A host of indicators point to the deteriorating US economic outlook, not to mention the first quarter preliminary GDP figures that were widely outpaced by the comparable Euro Area growth measures. Although lauded as beckoning higher interest rates, the impact from the surging US dollar has dramatically reversed the factors that had previously been responsible for growth. The persistent deflationary forces in import prices coupled with slack in exports are just one obvious indication adding to the mounting evidence of an impending recession. Prices have not collapsed at such a pace for such a period of time without historically ending in that very scenario. Add to woes the veritable breakdown in US consumer spending growth and suddenly the Federal Reserve is not faced with the tough task of adjusting monetary policy higher, but instead must focus on continued accommodation to quell a deeper, darker recessionary concern.
Lower for Longer
Although looked upon as a fringe, conspiracy theorist conception, the notion of the Federal Reserve dropping interest rates further or re-engaging in quantitative easing is not necessarily such an unequivocally irrational idea. Not to mention, the Gordian knot that has been tied by the balance sheet expansion cannot await an Alexander the Great-like figure to come and cut the balance sheet in two. For those unfamiliar with the tale, it beckons the conception of out-of-the-box thinking, in this case lateral thinking instead of conventional logic and wisdom applied to a problem. If anything, the idea of raising interest rates in a period of minimal growth and weak inflation has the ability to exacerbate the true problems holding the economy hostage. It must bear reminding that monetary policy does not operate in a vacuum, case in point being Europe.
Economists might choose to cite the pickup in Euro Area growth as just a transient factor in the latest reading, thereby confirming the wisdom of the temporary gains achievable through zero and negative interest rate policies. These gains touted by the European Central Bank as averting a deflationary disaster come at a time when the data is largely in direct confirmation of prevailing policies. However, as demonstrated by the tightening occurring across the Atlantic, once the impetus for the economic improvement is ended without a clear direction for fiscal policy, the limits of monetary policy are clearly visible. The lack of fiscal policy is evident on both continents as governments choose to focus on cutting budgets and engaging in austerity at the expense of using near-record low borrowing rates to finance fiscal stimulus.
Return to Easing Around the Corner
Doomier and gloomier analysts have pointed to this very fact as underlining the hypothesis that the US Federal Reserve will be forced to invariably resume quantitative easing in order to keep the economy competitive relative to other global peers presently engaging in unconventional monetary policies. Although the US intended to remain largely on the sidelines of the global currency war, it may be sucked back in as a factor of deteriorating fundamentals. However, easing has proven it comes at a substantial cost because of its deleterious impact on investment. Practically speaking, the best example of how unconventional monetary policies enable risky investing behaviors is the US tight-oil industry. In general, shale-oil projects are costly to develop and have inordinate breakeven prices due to the technology involved in releasing the hydrocarbons. Nevertheless, when money was cheap to borrow, it led to the financing of many projects that would otherwise prove economically unviable.
This revelation has two major implications. The first is that quantitative easing from a standpoint of currency devaluation is an effective policy tool especially in an environment of robust global trade. Its shortcomings in a downturn are also clear as well as considering the strong evidence of rampant investment misallocation. Luckily, contrary to the worst case scenario, broad debasement of the monetary base undertaken most recently by Central Banks of developed markets have not been shown to stoke hyper-inflationary tendencies despite the massive printing binge. However, much to the detriment of struggling economies, this form of stimulus is temporary and exhibits diminishing marginal returns with every dollar spent buying less economic momentum.
Raising to Lower
The Fed is facing a serious setback, caught between the proverbial two stools of credibility and prudence. Credibility insists that the Federal Reserve follow up on its promise to raise interest rates this year after signaling a shift in policy. Prudence suggests that the Central Bank insist on stronger fiscal measures from the government (unlikely considering the deadlock in Washington) while staying dovish on policy. If a US recession hits, the most likely course for policy is a situation in which the Federal Reserve raises rates a nominal amount, say 5 basis points, only to cut rates and announce the resumption of easing in the subsequent meeting. Regardless of the outcome, the data does not lie, US economic expansion is faltering and the probability of turning negative rises with each passing day.