By Thorsten Polleit *
Speaking at the Jackson Hole meeting on August 27, 2021, Federal Reserve Chairman Jerome J. hastened to add that interest rate hikes are still a long way off. The term “tapering” means that the central bank reduces its monthly purchases of bonds and slows down the monthly increase in the quantity of money accordingly. In other words, even with tapering, the Fed will still produce newly printed US dollar balances, but to a lesser extent than before; that is, it will still cause monetary inflation, but less than before.
Financial markets were not alarmed by the Fed’s announcement that it may take its foot off the gas pedal a bit: 10-year US Treasury yields are still trading at a relatively low level of 1 , 3%, the S&P 500 stock market index is hovering around records. Could it be that investors don’t believe the Fed’s suggestion that tapering will begin soon? Or is tapering much less important than we think for financial market asset prices and economic activity? Well, I think the second question nails it. To understand this, it should be noted that the Fed has put a “safety net” under the financial markets.
Following the politically dictated foreclosure crisis in early 2020, investors feared a collapse of the economic and financial system. Credit markets, in particular, have been unleashed. Borrowing costs have skyrocketed as risk premiums have increased dramatically. Market liquidity has dried up, putting great pressure on borrowers in need of financing. The Fed was quick to declare that it would guarantee the credit market, turn on the monetary taps, and issue all the money needed to fund government agencies, banks, hedge funds and businesses. The Fed’s announcement did what it was supposed to do: credit markets calmed down. Credit has started to flow again; system failure was avoided.
In fact, the Fed’s creation of a safety net is nothing new. It is perhaps better known as the “Greenspan Put”. During the 1987 stock market crash, then Fed Chairman Alan Greenspan cut interest rates significantly to help stock prices recover, setting a precedent for the Fed to come to the rescue by financial crisis. (The term “put” describes an option that gives its holder the right, but not the obligation, to sell the underlying asset at a predetermined price within a specified time. However, the term “safety net” could be more appropriate than “put” in this context, as investors don’t have to pay Fed support and fear an expiration date.)
The truth is that the US dollar fiat currency system is now more dependent than ever on the Fed to provide commercial banks with sufficient base currency. Given the system’s excessively high level of debt, the Fed must also do its best to keep market interest rates artificially low. To achieve this, the Fed can lower its short-term funding rate, which determines the costs of financing banks and therefore the interest rates on bank loans (although the latter link may be loose). Or it can buy bonds: By influencing bond prices, the central bank influences bond yields, and given its monopoly status, the Fed can print the dollars it needs at any time.
Or the Fed can make it clear to investors that it is ready to fight any kind of crisis, that it will bail out the system “no matter the price”, so to speak. Suppose such a promise is considered credible from the point of view of the financial market community. In this case, interest rates and risk premiums will remain miraculously low without any bond purchases by the Fed. And it is by no means an exaggeration to say that putting in place a safety net under the system has perhaps become the most powerful policy tool in the Fed’s bag of tricks. Largely hidden from the public eye, it allows the Fed to keep the fiat money system afloat.
The critical factor in all of this is the interest rate. As the Austrian money business cycle theory explains, an artificial fall in the interest rate triggers a boom, which turns into bankruptcy if the interest rate rises. And the more the central bank succeeds in lowering the interest rate, the more it can support the boom. This explains why the Fed is so eager to dispel the idea of an interest rate hike anytime soon. Tapering would not necessarily lead to immediate upward pressure on interest rates, if investors voluntarily buy bonds that the Fed is no longer willing to buy and / or if the supply of bonds declines.
But is it likely that investors will stay on the buying side? On the one hand, they have a good reason for continuing to buy bonds: they can be sure that in times of crisis, they will be able to sell them to the Fed at an attractive price; and that any decline in bond prices will be short-lived because the Fed will correct it quickly. On the other hand, however, investors demand a positive real interest rate on their investment. Smart money will rush out if nominal interest rates are consistently too low and expected inflation too high. The ensuing liquidation in the bond market would force the Fed to intervene to prevent rising interest rates.
Otherwise, as stated earlier, rising interest rates would collapse the debt pyramid and lead to a collapse in output and employment. It is therefore not surprising that the Fed is doing everything in its power to hide from the public the inflationary consequences of its policy: the sharp rise in inflation in the prices of consumer goods is considered to be only ” temporary ” ; asset price inflation would be outside the policy mandate, and the impression is given that increases in equity, house and real estate prices will not not represent inflation. Meanwhile, the increase in the money supply, which is the source of inflation in the prices of goods, is hardly mentioned.
However, once people start to lose faith in the Fed’s willingness and ability to keep commodity price inflation low, the “safety net trickery” hits a crossroads. If the Fed then decides to keep interest rates artificially low, it will have to monetize increasing amounts of debt and issue ever larger amounts, which in turn will drive up commodity price inflation and intensify the liquidation of bonds: a downward spiral begins, leading to a possible severe devaluation of the currency. If the Fed prioritizes lowering inflation, it must raise interest rates and control money supply growth. This will most likely trigger a rather painful recession-depression, potentially the largest of its kind in history.
In this context, it is difficult to see how to escape the depreciation of the US dollar and the recession. It is likely that high, perhaps very high, inflation will come first, followed by a deep collapse. For inflation is generally regarded as the lesser of two evils: the rulers and the ruled would prefer new money to be issued to prevent a crisis from letting businesses fail and unemployment to rise dramatically, at least in a short time. an environment where people still view inflation as relatively mooing. There is, however, a limit to the machinations of the central bank. It is achieved when people start to distrust central bank money and throw it away because they expect commodity price inflation to get out of hand.
But until this limit is reached, the central bank still has some leeway to pursue its inflationary policy and increase the damage: debase the purchasing power of money, increase overconsumption and bad investment, and make the big government even bigger, effectively creating a socialist tyranny if not stopped at some point. So, better stop. If we want to do this, Ludwig von Mises (1881-1973) tells us how: “To believe that a healthy monetary system can again be achieved without making substantial changes in economic policy is a serious mistake. What is needed above all is to give up all the inflationary fallacies. This renunciation cannot last, however, if it is not firmly based on a full and complete divorce of the ideology from all imperialist, militarist, protectionist, state and socialist ideas. “1
*About the Author: Dr Thorsten Polleit is Chief Economist of Degussa and Honorary Professor at the University of Bayreuth. He also acts as an investment advisor.
Source: This article was published by the MISES Institute
- 1. Ludwig von Mises, “Stabilization of the monetary unit – from the point of view of the theory (1923)”, in The cause of the economic crisis. And other tests before and after the Great Depression, edited by Percy L. Greaves Jr. (Auburn, AL: Ludwig von Mises Institute, 2006), p. 44, annex.