The Fed’s Policy Is Working – For Now
Ben Bernanke and his colleagues at the Fed are intent on reflating the economy and they are succeeding! Regardless of how you feel about America’s central bank, it would be a mistake not to recognize this fact.
As a direct result of Quantitative Easing, the S&P Index has just hit a new all time high and housing prices are finally moving up. The latest Flow of Funds data shows that household net worth increased by $5.4 trillion, or by 9%, in 2012 to $66 trillion. And, since the end of 2012, asset prices have risen considerably more.
Rising net worth is allowing Americans to spend more for two reasons. First, they can sell some of their stocks or real estate at a higher price than before and spend the proceeds. But, perhaps even more importantly, they can now borrow and spend more because the increasing value of their assets gives them more collateral to borrow against.
Consumer credit (i.e. consumer debt) increased by $154 billion in 2012. That compares with an increase of $86 billion in 2011 and contractions of $31 billion in 2010 and $116 billion in 2009. The increase in 2012 was the second largest ever, exceeded only by that recorded in 2000 at the peak of the Internet bubble. The surge in consumer credit, collateralized at least in part by rising asset prices, is allowing the American public to spend more relative to their income or, in other words, to save less. Consumer spending rose a relatively strong 0.7% in February compared with January. The personal savings rate, however, was back down to 2.6%. Before the mid-1980s, the personal savings rate in the US tended to range between 8% and 12%.
Meanwhile, corporate debt is expanding very rapidly. The extraordinarily low interest rates orchestrated by the Fed have encouraged corporations to borrow through the bond market even though the sector is sitting on unusually large stockpiles of cash. Corporate debt increased by $654 billion, or by 8.2%, in 2012.
Of course, the biggest borrower last year was the Federal Government. Its debt rose by $1.4 trillion, or by 10.9%. The issuers of asset-backed securities were the greatest source of deleveraging. Their debt contracted by $238 billion and now stands at $1.7 trillion, down from a peak of $4.5 trillion in 2007.
Altogether last year, total credit (and, consequently, total debt) increased by 3.1%. After adjusting for inflation, which was 1.7%, total credit grew by 1.4%.
Keep in mind that there were only nine years between 1952 and 2007 when total credit adjusted for inflation grew by less than 2%; and recall that each time that happened there was a recession. In 2012, the economy grew by 2.2% even though total credit adjusted for inflation increased by only 1.4%. Fed policy is the reason the economy grew despite weak credit growth. Quantitative Easing pushed up asset prices and created the wealth that fuelled consumption and economic growth.
As I have written many times before, this is not Capitalism. In a Capitalist economy, economic growth is not driven by massive fiat money creation by a central bank. Our economic system is managed by our government rather than by “market forces”. There is no point in pretending otherwise. Investors can’t afford to ignore this fact - whatever their philosophical preferences concerning the proper role of the government may be. The question investors must focus on, then, is what will the government do to generate economic growth this year.
I believe the answer is more of the same: more asset price inflation generated through more paper money creation. Here’s why. The government’s budget deficit will be several hundred billion dollars smaller this year due to higher taxes and sequestration. That means the government will borrow less and that total credit growth will remain very weak. It is crucial, therefore, that the household sector not only stops paying down its debt, as it has been doing since 2007, but that it once again begins to borrow more – and, from the Fed’s perspective, the more aggressively the household sector borrows the better, if the economy is going to grow.
Personal income growth is weak. Therefore, the only way the household sector will be able to borrow more is if asset prices rise further, thereby creating more collateral for people to borrow against. For that reason, I believe the Fed intends to push stock prices and property prices higher by continuing its current policy of creating $85 billion a month. After all, having gone this far, what choice does the Fed have now? If QE ends, the stock market will tumble, interest rates will rise, home prices will fall and the economy will spiral into recession.
The inflation rate is actually falling, while there are signs that the economy has begun to rebound from a very weak fourth quarter. So why would the Fed stop?
I fear our government-managed economy will eventually suffer a terrible fate as the result of so many decades of mismanagement. However, the investment community does not base its investment decisions on “eventually”. Investors are incentivized to focus on the short-run. At this moment, the creation of $85 billion a month by the Fed is creating a very favorable near-term investment environment. Asset prices are rising; and, it looks to me that the Fed intends to make sure that they continue rising.
The Fed’s reflation policy may eventually end disastrously, but I wouldn’t bet against it any time soon.