Regular readers of Goldmoney’s Insights should be aware by now that the cycle of business activity is fuelled by monetary policy, and that the periodic booms and slumps experienced since monetary policy has been used in an attempt to manage economic outcomes are the result of monetary policy itself. The link between interest rate suppression in the early stages of the credit cycle, the creation of malinvestments and the subsequent debt dénouement was summed up in Hayek’s illustration of a triangle, which I covered in an earlier article.[i]
Since Hayek’s time, monetary policy, particularly in America, has evolved away from targeting production and discouraging savings by suppressing interest rates, towards encouraging consumption through expanding consumer finance. American consumers are living beyond their means and have commonly depleted all their liquid savings. But given the variations in the cost of consumer finance (between 0% car loans and 20% credit card and overdraft rates), consumers are generally insensitive to changes in interest rates.
Therefore, despite the rise of consumer finance, we can still regard Hayek’s triangle as illustrating the driving force behind the credit cycle, and the unsustainable excesses of unprofitable debt created by suppressing interest rates as the reason monetary policy always leads to an economic crisis. The chart below shows we could be living dangerously close to another tipping point, whereby the rises in the Fed Funds Rate (FFR) might be about to trigger a new credit and economic crisis.
Previous peaks in the FFR coincided with the onset of economic downturns, because they exposed unsustainable business models. On the basis of simple extrapolation, the area between the two dotted lines, which roughly join these peaks, is where the current FFR cycle can be expected to peak. It is currently standing at about 2% after yesterday’s increase, and the Fed expects the FFR to average 3.1% in 2019. The chart tells us the Fed is already living dangerously with yesterday’s hike, and further rises will all but guarantee a credit crisis.
The reason successive interest rate peaks have been on a declining trend is bound up in the rising level of outstanding debt and loans, shown by the red line on the chart. Besides a temporary slowdown during the last credit crisis, debt has been increasing over every cycle. Instead of sequential credit crises eliminating malinvestments, it is clear the Fed has prevented debt liquidation for at least the last forty years. The accumulation of debt since the 1980s is behind the reason for the decline in interest rate peaks over time.
A quarter-point rise in interest rates, if it is reflected in the cost of servicing all outstanding debt, would be a burden to debtors of $167bn, and the increase from the zero bound is an added liability of over a trillion dollars so far. But it is more accurate and relevant to regard much of the accumulated debt as not immediately relevant, because it is in fixed interest bonds, including US Treasuries, and similar medium-term loans. Furthermore, where variable interest rates apply, nearly all major corporations have treasury officers which use derivatives, such as interest rate swaps, to protect themselves from interest rate changes.
Where it does matter is the effect of changes to the rate of interest that applies to circulating capital, put crudely on the cost of a business’s overdraft. Interest costs on circulating capital in turn determine the marginal returns of production, and therefore set the overall profitability of an enterprise.
Even if a business has no need to borrow, the cost of circulating capital is a measure that a business must pay attention to. If the returns on capital do not clear a hurdle rate based on current interest rates, a business would be better off using its money elsewhere. Central banks understand this, and their holy grail is to detect the rate at which a balance is achieved, and the economy can therefore grow at a sustainable rate. We see this reflected in monetary policy, whereby the FFR is moved up in baby steps, the effect on the economy being assessed after each rise. This point was confirmed by Jay Powell in yesterday’s press conference following the rate decision.
The Fed creates problems for itself
The drawback of state intervention in any field is that unexpected consequences arise as economic actors adjust to the opportunities created. The suppression of interest rates below their natural time-preference value is a transfer of benefit from savers to borrowers, so businesses are encouraged by suppressed borrowing costs to borrow to expand production. This is, of course, the intention behind monetary policy early in the credit cycle. But when the extra demand for capital goods (the goods used to produce final goods and services for consumption) develops, commodity and other intermediate production prices begin to increase reflecting credit expansion, and it is rising prices that always force a central bank to end interest rate suppression. They have to increase interest rates to a level sufficient to support the currency and contain the price consequences of earlier monetary inflation. Monetary policy targeting a neutral rate has to be put aside.
This is a problem that arises from intervention. If they must intervene to correct the inflationary effects of earlier interventions, central banks would be better more closely monitoring commodity prices and the prices of production rather than relying mainly on consumer prices, because consumer prices are the last to be affected by monetary expansion, except where the stimulus is directly through consumer borrowing. In other words, monitoring prices should be more flexible than it is under current inflation mandates.
Instead, the Fed wants to follow a more objective approach and to do away with as much guesswork as possible. It then falls into the econometric trap of believing there is such a thing as a scientific basis in a general price level. But a wholly artificial index of prices can be constructed to give you any answer you want, particularly through the application of hedonics. This is a fancy term for assuming that if the price of a product rises, you must deflate it for an assessed value of all improvements. This is why for statistical purposes an automobile today costs nearly the same as one thirty years ago, when it actually costs nearly twice as many dollars. Then there is product substitution, where index weightings are adjusted on the assumption that higher prices for one item will encourage some consumers to go for a cheaper alternative. Less steaks and more cheaper chicken breasts. The evidence of price inflation is thereby suppressed to only a few per cent.
Therefore, consumer price indices are now being used to quash the price effects of monetary inflation instead of recording it. It is a short step for the members of a monetary policy committee to move from accepting that these distortions exist and why they should be taken into account when setting rates, to taking doctored inflation statistics at their face value. This is one very good reason why central bankers are blindly unaware of the consequences of earlier interest rate suppressions.
Paradoxically, the best outcome for a central bank is to never achieve the economic revival that is the stated objective of monetary policy, because to do so merely leads to destructively higher interest rates and the termination of the credit cycle. This means that consciously or unconsciously, monetary committees are on the lookout for news that delays the need to raise rates. So, what we have is monetary policy based on misleading statistics that almost guarantees policy makers act like the fabled three wise monkeys, until it is too late.
The consequences of Powell’s partial epiphany
Blindness to the state of the cycle is certainly true of the ECB, Bank of Japan and Bank of England, as well as the majority of central banks suppressing interest rates in minor currencies. It was also true of the Fed, until recently. Chairman Powell now tells us business investment is increasing and the US economy is going like a train (not his actual words). He expects more interest rate increases to come. He is right about where we are in the credit cycle, but wrongly thinks it is a business cycle which will need no more than a neutral rate of interest to keep it under control.
In the world of central banking Powell is now an outlier, and in our globally connected world central bankers abroad who are still suppressing interest rates are now dangerously wrong-footed. There is bound to be an immediate period of painful readjustment. Currency strains and higher interest rates for nearly all other currencies seem set to undermine bond and equity markets, in a text-book run-up to the next global credit crisis.
We have now explained why monetary policy leads periodically to a credit crisis that exposes businesses which are only profitable so long as interest rates are suppressed. This has been a feature of the US economy during the current credit cycle for ten years until now, since the FFR was aggressively reduced following the peak rate of 5.25% in 2006-2007. Since the introduction of near-zero rates in 2008, a widespread belief has taken hold that interest rates will never increase significantly again. Consequently, we can be sure the distortions from interest rate suppression have built up to an extent unseen in the past.
This complacency is why an increase in the FFR into the danger zone should warn us that the crisis stage of the credit cycle approaches. But the only businesses directly affected by the FFR are the commercial banks. In the real world the actual interest rates paid by businesses on their circulating capital is what matters. That rate is set by commercial banks, which take into account lending risks to individual corporate borrowers, as well as their own costs of finance. The hurdle rate for a company is therefore significantly higher than the FFR. Our second chart shows the level set by the commercial banks’ prime lending rate.
Assuming the dotted line predicts the height of the prime rate to trigger a credit crisis, this chart suggests that an average prime lending rate of 6% or more will trigger the next credit crisis, against a current rate of 5%. The rule of thumb relationship with the FFR is FFR plus 3% and implies there is a little more margin in higher interest rates than implied in the earlier chart of the FFR.[ii] The merit of this chart is it applies to businesses, while the FFR chart does not, but the message is the same.
An increase in the prime lending rate to the 6% level could easily happen in the coming months. The FOMC statement last night included a forecast for the FFR of an average rate of 3.1% next year, which implies a prime rate of over 6%. There is full employment, not only in the US but in other major economies as well. Commodity prices, notably energy, are rising, and the heavily-sedated CPI-U is at 2.5%, already above the 2% target rate. It is against this background that President Trump is increasing government spending while cutting taxes. Even for Keynesian economists, the combination of monetary and fiscal stimulus may be too much and could already be leading to their feared excess demand. Higher prices and therefore interest rates will surely follow.
However, the path to higher prime rates seems unlikely to be straightforward. In a classically-defined credit cycle its mature phase is likely to see a shift of monetary capital away from financial to commercial activities, from Wall Street to Main Street if you like. We have seen some of this take place, evidenced by rising bond yields, but the quantity of money flowing into bonds continues apace, particularly from foreign sources.
The most notable evidence of a switch in the destiny of capital is likely to come from equity markets, which should turn down as money-flows are diverted into the real economy. But the banks have the reserves to finance both financial market speculation and increased production, at least to a degree. Furthermore, much of the expansion of bank credit is aimed at consumers, financing their demand for goods. Instead of there being a noticeable time lag between a peak in equity markets and an eventual peak in production, the two events could almost be bound up together, with equities falling just ahead of the credit crisis itself.
Rhyming with the past?
In that event, the approaching interest rate cycle peak could contribute directly to the collapse of economic activity through wealth destruction in equity markets as much as through the exposure of malinvestments in production. A credit crisis with these characteristics has much in common with the 1929-32 period.
The 1929 Wall Street Crash came at the end of a similarly extended period of credit expansion, which prolonged the final pre-crash phase of the credit cycle, just as it has today. Consumer price rises were subdued through the introduction of factory production lines for new goods. Today they have been restrained by the expansion of production in cheaper jurisdictions. There can be little doubt there are similarities between that period and conditions today, not least in the optimism over the non-inflationary outlook.
There were also significant differences, the most notable being globalisation was generally restricted to the market for commodities ninety years ago and some limited exporting of capital goods. This time, globalisation extends throughout the production chain from commodities to retail and embraces the coordination of monetary policy by central banks as well.[iii] This means that a crisis on Wall Street, which destroys wealth in America, is likely to spread rapidly to all other major economies. The role of the dollar as the world’s reserve currency is an additional factor binding all nations into the same credit and production cycles.
The onset of the next credit crisis in America could also be triggered from elsewhere, particularly the Eurozone. The ECB is still suppressing interest rates in negative territory and buying government bonds during what is increasingly seen to be the final stages of the Eurozone’s credit cycle, making the inevitable interest rate adjustments that follow potentially very sudden and violent. The situation in Japan is similar, but Japanese manufacturers are now global businesses that just happen to be based in Japan, so are more affected by the dollar and other major currencies.
All central banks are proceeding on the assumption there is no credit crisis on the horizon. This hubris was vividly demonstrated by Janet Yellen who a year ago told us she did not believe there would be another financial crisis in her lifetime, thanks largely to reforms of the banking system since the 2007-09 crash. That crash was a surprise to central bankers then, as was every crash before. Even Benjamin Strong in the late-1920s believed his new Federal Reserve System had tamed the business cycles of the previous century, though he died before being disproved by the 1929 Crash.
Strong’s hubris then was the same Yellen’s hubris last year. Central banks have learned nothing about the credit cycle in nearly a century. If they had, they would be promoting sound money and a hands-off policy, while ensuring commercial banks restrict their credit expansion. They would let malinvestments wash out of the system, not build up for one huge crisis. They are not even aware, it seems, that they are living dangerously as they raise interest rates into and beyond the zone that will trigger the next credit crisis.
A credit crisis today will be more catastrophic than that of ten years ago. And when the crisis comes, the response is always the same, except the quantities involved are far greater. The banks will be rescued by the Fed printing new capital for them without limitation, on condition they don’t foreclose on their customers. The Fed will take bad and doubtful debts off the banks at the same time. Government borrowing will rocket, reflecting increasing social liabilities and falling tax revenues. All the money required will be created out of thin air.
The great financial crisis of 2007/08 will be eclipsed. In a nutshell, this time the quantity of new money required will likely lead to the destruction of the “full faith and credit” in the currencies themselves, which until now has been broadly unquestioned by ordinary members of the public.
[ii]There was cooperation between the Fed and the Bank of England in the 1920s in an attempt to manage gold reserves, but it did not extend to monetary policy per se.