On Tuesday afternoon, the minutes from the March 13 Federal Open Market Committee meeting were released, revealing surprising insights. To the shock of Wall Street, there was no mention of monetary easing options. The reaction from traders was immediate and negative; they began selling off their positions. This trend continued into Wednesday.
“The significant support for both the economy and financial markets over the past two years has stemmed from stimulus measures. Without this support, it remains uncertain whether these economies can sustain themselves,” stated Bruce Bittles, chief investment strategist at Robert W. Baird & Co in Nashville. The swift market sell-off indicates that investors lack faith in the economy’s ability to thrive independently.
Moreover, with gas prices reaching $4 per gallon ahead of the summer driving season, implementing further monetary inflation is not a politically pragmatic choice at this time. However, this situation could shift in a few months. The complex relationship between monetary policy and politics will need to navigate toward a new equilibrium.
It has become increasingly clear since the 2008 financial crisis how heavily both the economy and financial markets rely on money created by the Federal Reserve. After every monetary policy experiment—like Quantitative Easing (QE) and QE2—when the Fed ceases its bond purchasing programs, the stock market tends to plunge, and growth often stalls. With the conclusion of Operation Twist, it is apparent once more that continued monetary inflation is vital for economic survival.
Gas, The New Vigilante
Returning to the financial climate of pre-2008 is now a distant possibility. The Fed cannot reduce its balance sheet without triggering a significant economic downturn. In fact, the Fed will need to enlarge its balance sheet simply to maintain the current state of the economy—not to mention achieving a growth rate of 2 percent. Yet, this is just the tip of the iceberg…
Due to extensive Fed involvement in capital markets, the government currently runs annual deficits exceeding $1 trillion with little apparent risk. Two decades ago, a deficit-to-GDP ratio surpassing 4 percent would have prompted bond vigilantes to sell off their treasury holdings, leading to rising interest rates. Presently, the government is managing a deficit nearly equivalent to 10 percent of GDP without crisis, thanks to the Fed’s practice of printing money to purchase treasuries, which keeps yields on the 10 Year Note below 2 percent.
In this new environment, gas prices have taken the role of a fiscal and monetary enforcer. High fuel costs serve as an unwelcome side effect of monetary inflation. The escalating gas prices reflect the endless infusion of digital cash into the economy, contrasted against a limited supply of real resources.
As gas prices rise beyond $4 per gallon, Fed monetary inflation faces increased political scrutiny. The Fed then must pause its stimulus activities, which leads to economic decline and reduced oil demand. Subsequently, as the economy falters and demand decreases, gas prices follow suit.
At that juncture, politicians will typically call for the Fed to take action. The Fed usually complies, creating more money to support government debt, or funnelling it into the mortgage and other credit markets.
Monetary Policy, Explained
By late summer—or perhaps even earlier—the economy is likely to stall, causing the S&P 500 to dip below 1,000. This would compel the Fed to embark on another round of monetary inflation. The need for continued Fed intervention is underscored by how distorted both the economy and financial markets have become—requiring ongoing support to simply maintain stability. Remove that support, and conditions could deteriorate rapidly.
A declining economy and lackluster stock market will be an untenable situation for politicians, especially as elections approach. Incumbents will inevitably push for Fed stimulus measures.
However, perpetuating policies of monetary stimulus may ultimately be futile. As economist Ludwig von Mises observed in his work “Human Action,” “There is no means of avoiding the final collapse of a boom brought about by credit expansion.” The only question remains whether the crisis will occur sooner through a conscious halt to credit expansion, or later as a total catastrophe of the currency system unfolds.
In this managed economy, heavily influenced by monetary intervention, the Fed’s tactics of expanding credit are often interspersed with sporadic pauses. Their goal is to navigate the opposing forces of deflation, stemming from an over-leveraged economy, and inflationary pressures, such as rising gas prices, triggered by excessive monetary supply. In essence, the Fed appears to be improvising in response to these complex dynamics.
This captures the essence of the current monetary policy landscape.
Sincerely,
MN Gordon
for Economic Prism
