possesses a balance sheet of $5 trillion, which is greater than its peak of $4.5 trillion in 2016. It is estimated that its balance sheet will hit $10 trillion after bailing out the repo markets, acquiring Treasurys, and pumping liquidity into the economy.
The Fed has just gotten started in its quest to rescue America from the Coronavirus. The latest M2 money supply data show a huge spike, suggesting that more dollars will be printed and injected into the system. It explains why the stock market posted a multi-day rally, despite plenty of bad news.
When the Fed eventually slows down QE, and the lockdown is gradually lifted, it is inevitable that skyrocketing price inflation will be the welcoming force greeting the public with wheelbarrows to help pay for goods and services. While hyperinflation will not seep into the market just yet, a multi-point jump in the consumer price index or the producer price index is not outside of the realm of possibility. When you factor in the likelihood of lower Chinese imports, the cost of living will likely be higher.
By the time the economy returns to normal – with or without second and third waves of COVID-19 – the country will need to contend with the real bust in the business cycle. Remember, the Coronavirus did not kill off the problems of the past, whether it was bubblemania or the enormous levels of debt. Those still linger, and the short-term fixes have amplified them. When the next downturn strikes, negative interest rates will be the only tactic the Fed can employ, which expands the money supply and produces a whole lot of price inflation.
Once everything cools down, the Fed needs to decide if it maintains the status quo or takes away the narcotic from Wall Street.
The Spirit of Volcker
Fed Chairman Jerome Powell’s successor will preside over an unenviable situation comparable to what Volcker inherited. And, like the Tall Man, that central banker will likely dramatically normalize monetary policy in the form of higher interest rates to extinguish the out-of-control flames of inflation. Will it be the panacea that remedies the ailments of the U.S. economy? That might be hard to answer under present conditions, but that is the only economic outcome that makes sense in this crazy mixed-up world.
Put simply, NIRP is the detour to higher interest rates.
Remember, the United States still needs to pay for the inflation created by the Fed during the 2008 economic collapse. The money supply was immensely expanded to prevent the recession from metastasizing into a depression. It may be counterintuitive, but that was the worst thing the Fed could have done since a steep economic downturn could have allowed the United States to enjoy genuine prosperity, not one crafted through mirages. So, when you factor inflation from QE one, two, and three and then add in money supply expansion from QE four and five, you eventually get double-digit interest rates.
When you are in the middle of a 10,000-point wipeout of equities, a pandemic that could kill 100,000 Americans, and a mainstream media that adds fuel to the panic, you may not have the luxury of sitting in your ivory tower, reading economics textbooks, and weighing what is right and wrong on the scales of justice. In real time, the world is falling apart. Politicians and the proletariat depend on the century-old institution to act to save the economy from destitution. But the financial system has tapped this well too often, like a junkie reliant on the next fix from the Fed. Eventually, the economy overdoses. It either dies or goes into rehab.
Read more from Andrew Moran.
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