Written by Jim Rickards
The Federal Reserve, the central bank of the U.S., is nearing the end of its ability to manipulate the U.S. economy without producing consequences worse that those it set out to avoid in 2008. The Fed has no good exits from seven years of market manipulation. If it continues its current policy of reducing purchases of assets, the so-called “tapering,” it risks throwing the U.S. into a recession. If it reverses course and pauses the taper and later increases asset purchases, it risks destroying confidence in the dollar among foreign creditors of the U.S. Both outcomes are potentially disastrous, but there are no good outcomes on the horizon. This is the result of manipulating markets to the point where they no longer function as markets providing useful price signals and guiding the efficient allocation of capital. Today markets are a mirage, created by the Federal Reserve, which is caught in a prison of its own device.
Fed Is Wrong about Recovery
Since 2007, the Fed has tried to revive the U.S. economy through monetary ease. It began with a series of interest rates cuts, but by late 2008 interest rates had effectively reached zero and the Fed resorted to money printing, called quantitative easing or “QE” as a way to continue to stimulate nominal growth and aggregate demand. The money printing is done by purchasing bonds from banks and paying for the purchases with money that comes from thin air. This money printing has continued in three programs over six years called QE1, QE2 and QE3. The most recent program, QE3, began in September 2012 and was open-ended as to duration and the amount of bonds being purchased.
By late 2013, the Fed’s balance sheet has swollen to over $4 trillion due to the money printing. Because U.S. growth appeared to be stronger in late 2013 and the unemployment rate had fallen sharply, the Fed began to reduce the rate at which it printed money. This was the “taper” of asset purchases. However, the data on which the Fed relied was highly misleading. U.S. growth had been propped up by inventory accumulation. The declining unemployment rate had been caused not by job creation but by people dropping out of the labor force.
In fact, the Fed had not tapered into economic strength, it had tapered into weakness. This quickly became apparent when U.S. growth in the first quarter of 2014 showed a decline and as the U.S. labor force continued to shrink. Many other negative signs appeared including weak retail sales, declining real wages, lackluster consumer confidence, and a cooling-off in the housing market. In short, the U.S. economy was showing signs of sharply declining growth if not outright recession.
Why Tapering Is Nothing New & Why the Fed Needs To ‘Untaper’
This should not have come as a surprise. Those who focused on the tapering in December 2013 did not recognize that the Fed had tapered twice before. The end of QE1 in June 2010 was, in effect, a 100% taper. The end of QE2 in June 2011 was also a 100% taper. So, the famous taper of December 2013 was actually the third time the Fed had tried to withdraw from money printing. The first two times were failures as evidenced by the fact that the Fed had to launch new money printing programs after each withdrawal. By early 2014, it appeared that the taper of QE3 would also be a failure.
Depending on economic data in coming months, the Fed may have to pause the taper before it is completed late in 2014. Even if the Fed does not pause the taper but completes the process of reducing new asset purchases to zero, it appears likely that the Fed will have to increase money printing in 2015 in what will no doubt be called QE4. The U.S. economy has not shown an ability to achieve self-sustaining growth, so continued Fed money printing is needed to keep the economy growing at all.
Monetary Expansion Comes at a Price
But money printing carries its own risks. Foreign creditors of the U.S. are watching the Fed’s money printing closely and are visibly uncomfortable. Major creditors such as Russia and China are taking steps to insulate themselves from the potential for inflation in the near future if the Fed’s QE money printing programs continue.
Treasury data shows that net foreign purchases of U.S. Treasury debt have dropped sharply over the past year. Russia has been dumping U.S. Treasury debt since late 2013, partly as a result of fear of U.S. economic sanctions and partly out of concern about the fate of the U.S. dollar. Both Russia and China have been buying enormous quantities of gold to hedge against possible U.S. dollar inflation.