Terminal Velocity “And Now the End Is Near” used the allegory of Federal Reserve Governors singing the from the same page (like the Rat Pack) but in the wrong order. The dissonance created ripples in capital markets; which became waves of much larger amplitude in the real economy. Terminal Velocity “The Final Curtain” suggested that these destructive waves would lead to the permanent creation of a new wave of liquidity by the Fed.
At the last FOMC meeting, the Fed took the precautionary step of postponing the “Taper” due to the onset of the seasonal fiscal headwind from Congress. The Fed can now be seen as highly prescient. This perceived headwind effectively led to the partial shutdown of the Federal Government; and a rolling shutdown going forward, as the stalemate in Congress becomes prolonged. As the crisis unfolds, the tone of the Fed singers becomes sharper.
Eric Rosengren began to subtly change the tune, from following a data dependent rhythm to a new crisis beat which will require more QE. This beat was picked up by John C. Williams, who embellished it with specific reference to the threat created by the shutdown. It was attenuated by Dennis Lockhart; who opined that a prolonged shutdown reduces the imminence of the “Taper”. The song remains the same for Richard Fisher however; who blames the “feckless” Congress for the economic uncertainty that has now extended to the timing of the “Taper”[i].
The capital markets are also dancing to a different tune these days. High Yield bonds now correlate directly with US Treasury Yields.
The capital markets now discount the negative consequences for economic growth from higher US interest rates. This weakness, discounted by the capital markets, was affirmed by the latest Fed Senior Loan Officer Survey. This survey is a measure of banks willingness minus lack of willingness to lend. In the July survey it fell to a net 13% willingness compared with 22% in April[ii]. So far in the recovery, credit growth has been way below the normal measures observed in previous recoveries and economic expansions. The fact that loan growth is stalling out now, suggests that a new economic plateau phase is occurring[iii]. Clearly this plateau is unacceptable to policy makers in terms of unemployment. This plateau is the best that the bankers can sustain; what is now missing is the Federal Government contribution. This contribution is now being waylaid in the Congress. As a result, the Administration is trying to transfer it to the Fed’s balance sheet rather than to the Taxpayers’. Republican ideology won’t accept higher taxes to contribute to Federal Spending; therefore the Federal Reserve must oblige with the permanent creation of new money.
The recession, which will beget this permanent creation of money, is now starting to get factored in.
The “Shutdown” was a double edged sword. The first blade cuts into economic growth by decreasing the fiscal stimulus. The second blade makes it impossible to see the impact of the first blade; because the departments which create the economic monitoring data have been closed down by the first blade. Economic agents in the real economy, the Fed and the capital markets are therefore all operating in the dark. If the species known as “Homo Economicus” exists, he and she will not be capable of making the rational decisions that the accepted wisdom in the economics profession always assumes are being made. It is reasonable to assume that this species will be operating under conditions of extreme pessimism based on this uncertainty. The US Treasury tried to rationally get ahead of this irrational situation with its timely release of a report entitled The Potential Macroeconomic Effect of Debt Ceiling Brinksmanship[vi].
The Treasury uses the behaviour of the markets and economy back in 2011, under similar conditions, as the rational indicator of what to expect in the current situation. It concludes that even the threat of a “Shutdown” has an impact similar to a real “Shutdown”.
The first signs of this uncertainty and pessimism can be seen in the latest Consumer Confidence surveys. American economic confidence (as measured by Gallup) has totally collapsed in the last few days since the “Shutdown” occurred; having already started to fall as a victim of the “Taper Talk” since Q2[vii]. The “Shutdown” has hit the economy just as it was already weakening because of the expected “Taper”. This confluence of factors has to some extent been self-reinforcing in terms of negative consumer sentiment. The Treasury’s analysis of a repeat of 2011 therefore looks prescient.
One should therefore look beyond the crisis of 2011 to see what happened to end it. In fairness, some of the 2011 crisis must be attributed to the unravelling of the Sovereign Debt Crisis in Europe. This time round, Europe is less of a threat because the economy is growing and Angela Merkel is in the process of forming a Europhile Grand Coalition government. Emerging Markets are however unravelling, so these can be used as the cypher for the Eurozone Debt Crisis of 2011. What then happened in 2011 was QE2, announced by James Bullard. This time around therefore, one should be expecting something of similar significance from the Fed. The first step will be to roll back the “Taper”, which clearly some Fed Governors have been doing in their recent speeches.
One must also look at the cool hand being played by the Obama Administration. Presumably if it believes in the 2011 rhyme, it is betting on the Fed again. The politics of the situation therefore require the framing of the Republicans as the cause of the problem; after which, as the song goes, the President will be able to state the case of which he is certain.