It looks like the Fed has finally reached the point where it should admit that, despite all its efforts, it can’t put the economy back together again.
All of its efforts and actions over the last 10 years need to be second guessed right now.
Economic indicators are flashing red. We’re looking at a significant moment with yield curve inversions, and there are few tools left for the Fed to deploy.
The question is, will the Fed admit the errors of its ways, that it did too little too late, and that its window of opportunity is gone? Or will it double down and dump gasoline on the fire?
A Giant Red Flag
Signs of economic slowdown are flashing across the board, with none being bigger than the yield curve inversion.
The two-year Treasuries yield is now higher than the five-year Treasuries. Now the three-month notes offer more than the 10-year notes for the first time in over a decade.
Simply put, a lender gets less money by locking their money into U.S. debt in the long term than in the short term.
To put it another way that is more illuminating, consider this — debt is simply a way to take money from the future and use it now. Saving or buying bonds is the opposite.
Investors are collectively convinced that debtors will have a hard time creating enough growth and revenue in the near future to support all their future money they’ve already spent. That increased risk is expressed through a higher short-term yield.
Even without all the world’s woes — trade wars, Brexit, cyclical slowdowns, etc. — there is certainly reason to believe it.
As spectacular as “growth” has been, we’ve borrowed more money from the future over the last decade than we’ve been able to create or reasonably expect to create.
According to the Institute of International Finance, total world debt is near $250 trillion, or 320% GDP through 2018.
The (relatively) responsible categories were households, who saw debt grow by over 30% to $46 trillion, and the financial sector, where debt rose 10% to around $60 trillion.
Total government debt went over $65 trillion in 2018, up $37 trillion from a decade ago.
Non-financial corporate debt went over $72 trillion last year, now near an all-time high of 92% of GDP.
The two largest categories, government and non-financial corporate, went on a debt-fueled spending spree thanks to the Fed’s artificially-low yields.
Now the thing that created a decade-long bull market also created the very thing that will kill it.
Out Of Time
The Fed had the capacity to slow down the accumulation of this unprecedented level of debt over the last several years.
It didn’t just fail to heed the warning signs. It failed to resist pressure to treat the stock market and the economy as one and the same.
As a result, it fed around $2.5 trillion through bond purchases alone into the system by using what really amounts to balance sheet tricks. It borrowed from itself in a roundabout way to make borrowing easier and cheaper for corporate interests.
While the tools to do this were new this time around, the trend has been in place for decades.
With lower and lower interest rates going into recessions, the Fed finally hit the point where it had to resort to an untested and risky method. One that has only just begun to unwind.
Now there is no room to use the Fed Funds Rate in an effective way to stimulate short-term growth without plunging it well into the negative, making things even weirder.
The Fed just embarked on its version of a PR tour to defend this system. President of the Federal Reserve Bank of Boston Eric Rosengren just became the third policymaker in two days to talk about bond buying.
He even went a bit further by supporting buying shorter-term bonds and exchanging them for long-term bonds to manipulate rates out of inversion.
The “double down” crowd is already speaking up and has an upper hand over those who advocate for a tempered response rooted in what we know works better for long-term stability.
Make no mistake about it, this is the Fed falling for the age-old sunken cost fallacy. Its members want to dig themselves deeper to dig themselves out.
The clarity of hindsight will show that the Fed created this crisis.
It will become painfully clear that it set out the spiked Kool-Aid at the behest of corporate interests, utterly failed to wean them off, and abandoned its core responsibilities to keep the party going.
A drug addict is to blame for their actions, but the dealer bears a greater responsibility.
