Why the next recession will be a doozy...
"STOCKS Slide After Powell Testimony," reads a headline at Bloomberg, writes Bill Bonner in his Diary of a Rogue Economist.
The Dow left February as the worst month in two years.
What did the new Fed chief say?
Only that he thought the economy was doing so well that the Fed would be able to continue raising rates and reducing its bond holdings. It is currently scheduled to get rid of nearly $2 trillion worth of bonds in its quantitative tightening program over the next two years.
Fed policy is as easy as 1...2...3...
- It keeps rates too low for too long.
- It raises them, causing a serious allergic reaction on Wall Street...
- ...which it then medicates with more low rates.
It is now in the middle of Mistake 2. And our guess is that a recession/crash will happen before it has had a chance to restock the medicine cabinet.
Yes, Dear Reader, Wall Street is allergic to higher rates. Not only do they raise the discount rate, making the flow of earnings less valuable in today's money...they also signal that the Fed no longer has investors' backs.
And now, after so many years of the Fed favoring financial assets with EZ credit policies, the financial world is particularly sensitive. Even a small increase in rates could send Wall Street to the emergency room.
Which is okay with us. We don't care about higher rates. Or lower rates. We just want honest rates.
Because honest rates produce honest prices. And honest prices are what an economy needs to make the right decisions.
Which merely raises the same question we already asked.
How can some guys and gals with PhDs in economics know what the honest interest rate should be?
Even markets don't know.
They have to discover honest prices...minute by minute...based on all the information coming their way. Take away the information (from willing buyers and sellers, lenders and borrowers, bulls and bears) and you are lost.
But that doesn't stop the Fed.
It decides, by committee, where it thinks rates should be. And then, it proceeds to make Mistakes 1, 2, and 3.
Of course, ours is a minority view. Most people believe the Fed knows what it is doing.
Alan Greenspan, who chaired the Fed from 1987 to 2006, was lionized for making Mistakes 1, 2, and 3. And Ben Bernanke, his successor, was lauded when he had the "courage to act" by making Mistake 3.
Mr.Bernanke's successor, Janet Yellen, was acclaimed for making Mistake 1 for four years. And now Powell – no fool – is going to stick with the script: make Mistake 2 until it is time to make Mistake 3 again.
Same old. Same old.
What is new is that Mistake 2 is likely to set off a chain of events too powerful for Mistake 3 to stop.
So far, the Fed has unloaded just $21 billion in bonds. It was supposed to dump $50 billion a month, but it seems to have gotten cold feet. And in the mini-crash of early February, it actually rushed ahead to Mistake 3 (a preview of things to come) and added $16 billion to its bond portfolio.
Even former Treasury secretary Larry Summers, whom we caught on Bloomberg TV, sees the feds making errors.
The understatement headline: "Summers Warns Next US Recession Could Outlast Previous One."
Mistakes are costly. They distort prices, causing investors, consumers, and businesses to make mistakes, too. And they add debt.
Eventually, you get to the point where the economy has too much debt; it can't add more. The Fed...like a dirty old man hanging around a schoolyard...runs out of candy.
Even with the lowest rates in 5,000 years, the Fed has been unable to coax households into adding substantially more debt.
Home buyers and lenders saw what happened the last time. Mortgage debt has declined. Besides, households just couldn't add much more debt...they had too much already.
Aside from their houses, they had little collateral. So they could only borrow against easily-repossessed autos...or get scammy student debt, backed by the feds.
That left businesses and the feds themselves to do the heavy lifting. And yes, they bent to the task with great enthusiasm. Business debt is now about 40% higher than it was in 2008. And the federal government has added $10 trillion to its burden since then.
The problem now is that the Fed has run out of bonbons. It has few rates to cut. And cutting them doesn't do much good anyway. As the Fed might say, we may already be beyond Peak Debt.
There's a limit to how much people can borrow. As interest rates rise, even the federal government runs into trouble.
It can control the amount of fake money it puts out. Or it can control the quality (price) of it. It can't control both.
And when investors see it favoring quantity over quality, they get nervous. The price of money drops. The prices for goods and services go up.
Interest rates rise in anticipation of higher inflation. This deepens the stock sell-off and intensifies the economic slump. Then, with no more rates to cut, the Fed looks back at Mistake 3 wistfully.
What can it do?
It has to commit Mistake 4. Rarely seen in civilized economies, Mistake 4 stirs dull roots like warm spring rain...
...and excites strains of catastrophe now lying dormant in the laboratories of Hell.