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How can the Fed unlimited QE be deflationary?


muscleman
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https://seekingalpha.com/news/3573614-stan-druckenmiller-not-buying-this-rally

I am puzzled by the article here that summarizes Stans Druckenmiller's view.

"The risk-reward for equity is maybe as bad as I've seen it in my career," says Stanley Druckenmiller, speaking at an event for The Economic Club of New York. The V-shaped recovery, he says, is "a fantasy."

 

Always hedging, he adds this line: "The wild card here is the Fed can always step up [asset] purchases."

 

Scratching his head about the excitement surrounding Gilead's remdesivir, Druckenmiller says he can't see why anyone would change their behavior over the viral drug.

 

Differing with some other hedge fund heavy hitters, Druckenmiller says the government's massive stimulus push is more likely to be deflationary than inflationary.

 

On Amazon (NASDAQ:AMZN), he sounds like a fan: "We should just get down on our knees and thank the Lord that this company existed in this pandemic."

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It is ironic that the 2017 link that you submitted above came with a top "breaking news" announcement: "EU unveils plan to borrow 750 billion euros to aid economic recovery"

What is presented as a Marshall-like (it clearly is not) Plan or as an Angela Merkel's "Hamilton moment" (destiny will get more correlated) triggered the following comment from a timid opposing voice: "There will be no end".

From Mr. Druckenmiller (2017): "The longer this goes on, the worse it's going to be".

The Rubicon has been crossed.

 

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He is referring to the different time horizons.

 

In the short-term QE is stimulative, but over the medium to long term - QE tends to be destructive.

Markets have a short-term orientation, and view QE stimulus as permanent (consistent with the view); capital flow creates an asset bubble, market players leverage against the higher valuation. The QE is subsequently unwound, the asset bubble bursts, and the debt is cleared via bankruptcy. The issue is that too much bankruptcy, too quickly, tends to trigger a collapse. Basically - too much QE, for too long, is toxic.

 

A key lesson from the Great Depression - is that nations need sustained, unlimited spending to get out of it.

World war type spending that BOTH stimulates the economies of the entire world, AND destroys the entire capital stock of the losing nations. The subsequent rebuilding, and shortage of labour, typically stimulating the global economy for a decade plus. We have the spending (global cumulative QE spend), but not the turnover in capital stock (new infrastructure replacing old). Unpredictable obsolescence write-offs triggering bubble collapses (RE, vehicle manufacturing, o/g, national grid, health-care, etc).

 

Too much unskilled labour, worsened by demographics, geography, and automation.

Cheap labour is readily outsourced (migrant labour planting/picking crops, extraction industry camps, etc). High volume, standardized product, is better achieved via automation (machines, call centres, etc.). In war time these people are the cannon fodder, that do the dying. In peace time where do those millions of obsolete go? what do they collectively do in civil society? how are they supposed to buy anything with no income? In the US, this is Trumps 'base'; in the UK, they were enough to produce 'Brexit'. Unpredictable changes in civil society, triggering bubble collapses.

 

Unfit capital markets.

Any new analyst entering capital markets since 2006, has had very limited experience with anything but QE. 3 successive generations (average 5-year career life) of analysts, all mutually reinforcing each other (levels within the organization), and all very fragile to anything but continuing QE. And this is before the automation of smart-contracts, and AI. Unpredictable reactions to material structural change, and greater volatility, triggering bubble collapses.

 

Of course to some - Nero fiddling while Rome burns, is an opportunity!

In Taleb speak, this has all the makings of a great asymmetric bet on fragility failures (bubble bursts) - as long as the counter-party can make good on their obligations. Problem is, keeping the money - while the world around you is burning.

 

SD.

 

 

 

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Druckenmiller says the government's massive stimulus push is more likely to be deflationary than inflationary.

 

I have no idea what he is talking about - I don't think he does either.....    8)

 

I remember a line from a great Motley Fool poster (howardroark) that has stuck with me over the years that I think describes Druckenmiller, Tepper, etc.  I view them as great investors who seem to also be great traders with an ability to zig and zag at many of the right times ....

 

"I sometimes think of those few investors who are actually great as having only slightly more attentional control over their talents as Eric Dickerson [NFL Hall-Of-Fame RB] did over his stride -- that much of the fancy talk is after-the-fact mere description, and that often the key decision process is mostly magic even to the decider."

 

wabuffo

 

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QE can be deflationary if a central bank insists on paying interest on reserves.  I know it's in fashion to say that private banks create most of the money, but this isn't true in a practical sense. The nominal anchor is still the monetary base and that is controlled by the Fed

 

Under normal open market operations (OMOs), the Fed injects 0% yielding reserves in place of say 2% yielding treasuries. This makes a commercial banks balance sheet a bit less risky.  Since reserves are "stuck" in the commercial banking system, the only thing these commercial banks can do (as a whole) is make more loans, etc to bring their balance sheet metrics back in line

 

However, when the Fed insists on paying interest on these reserves, now the open market operations are swapping say 2% treasuries for 2% yielding reserves.  There is no incentive for banks to "rerisk" their balance sheet and hence the banks have very little reason to make more loans.  Of course this will look like "hoarding" of money, etc and result is lower economic (nominal GDP) growth.

 

If the Fed clearly signaled their intention to move to negative interest on reserves, etc, then I think we'd see more inflation/nominal GDP growth.  I'm simplifying a bit, but do think this is the general idea.  Monetary policy is not (and is never) "out of ammo"

 

I don't think ideas like "asset price inflation" or "market distortions" (from fairly basic OMOs) are all that valid at all.

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I think he used a poor choice of words - instead of deflationary, I think he's not talking about a monetary vector, but an economic one.  He means slower growth - and not monetary deflation such as occurs in a financial debt panic.

 

The reason for QE being an economic growth suppressant, in my view, is for two reasons:

 

1) QE tries to push rates down.  But, low interest rates punish savers more than they help debtors.  The low rates force savers to save even more, thus cutting consumption, which slows economic growth.

 

2) QE replaces interest expense from the US Treasury - which flows to the private sector as income.  The Fed swaps Treasury debt held by the private sector with reserves held by the banks.  While the Fed pays the banks interest on their excess reserves, it stays in the reserve accounts at the Fed and does not flow to the private sector.  So QE takes interest income away from the broader economy and doesn't replace it with any other forms of income for the private sector - so its a net loss of income

 

Both of these factors hurt the economy - despite the intention by the Federal Reserve to try to stimulate it.

 

wabuffo

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Wabuffo,

 

Regarding your points:

 

1) QE should *raise* rates, not lower them.  Lower rates signify tight monetary policy as Scott Sumner mentions here:

 

Indeed, if QE always led to lower rates, then we could stop collecting taxes and just have the Fed Fund all gov't expenses with QE.  Unfortunately this wouldn't happen, and if you do enough QE, then inflation and interest rates will eventually go *up*

 

2) There may be some minor interest income that is lost, but the overwhelming factor is the increase in lending that can result.  There are problems with the money multiplier, but if done right, it gives an approximate order of magnitude..that is something like X increase in MB leads to 10X increase in M2 and NGDP (over the long run)

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https://seekingalpha.com/news/3573614-stan-druckenmiller-not-buying-this-rally

I am puzzled by the article here that summarizes Stans Druckenmiller's view.

"The risk-reward for equity is maybe as bad as I've seen it in my career," says Stanley Druckenmiller, speaking at an event for The Economic Club of New York. The V-shaped recovery, he says, is "a fantasy."

 

Always hedging, he adds this line: "The wild card here is the Fed can always step up [asset] purchases."

 

Scratching his head about the excitement surrounding Gilead's remdesivir, Druckenmiller says he can't see why anyone would change their behavior over the viral drug.

 

Differing with some other hedge fund heavy hitters, Druckenmiller says the government's massive stimulus push is more likely to be deflationary than inflationary.

 

On Amazon (NASDAQ:AMZN), he sounds like a fan: "We should just get down on our knees and thank the Lord that this company existed in this pandemic."

 

Maybe there is a differentiation between gov't and Fed since the Fed is technically independent?

 

Government debt in inflationary upon issue and deflationary upon service and repayment. The trillions the Treasury has issued is inflationary, but it primarily offset by an economy with near 0 activity and 40 million unemployed (massively deflationary forces). So you're not going to see the inflation, but you will see the disinflationary/deflationary forces every quarter the gov't has to make interest payments on that unproductive debt. I think this is what Druckenmiller may be referencing.

 

There's also arguments like the more the government spends on interest is less money the government can spend on other things and the corollary for tax payers is higher taxes mean less money for other things. Both ought to be somewhat disinflationary as you have less money chasing the same goods - particularly if those taxes/interest payments are going outside of the U.S. consumers/business to foreign owners and the Fed.

I think he used a poor choice of words - instead of deflationary, I think he's not talking about a monetary vector, but an economic one.  He means slower growth - and not monetary deflation such as occurs in a financial debt panic.

 

The reason for QE being an economic growth suppressant, in my view, is for two reasons:

 

1) QE tries to push rates down.  But, low interest rates punish savers more than they help debtors.  The low rates force savers to save even more, thus cutting consumption, which slows economic growth.

 

2) QE replaces interest expense from the US Treasury - which flows to the private sector as income.  The Fed swaps Treasury debt held by the private sector with reserves held by the banks.  While the Fed pays the banks interest on their excess reserves, it stays in the reserve accounts at the Fed and does not flow to the private sector.  So QE takes interest income away from the broader economy and doesn't replace it with any other forms of income for the private sector - so its a net loss of income

 

Both of these factors hurt the economy - despite the intention by the Federal Reserve to try to stimulate it.

 

wabuffo

 

1) Seems like QE massively fails at what it intends to accomplish then. Every one of the QEs following the financial crisis resulted in yields that were flat to up from when the program started. Sure, maybe the Fed's involvement raised inflation expectations which in turn impacted the yields more than their buying, but the outcome of QE was always the same - rates didn't go lower.

 

2) Isn't IOER at 0% right now? I don't think banks aren't lending because of 0% rates on excess rates. This may have been an argument back in 2017/2018 when IOER was positive, but it wasn't as positive as Treasuries or Corporates or Mortgage loans which meant banks earned a premium for the risk they were willing to take. Maybe when IOER gets too high we could make this argument (like when the curve inverted in mid-2019), but even then I don't think many were complaining about lack of available credit suggesting banks were still lending to meet the demand?

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1) QE should *raise* rates, not lower them.

Huh?  You should tell that to the Fed.  They think they are doing long-term yield curve suppression.  The Fed lowered short-term rates to zero.  The talk now is over yield curve control.

 

2) There may be some minor interest income that is lost, but the overwhelming factor is the increase in lending that can result.

It is not minor - cop a squint at the Fed's Z.1 report and then think through which rates tend to be fixed (credit cards) and which variable and look at household assets and liabilities.  It is pretty major hit to income.  And that's before the effect on pensions and other forms of saving.

 

There are problems with the money multiplier...

Money mutliplier is a flawed concept because it tries to use to different currencies (private sector money and bank reserves).  Monetary base includes reserves which don't flow to the private sector and are controlled by the Fed (now that we have massive excess reserves).  Reserves are inert.  Banks do not and have not needed reserves to lend since a new loan in the banking sector creates a deposit simultaneously.  Bank lending is driven by whether banks can make money given the credit risk, collateral quality and capital costs.  If the economy slows as it will under QE, there will be less risk appetite, not more.

 

wabuffo

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Maybe there is a differentiation between gov't and Fed since the Fed is technically independent?

Nope - they are both agencies of the Federal government.  The Federal Reserve is basically the US Treasury's bank.  They co-ordinate their policy.  They have to.

 

Government debt in inflationary upon issue and deflationary upon service and repayment.

I don't think so.  US Treasury deficit spending creates excess reserves in the banking system, US Treasury net debt issuance soaks them up - without the debt, the banks' reserves would equal the size of net debt held by the public (over $19t - instead of the current $3t of bank reserves at the Fed).  That's because US Treasury spending creates a new deposit in the banking system (and a new bank reserve for that bank).  US Treasury debt issuance is an interest rate maintenance activity - it sets the long-term risk free rates along the yield curve by replacing a private sector bank deposit (and reducing the corresponding bank reserve) with a Treasury bond - while the Federal Reserve sets the short term risk-free rates via its interest on excess reserves.  The Federal Reserve and US Treasury together set benchmark risk-free rates along the entire yield curve at whatever they want them to be - since the alternative would be $19t of bank reserves getting zero today.

 

There's also arguments like the more the government spends on interest is less money the government can spend on other things

Nope - no such thing as "crowding out".  The US Treasury has no constraints other than courting inflation.  When you pay your taxes in cash, the US Treasury/Fed shred the bills (so much for needing taxes in order to spend).

 

wabuffo

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I think he used a poor choice of words - instead of deflationary, I think he's not talking about a monetary vector, but an economic one.  He means slower growth - and not monetary deflation such as occurs in a financial debt panic.

 

The reason for QE being an economic growth suppressant, in my view, is for two reasons:

 

1) QE tries to push rates down.  But, low interest rates punish savers more than they help debtors.  The low rates force savers to save even more, thus cutting consumption, which slows economic growth.

 

2) QE replaces interest expense from the US Treasury - which flows to the private sector as income.  The Fed swaps Treasury debt held by the private sector with reserves held by the banks.  While the Fed pays the banks interest on their excess reserves, it stays in the reserve accounts at the Fed and does not flow to the private sector.  So QE takes interest income away from the broader economy and doesn't replace it with any other forms of income for the private sector - so its a net loss of income

 

Both of these factors hurt the economy - despite the intention by the Federal Reserve to try to stimulate it.

 

wabuffo

 

I have limited understanding, but I think this might not be right.

 

But, low interest rates punish savers more than they help debtors. 

 

How? What is the reasoning behind this to say low interest punish savers more than debtors?

 

I would argue that it could be either way. It might help debtors more than savers and it depends on who is in the most need or the most vulnerable.

 

Take a simplistic case of savers being all billionaires and debtors being all poor households. In this case low interest rates would be of immense help to the overall economy.

 

Take a more realistic case of debtors being more economically vulnerable and savers less so, then it seems more likely that low interest rates help rather than hurt the overall economy.

 

The low rates force savers to save even more, thus cutting consumption, which slows economic growth

 

Again in depends and there is no logical reason to believe that this is true.

 

If savings are concentrated among the higher income population, changes in interest income is not going to drive their consumption behavior.

 

Vinod

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I think he used a poor choice of words - instead of deflationary, I think he's not talking about a monetary vector, but an economic one.  He means slower growth - and not monetary deflation such as occurs in a financial debt panic.

 

The reason for QE being an economic growth suppressant, in my view, is for two reasons:

 

1) QE tries to push rates down.  But, low interest rates punish savers more than they help debtors.  The low rates force savers to save even more, thus cutting consumption, which slows economic growth.

 

2) QE replaces interest expense from the US Treasury - which flows to the private sector as income.  The Fed swaps Treasury debt held by the private sector with reserves held by the banks.  While the Fed pays the banks interest on their excess reserves, it stays in the reserve accounts at the Fed and does not flow to the private sector.  So QE takes interest income away from the broader economy and doesn't replace it with any other forms of income for the private sector - so its a net loss of income

 

Both of these factors hurt the economy - despite the intention by the Federal Reserve to try to stimulate it.

 

wabuffo

 

QE replaces interest expense from the US Treasury - which flows to the private sector as income.  The Fed swaps Treasury debt held by the private sector with reserves held by the banks.  While the Fed pays the banks interest on their excess reserves, it stays in the reserve accounts at the Fed and does not flow to the private sector.  So QE takes interest income away from the broader economy and doesn't replace it with any other forms of income for the private sector - so its a net loss of income

 

Hi wabuffo,

 

I have limited understanding and hope you would correct me on this, but I think the above might not be true.

 

This is helpful to the economy the way I see it. With QE, Treasury is not borrowing money from the public to pay the interest. So how is the public missing out on the interest income? Public did not lend money and they are not getting interest. So no effect in that regard.

 

Now, instead of borrowing from the public (via selling of Treasuries), it gets money from the Federal Reserve (indirectly via the Banks) and what does it do with the money? It spending it on the public. Especially all the COVID programs. They are spending it without either taxing the money from the public or borrowing from the public.

 

So why is that not massively helping the economy? Yes, the concerns about this seemingly easy way to fund the Government programs are valid, but we cannot say it is not helping the economy.

 

Vinod

 

 

 

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My understanding from the webinar and previous interviews on Realvision is that he believes that because the hurdle rate for investment has been lowered so much (low interest rates) & so much liquidity added to the system (QE) - that effectively every fixed asset or capacity/growth increasing investment that could or barely could be justified by any CEO/CFO has been done already. Increasing supply, driving down prices in the real economy & causing deflation.

 

Indeed he also argues that a lot of investments that DONT make sense have been done too in the VC space with structurally unprofitable companies funded for years and years beyond what might be considered 'normal' growth capitalism or put another way companies are burning cheap capital and engaging in below cost selling at a scale & for a length of a time that reflects that the price of money has been fixed at an artificially low level.

 

Finally we are all aware of the concept that there exists in this cycle a greater than normal level of 'Zombie' companies who's continued existence is only enabled by cheap and abundant credit. Ordinarily these companies would have ceased to exist in the creative destruction sense of the word removing their supply of services from the economy. They have not ceased to operate in this cycle - increasing supply & causing deflation.

 

For further reading I point folks to this thread and you can see what Druckenmiller is getting at - selling & delivering pizzas for less than they cost sure seems deflationary to me, ditto Uber rides etc. etc.: https://www.cornerofberkshireandfairfax.ca/forum/general-discussion/this-is-your-brain-on-venture-capital/

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Take a simplistic case of savers being all billionaires and debtors being all poor households.

 

Vinod1 - let's move from the hypothetical and go right to the film.  From the Fed's Z.1 report:

https://www.federalreserve.gov/releases/z1/20200312/z1.pdf  Cop a squint at p.152

 

From that page, here's a high-level balance sheet for US households (Q4, 2019 - $billions):

ASSETS:

04. Real Estate (households - owner-occupied).....$29,326

11. Time and Savings Deposits...........................$10,163

12. Money-Market Fund Shares...........................$ 2,148

 

LIABILITIES:

33.  One-to-Four-Family Residential Mortgages.....$10,610

34:  Consumer Credit........................................$  4,191

 

So let's ignore the effect of low rates on pensions and post-retirement benefits.  This household balance sheet snapshot at the end of last-year shows about $12.2 trillion held in short‐term rate‐sensitive instruments like savings accounts and money market funds. 

 

On the liability side, most household liabilities are fixed‐rate mortgages, where payments are unaffected by rate changes. Consumer credit is made up of credit card debt and car lease payments and totals $4.2 trillion, most of which is also fixed.  But let's assume that 25% of the household debt can be made variable interest.

 

Net, net - (assuming 75% of the liabilities are fixed rate) we can estimate that households have about $8.6 trillion in exposure to short‐term interest rates, so a 1% change in rates adds about $86 billion to annual income.  Thus, I maintain that lowering rates punishes households more than it helps them.  Its not a coincidence, IMHO, that GDP growth took off in 2017 and 2018 when the Fed started to raise rates and slowed down in 2019 when they started to lower them again.

 

wabuffo

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This is helpful to the economy the way I see it. With QE, Treasury is not borrowing money from the public to pay the interest. So how is the public missing out on the interest income? Public did not lend money and they are not getting interest. So no effect in that regard.

 

The US Federal Govt spends first, then borrows.  If not, how does the private sector ever get the govt's money?  Taxation and other forms of payment to the US government create the private sector's need for the government's money which the govt provides via spending.  It then borrows to remove the reserves it has created in the banking system. 

 

States and municipalities can't do this since they are not allowed to issue their own currencies.  This is why the Eurozone has so many problems - nations like Greece and France can no longer issue their own currency and must balance their budgets.  Even here it is interesting to watch states like Illinois and California sometimes get into severe budget crises and then issue IOUs which they give value to (in order for vendors to accept) by allowing these IOUs to extinguish state tax and fee obligations. 

 

This proves the model that US Federal govt's money is basically an IOU that the private sector needs to extinguish its tax liabilities - except its more formal and systematized such that we don't even think about it at all.  It follows that the Federal govt (after creating the tax obligations, must spend first in order for the private sector to be able to pay its taxes - just like a municipal bus system must issue tokens first, so that riders can exchange them for bus rides).

 

Now, instead of borrowing from the public (via selling of Treasuries), it gets money from the Federal Reserve (indirectly via the Banks) and what does it do with the money? It spending it on the public. Especially all the COVID programs. They are spending it without either taxing the money from the public or borrowing from the public.

 

So why is that not massively helping the economy? Yes, the concerns about this seemingly easy way to fund the Government programs are valid, but we cannot say it is not helping the economy.

 

I'm not following what you are saying here.  Could you re-phrase?

 

wabuffo

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Take a simplistic case of savers being all billionaires and debtors being all poor households.

 

Vinod1 - let's move from the hypothetical and go right to the film.  From the Fed's Z.1 report:

https://www.federalreserve.gov/releases/z1/20200312/z1.pdf  Cop a squint at p.152

 

From that page, here's a high-level balance sheet for US households (Q4, 2019 - $billions):

ASSETS:

04. Real Estate (households - owner-occupied).....$29,326

11. Time and Savings Deposits...........................$10,163

12. Money-Market Fund Shares...........................$ 2,148

 

LIABILITIES:

33.  One-to-Four-Family Residential Mortgages.....$10,610

34:  Consumer Credit........................................$  4,191

 

So let's ignore the effect of low rates on pensions and post-retirement benefits.  This household balance sheet snapshot at the end of last-year shows about $12.2 trillion held in short‐term rate‐sensitive instruments like savings accounts and money market funds. 

 

On the liability side, most household liabilities are fixed‐rate mortgages, where payments are unaffected by rate changes. Consumer credit is made up of credit card debt and car lease payments and totals $4.2 trillion, most of which is also fixed.  But let's assume that 25% of the household debt can be made variable interest.

 

Net, net - (assuming 75% of the liabilities are fixed rate) we can estimate that households have about $8.6 trillion in exposure to short‐term interest rates, so a 1% change in rates adds about $86 billion to annual income.  Thus, I maintain that lowering rates punishes households more than it helps them.  Its not a coincidence, IMHO, that GDP growth took off in 2017 and 2018 when the Fed started to raise rates and slowed down in 2019 when they started to lower them again.

 

wabuffo

 

Thank you for the explanation and the link to data.

 

My point is that it ignores the distribution of wealth and income across the population. I am not sure about the numbers, but from what I remember the bottom 50% of the population have very little savings. Much of the savings are likely in the top 25% of the population with top 10% owning a lot of these savings.

 

To those in the top 10%, the interest income is unlikely to make any difference to their propensity to spend. Older retirees with modest portfolios would be most impacted, I concede.

 

I would imagine most of the COBF board members would not be changing their spending habits if interest rates on savings are 1 or 2% higher, if they notice them at all.

 

Vinod

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I would imagine most of the COBF board members would not be changing their spending habits if interest rates on savings are 1 or 2% higher, if they notice them at all.

 

Macro forces are powerful and sometimes you can't feel them as they move slowly.  But as I showed earlier the numbers are quite large.

 

Ok - let's try this a different way.  Think of it from a pension perspective - similar to a defined benefit pension plan.

 

Lower rates increase the future liabilities in present value terms due to the effects on discount rates.

Lower rates also affect expected returns on current assets. They are lower.

 

The effect of lower returns on assets and higher present value of liabilities for a pension (or for someone trying to save for retirement) is the requirement for more cash to be put into the retirement plan.  This diverts from consumption.

 

Again I point to how as the Fed was raising rates in 2018 led to higher quarterly GDP prints (3-3.5% per Q).  After the Fed did a U-turn and starting dropping rates in 2019, quarterly GDP fell to the 2-2.1% per Q range.  No doubt, the US economy is complex and subject to a multitude of forces - but I am convinced that lower rates hurt the economy more than they help.

 

We can agree to disagree.  Its an interesting question, though, to ponder that the Federal Reserve could be hurting the US economy when it thinks its helping by lowering rates.  This is different than its effect when it is acting as a lender-of-last-resort (which has nothing to do with rates) as it has been in this crisis.

 

wabuffo

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This is helpful to the economy the way I see it. With QE, Treasury is not borrowing money from the public to pay the interest. So how is the public missing out on the interest income? Public did not lend money and they are not getting interest. So no effect in that regard.

 

The US Federal Govt spends first, then borrows.  If not, how does the private sector ever get the govt's money?  Taxation and other forms of payment to the US government create the private sector's need for the government's money which the govt provides via spending.  It then borrows to remove the reserves it has created in the banking system. 

 

States and municipalities can't do this since they are not allowed to issue their own currencies.  This is why the Eurozone has so many problems - nations like Greece and France can no longer issue their own currency and must balance their budgets.  Even here it is interesting to watch states like Illinois and California sometimes get into severe budget crises and then issue IOUs which they give value to (in order for vendors to accept) by allowing these IOUs to extinguish state tax and fee obligations. 

 

This proves the model that US Federal govt's money is basically an IOU that the private sector needs to extinguish its tax liabilities - except its more formal and systematized such that we don't even think about it at all.  It follows that the Federal govt (after creating the tax obligations, must spend first in order for the private sector to be able to pay its taxes - just like a municipal bus system must issue tokens first, so that riders can exchange them for bus rides).

 

Now, instead of borrowing from the public (via selling of Treasuries), it gets money from the Federal Reserve (indirectly via the Banks) and what does it do with the money? It spending it on the public. Especially all the COVID programs. They are spending it without either taxing the money from the public or borrowing from the public.

 

So why is that not massively helping the economy? Yes, the concerns about this seemingly easy way to fund the Government programs are valid, but we cannot say it is not helping the economy.

 

I'm not following what you are saying here.  Could you re-phrase?

 

wabuffo

 

The way I see it, a Government can generate money in 3 ways to fund its expenses

 

1. Taxes

2. Debt

3. Direct debt monetization (Printing money). I understand the US has legal protections where it cannot do that directly. Treasury sells bonds to primary dealer banks, then the Fed Reserve buys the bonds from the primary dealer banks. Because the Fed intention is that they would only be holding these bonds "temporarily" and would sell the bonds to the public later on, we can go with the assumption and/or pretension that debt is not being monetized.

 

When Govt does #1 and #2, it is taking away money from the public to fund its expenses. So the public has less to spend on other things.

 

QE is helping fund US Govt at lower rates than would otherwise be the case. In addition, to the extent that Fed does not sell the bonds to public at a later time, that part of the debt is directly being monetized. So instead of some other entity (US Citizens, other countries, etc) buying the US Treasuries, it is Fed that is ending up owning these US Treasuries.

 

Point being, this is money that is not being "extracted" from anyone. It is being generated out of nowhere. As to the risks of this, that is a separate discussion. But if you can do this, why would it not be helpful to the economy? At least in the short term.

 

Vinod

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I would imagine most of the COBF board members would not be changing their spending habits if interest rates on savings are 1 or 2% higher, if they notice them at all.

 

Macro forces are powerful and sometimes you can't feel them as they move slowly.  But as I showed earlier the numbers are quite large.

 

Ok - let's try this a different way.  Think of it from a pension perspective - similar to a defined benefit pension plan.

 

Lower rates increase the future liabilities in present value terms due to the effects on discount rates.

Lower rates also affect expected returns on current assets. They are lower.

 

The effect of lower returns on assets and higher present value of liabilities for a pension (or for someone trying to save for retirement) is the requirement for more cash to be put into the retirement plan.  This diverts from consumption.

 

Again I point to how as the Fed was raising rates in 2018 led to higher quarterly GDP prints (3-3.5% per Q).  After the Fed did a U-turn and starting dropping rates in 2019, quarterly GDP fell to the 2-2.1% per Q range.  No doubt, the US economy is complex and subject to a multitude of forces - but I am convinced that lower rates hurt the economy more than they help.

 

We can agree to disagree.  Its an interesting question, though, to ponder that the Federal Reserve could be hurting the US economy when it thinks its helping by lowering rates.  This is different than its effect when it is acting as a lender-of-last-resort (which has nothing to do with rates) as it has been in this crisis.

 

wabuffo

 

Thanks for taking the time to help me understand. Appreciate your thoughtful response. I need to think some more about this.

 

Vinod

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I would imagine most of the COBF board members would not be changing their spending habits if interest rates on savings are 1 or 2% higher, if they notice them at all.

 

Macro forces are powerful and sometimes you can't feel them as they move slowly.  But as I showed earlier the numbers are quite large.

 

Ok - let's try this a different way.  Think of it from a pension perspective - similar to a defined benefit pension plan.

 

Lower rates increase the future liabilities in present value terms due to the effects on discount rates.

Lower rates also affect expected returns on current assets. They are lower.

 

The effect of lower returns on assets and higher present value of liabilities for a pension (or for someone trying to save for retirement) is the requirement for more cash to be put into the retirement plan.  This diverts from consumption.

 

Again I point to how as the Fed was raising rates in 2018 led to higher quarterly GDP prints (3-3.5% per Q).  After the Fed did a U-turn and starting dropping rates in 2019, quarterly GDP fell to the 2-2.1% per Q range.  No doubt, the US economy is complex and subject to a multitude of forces - but I am convinced that lower rates hurt the economy more than they help.

 

We can agree to disagree.  Its an interesting question, though, to ponder that the Federal Reserve could be hurting the US economy when it thinks its helping by lowering rates.  This is different than its effect when it is acting as a lender-of-last-resort (which has nothing to do with rates) as it has been in this crisis.

 

wabuffo

 

Correlation does not mean causation. I do agree they in the long run, lower interest rates than the current low level is probably going to hurt growth more than it helps. The point about increasing future liabilities (retirement, pension ) is true as well leading to more saving.

 

The deflationary aspect comes from companies offering services at it below cost. They can do this as long as market forces supply them with almost unlimited funding. Uber/Lyft Are examples of this, but also Amazon in a way.

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The low rates force savers to save even more, thus cutting consumption, which slows economic growth.

 

Not that I think you need any reassurance but this is a potentially great critique of recent Fed/ECB/BOJ actions — and one that hasn’t been repeated a million times.

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The low rates force savers to save even more, thus cutting consumption, which slows economic growth.

Not that I think you need any reassurance but this is a potentially great critique of recent Fed/ECB/BOJ actions — and one that hasn’t been repeated a million times.

If you follow comments made by Mr. Druckenmiller over the years, he referred to the hot potato effect whereby people in general would then have a lower propensity to hold cash or low yield risk-free debt and reach for yield raising the risk of capital misallocation and resulting in the possibility of asset inflation and subsequent asset deflation once easing was gone or when easing could not mitigate economic deterioration.

The effect on savers is difficult to ascertain because the aggregated data hide significant asymmetry.

In the US, in general, the three-legged stool of retirement reveals a widely insufficient level of personal savings and many rely on Social Security (defined benefit plans are on their way out). The future status of Social Security is interesting, only considering reasonable scenarios.

https://bipartisanpolicy.org/blog/covid-19-may-deplete-social-security-trust-funds-this-decade/

An interesting and related (to easing and low interest rates) aspect is that excess amounts from the payroll tax have been funnelled to trust funds. The government (through the Treasury) borrows the excess funds for "general corporate purposes" and pays interest on the special and non traded debt security. In a fascinating way, the interest paid by the government on the inter-department debt has somewhat closely followed the net national savings rate of the US (private, corporate and government).

https://www.ssa.gov/OACT/ProgData/newIssueRates.html

The interest (and net savings rate) was around 6% 20 years ago. The interest was at 2.00% in January 2020 and went down to 0.75% in May 2020. The net national savings rate has been coming down over several decades after reaching a high during WWII (despite large government deficits). It briefly went slightly negative in 2009 and then 'recovered' to its secular trend but is about the see an amount of negativity not encountered since the Great Reset that came after the 1920-1 deflationary recession.

Of course, it's possible that the Fed has conquered the cycle. For example, in the last few cycles, the Fed has been able to mitigate the decline of commercial and industrial loans through bridge-financing mechanisms but this time around there was a record increase in commercial and industrial loans during the actual formation of recessionary conditions. The numbers i look at suggest that bank debt taken up by the corporate sector since early 2020 is equivalent to the total bank debt taken in the last 6 years before that (the capital market is cooperating too). It is said that in China, because of unlimited and unbound powers, the authorities consider putting into law provisions forcing companies to report profits at all times. Under those conditions, who wants to be a saver?

Attempt to make this relevant for stock picking: Recently KJP put up Williams Sonoma as a case study and wondered at the price evolution. It seems the business just surfed the right waves and it appears to me that, absent the recent positive performance (which could be noise), the price performance of the last few years is very similar to the S&P 500. It's easier to be a genius when the wind is in your back (and when the Fed prevents deflation at all costs).

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CB - bringing up the savings rate is another very interesting aspect of the effects of US Treasury deficit spending. 

 

As I indicated upthread, US deficit spending adds new bank deposits (and therefore new financial assets) into the private sector.  So it is therefore, an accounting identity that:

1) Public sector (federal govt) deficits = Private sector (households and business) surpluses (ie., savings)

2) The private sector = US domestic private sector + Foreign sector (which "saves" USD assets via running a trade surplus with us).

 

The period from 1997-2007 provides some interesting data that seems to highlight how the Federal budget surpluses in 1997-2001 and the increase in trade with China (through China's entry into the WTO in 2001) delivered a 1-2 punch which forced the US private sector to increase its borrowing to maintain its consumption - and the main source of that borrowing was via the housing market.

 

First, here's the calculation starting with the year 1994.  The federal deficit that year was -2.51% of GDP.  Thus, the private sector surplus was equal +2.51% of GDP.  The private sector in 1994 saved an amount equal to 2.5% of GDP.  But there is a foreign private sector and a US domestic private sector.  In 1994, the foreign sector ran a trade surplus = 1.63% of GDP.  So if total private sector had savings of 2.51%, the US domestic private sector had 2.51-1.63 = savings of 0.89% of GDP. 

 

That's how the calculations work.  Here's the table for every year from 1994-2016 (I did this a few years ago and haven't updated the numbers since - probably should do that!)

Clinton-Surplus.jpg

This table shows how starting in 1997, the Federal deficits started to tip over into a surplus.  As it goes from nearly zero to a surplus of 2.42% of GDP in 2001, the private sector starts to get squeezed and begins to run a deficit (ie, take on debt) to maintain its consumption.  But because the trade deficit is persistent (the rest of the world needs to net save a portion of its growing wealth in super-safe USD assets), the domestic US private sector gets really squeezed.  This leads to the recession of 2000-2002 with the worst year being 2000 (US private sector runs a deficit of 6.3% of GDP).  In the far left, I start a cumulative effect column which mathematically adds the deficits in a cumulative fashion (I'm not sure this is actually mathematically correct but it indicates the level of falling savings/rising debt that the US domestic private sector is feeling).

 

The recession of 2000-2002 tips the US federal budget from surplus into deficit and this relieves a bit of the pressure of US households and businesses in 2002-2004.  But the growing effect of trade with China (plus a rising oil price which the US still is a net importer of) continues to press down.  Paradoxically, the US budget deficit starts to shrink again in 2006-2007 just as the trade deficit hits its peak at 5-6% of GDP.

 

This delivers the coup-de-grace to the US private sector in 2006-2007 as debt once again increases.  This of course leads to the Great Financial Crisis of 2008 and the opening of US Treasury deficit spending in 2008-2012.  You can see that both the combination of the deficit plus the GFC impact on foreign trade relieves the savings pressure on the US domestic private sector and savings rates zoom higher.  The cumulative effect also improves - though not quite getting back to 1994 levels.

 

Here's another chart that shows for the same 1994-2016 period: US GDP, Household Sector Debt and Business Sector Debt.  This chart highlights the tremendous growth in leverage and debt that peaked in 2008 - particularly for households (but also business sector too).

 

Clinto-Surplus-Debt.jpg

 

One final table - this time comparing the deficit/surplus with the effect on the dollar (as measured by its price in gold).  People worry about deficits leading to inflation.  Even MMTers admit that the size of the deficit (even with a Green New Deal or Jobs Guarantee) will always be limited by inflation.  But inflation as measured by the CPI is a flawed concept, IMHO.  I watch the gold price instead as a measure of currency debasement.  Whatever you think of gold (and lots of value investors hate it or ridicule it) - it has an important attribute - stability in its supply.  Annual gold production, year-in and year-out averages 2% per year vs above-ground inventory.  No other commodity (or currency) has that kind of supply-to-inventory ratio (though I guess Bitcoin follows the same 2% limit on annual supply growth rule).  This makes gold an excellent measuring stick from a collateral value perspective.  Anyhoo - I just wanted to highlight that when the US ran a persistent surplus in 1997-2001, the gold price fell.  This means that there was an undercurrent of monetary deflation happening.  Its also interesting to note that when the deficits-to-GDP grew large in the late 2009-2012 period, gold ran up significantly in price.  These days, deficits are climbing again and will probably go above 10% of GDP - for how long? who knows.  But gold is rising again.

 

Clinton-Surplus-Gold.jpg

 

What can I say - I'm a monetary theory nerd.  Sorry for the long post.

 

wabuffo

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