Economic Good News and Bad News

The FOMC finished up its latest meeting on monetary policy on Wednesday. Janet Yellen and the Fed decided to keep the federal funds rate the same, which is a target rate of 0.25% to 0.5%.

This comes on the heels of its December meeting, when it announced its first change since 2008. The overnight lending rate for banks had stood at near zero for seven years.

Just a month ago, analysts were predicting that the Fed would raise its key rate another three or four times in 2016. Then the first two weeks of January happened.

With trouble in China escalating and oil and U.S. stocks plummeting, some are questioning whether we will see another rate hike at all in 2016.

It was a rather tough meeting for Yellen and company. They just raised the key rate, which has actually translated into lower long-term interest rates due to fears of a recession. When stocks go down, bonds tend to do well, especially in an environment of expectations for low price inflation.

The FOMC statement said about all it could say. They supposedly remain upbeat on housing and the labor market, but did not directly address the problems in China and the stock market decline in the U.S.

It must not sit well with Fed officials that after the announcement, stocks took another beating on Wednesday afternoon. Usually a more “dovish” stance by the Fed is good for stocks. But in this case, investors are looking at the situation and determining that a possible recession is more of a threat to their stock portfolios than a dovish policy of the Fed is beneficial.

Malinvestment

The term “malinvestment” was used by the Austrian school economist Ludwig von Mises.

Malinvestment refers to the misallocation of resources based on easy money and artificially low interest rates. The easy money and low interest rates direct capital into certain sectors where it would not otherwise have gone.

This means there is an artificial boom. It can often be mistaken for genuine prosperity. The economy may seem to be doing better than it actually is. The worst part is that the misdirected capital is further damaging savings and investment, which are the bedrock of true economic growth.

Based on the easy money and credit by the Fed since 2008, we have to assume that some of the so-called recovery is artificial. The Fed had three rounds of money creation (QE1, QE2, and QE3) from 2008 to October 2014. When this new money starts to dry up, the malinvestment is exposed.

Oil prices have already fallen drastically, and stocks now seem to be following. The stock market rose to new highs with easy money, and now the bubble appears to be deflating it.

One important point that is often misunderstood is that a correction or recession is not the actual problem. It is a symptom of the problem, which is easy money and government intervention into the economy. A correction is just that: an attempt by the market economy to fix the previous malinvestment. A correction realigns resources with actual consumer demand. It is painful yet necessary.

The problem is that the government and central bank often do not let the correction actually correct things. This is what happened in 2008–2009.

At this point, the damage has already been done. Some kind of a correction is necessary. It is just a question of how big the correction will be and when it will happen. There will also be a bigger question of how the Fed reacts to it.

You Can Bank on This Good News

Unfortunately, the Fed’s really loose monetary policy for six years has done some real damage. Not only will asset bubbles likely deflate, but we could also see unemployment go back up as resources realign. In some ways, the damage could be even worse than 2008.

With that said, there is one area where we are likely much better off today than we were in 2008: the banking sector.

When the financial crisis hit in 2008, the major banks were in big trouble. They had to be bailed out.

As an advocate of free market policies, I am still not sure what the right solution was at that time. The problem is that it was interventionist policies that caused the problems in the first place, so there was no easy free market solution.

People were mad about the massive bailouts of the banks. But I have a feeling they would have been even madder if they went to their bank and didn’t have access to the money in their checking accounts.

After the initial bank bailout, the Fed smartened up to the situation. It did not need to have a revolution on its hands. It continued to bail out the banks, but in much more discreet ways.

As part of its quantitative easing programs, the Fed enacted a new policy of not just buying government debt, but also buying mortgage-backed securities (MBS). The Fed bought the MBS from the banks at face value. The Fed did not pay market value.

The problem is that many of the mortgages were already in default from the housing bust. Many of these securities were worth only a fraction of what the Fed was actually paying for them.

It was done under the name of helping the mortgage market, but it was really just a backdoor bailout of the banks.

There is another form of bank bailouts that has been happening. Since 2008, the Fed has used a new policy tool of paying interest on bank reserves. The rate was 0.25%. This went up to 0.5% in December. The Fed did this in order to hike the federal funds rate.

This may not seem like a high interest rate — and it isn’t — but consider that much of the new money created by the Fed since 2008 has gone into bank reserves. Banks have gladly accepted the small return from the Fed instead of making risky loans.

In essence, the banks have received at least three different variations of bailouts since 2008. This comes out of our pockets, whether directly or indirectly. But the banks are far better off for it.

If we hit a deep recession similar to 2008, there will certainly be some defaults on car loans and housing loans. But it will not likely be as dramatic as the last time. Most of the country is not like San Francisco right now. In many places, housing prices are still well below where they were at the peak of the last housing bubble.

Your Pocket

The banks are in rather good shape due to their huge piles of reserves and the essentially free money they have received. With all of the Fed bailouts, all of this money comes from some form of inflation, debt, or taxation.

The good news is that if we do hit another deep recession, the big banks should not have to be bailed out — or at least not nearly as much as last time. I say this partially sarcastically, but also somewhat seriously.

For this reason, maybe there is a slim chance that the Fed won’t step on the monetary accelerator this time, or at least not as much. The Fed’s main purpose is to keep the big banks afloat. It has done its job well in this respect.

The other main purpose of the Fed is to help Congress fund its deficit spending at low rates. There is always a slight glimmer of hope that Yellen and company will tell Congress to figure things out, even if it means cutting spending.

Don’t take this as a recommendation to buy shares in the big banks. They still may suffer in a downturn, but it seems it should be far less severe than the last time.

Your next major financial moves should revolve around the Fed’s reaction to an economic downturn. Will they turn to QE4 or tell Congress to figure things out on its own?

The Fed should not need QE4 to bail out the banks, because it has been constantly bailing out the banks for the last seven years. At least our money hasn’t been completely wasted.

Until next time,

Geoffrey Pike for Wealth Daily