Question: Can ZIRP + Recession = Economic Death Spiral?

September 7th, 2015
in Op Ed

by Michael Haltman

This is a question worth pondering particularly with the rampant speculation over what the Fed will do with interest rates this month!

First the obvious thought, what is ZIRP?

Follow up:

In a nutshell...

'Zero interest-rate policy (ZIRP) is a macroeconomic concept describing conditions with a very low nominal interest rate, such as those in contemporary Japan and, since December 16, 2008, in the United States. It can be associated with slow economic growth.' (Google)

Given the swirl of pundits, economists and investors who fall on one side or the other of the raise or not raise rates mystery, all eyes will be on the economic data released prior to the Fed meeting for some clue regarding the actions they may take.

For those who fall on the not raising rates side, their arguments include the fact that for many ordinary citizens in the United States today there really is no question about whether we are currently still in recession. A labor force participation rate at a decades low level is another as is the fact that whatever jobs are being created are not the quality of the jobs created in the past.

Those on the raise rates side will point to the latest GDP report and the fact that unemployment has fallen to about 5.3%. They may also point to the fact that at 0% rates the Fed would have no ammo in its quiver were the U.S. to reenter recession.

In a great article that sifts through many of the issues, Martin Hutchinson has written the article 'ZIRP + Recession = Death Spiral'. With his permission I am reprinting it below.

'Last week, economist Larry Summers and Bridgewater Associates Chairman Ray Dalio called for a new round of quantitative easing (QE) bond purchases.

Meanwhile, New York Fed Chairman Bill Dudley scaled back expectations of a September rate increase. Even though second-quarter U.S. gross domestic product (GDP) growth was revised upward, it's now unlikely that the Fed will raise rates at its September 16-17 meeting.

At this point it's worth wondering whether the Fed will ever have the guts to move off the "zero-bound."

Under such circumstances, we're compelled to ponder what will happen if the fed funds rate is still at zero when the next recession hits.

We're already more than six years into an economic upturn, and unemployment is down to 5.3%. A cyclical recession can't be far off. The elevated state of the stock market also suggests that a decline is near. If the market had followed nominal GDP since the first monetary easing in February 1995, the Dow would now be around 9,000, little more than half its current level.

Finally, Austrian economic theory suggests that the prolonged period of ultra-low interest rates has produced an orgy of misdirected malinvestment that will have to be liquidated, causing a recession.

A Political Matter
The timing of the next recession will seriously impact the 2016 election, which in turn will influence the Fed's actions and, ultimately, the future of the world economy.

If recession hits hard before November 2016, it'll help the Republicans. Indeed, it will validate many of the criticisms made by the Tea Party wing. If Republicans win the election, we'll get a new Fed Chair in January 2018, when Janet Yellen's current term ends, and presumably a different Fed approach from then on.

On the other hand, if there's no recession prior to the election, then Hillary Clinton or some other Democrat is likely to win. In that instance, Fed policy will remain unchanged, whether under Yellen or a like-minded successor.

Assuming current Fed thinking prevails when recession hits, the most likely reaction will be to bring out the big guns of monetary "stimulus."

However, if interest rates are still at zero, the Fed will have just two possible courses of action. One would be to set the interest on excess reserves to a substantial negative number (it's currently 0.25%). That would force the banks to take their money out of the Fed - though in a recession, they likely wouldn't lend the money. Instead, they'd simply invest in Treasuries, intensifying the effect of the Fed's quantitative easing program.

The other option would be engaging in a shock and awe-sized bout of bond purchases.

The Bank of Japan (BoJ) has shown how this can be done. Its current QE program is three times the size of the largest U.S. QE program, in terms of GDP. In fact, the BoJ is buying all kinds of bonds, not just government and housing agency bonds.

In the event of a recession, the Fed could announce a QE program of, say, $250-billion worth of bond purchases per month. This is comparable in size to Japan's current program. That would expand the Fed's balance sheet by $3 trillion per year, equivalent to 17% of GDP - and would satisfy even rabid Keynesians like Summers and, apparently, Dalio.

With its massive new QE program, the Fed would absorb more than 100% of the new Treasury bonds issued each year. And even though interest rates are already very low, they'd decline further, especially when inflation is taken into account.

Coupled with bank lending, the Fed's bond purchases would force $3-$4 trillion worth of extra liquidity into the market annually. Whether or not this caused inflation directly, it would certainly cause the dollar to decline, just as the Bank of Japan's program has caused the Japanese yen to drop.

In turn, that would produce a new level of "currency war" in which the United States was no longer standing passively by allowing the dollar to appreciate against almost all other currencies. Instead, the United States would be actively trying to depreciate the dollar.

In 2010, during the first QE program, Brazil's finance minister accused the United States of waging a currency war. That accusation didn't take hold then - but this time, with renewed recession and a massive injection of liquidity into the market, the Fed's actions would anger China, Japan, and the EU.

The end result would almost certainly be a round of protectionism, as everybody tried to protect their domestic industries against the effects of other countries' currency wars.

A Recipe for Disaster
Now, we've seen this movie before - in the 1930s - and it didn't end well.

World trade declined by 65%, while countries like Nazi Germany abandoned the international trading system altogether and set up bilateral arrangements with favored sources of raw materials. Within a decade, of course, the world was at war.

Better to hope that the Fed's renewed QE produces a sharp rise in inflation. At least then the policy would have to be abandoned, without wrecking the world economy altogether.

Good investing,'

Martin Hutchinson

For 27 years, Martin Hutchinson was an international merchant banker in London, New York, and Zagreb. He ran derivatives platforms for two European banks before serving as director of a Spanish venture capital company, advisor to the Korean company Sunkyong, and chairman of a U.S. modular building company.

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