MacroView: Is The Fed Walking Into A Trap?

Currently, the Fed is injecting liquidity into the markets and economy at a record pace. While liquidity does have positive short-term benefits, is the Fed walking into a trap?

The Unseen

Over the last decade, the Federal Reserve, and Central Banks globally, have engaged in never-ending “emergency measures” to support asset markets. While the stated goal was that such actions were to foster full employment and price stability, there has been little evidence of success.

The chart below shows the expansion of the Fed’s balance sheet and its effective “return on investment” on various aspects of the economy. No matter how you analyze it, the “effective ROI” has been lousy.

(Click on image to enlarge)

Fed Trap, #MacroView: Is The Fed Walking Into A Trap?

Fed Trap, #MacroView: Is The Fed Walking Into A Trap?

These are the unseen consequences of the Fed’s monetary policies.

The Seen

The only reason Central Bank liquidity “seems” to be a success is when viewed through the lens of the stock market. Through the end of the Q1-2020, using quarterly data, the stock market has returned almost 127.79% from the 2007 peak. Such is more than 3x the growth in GDP and 6.5x the increase in corporate revenue. (I have used SALES growth in the chart below as it is what happens at the top line of income statements and is not AS subject to manipulation.)

(Click on image to enlarge)

Fed Trap, #MacroView: Is The Fed Walking Into A Trap?

Unfortunately, the “wealth effect” impact has only benefited a relatively small percentage of the overall economy.

While in the short-term ongoing monetary interventions may appear to be “risk-free,” in the longer-term, the Fed may be getting trapped.

The Fed Liquidity Trap

One of those traps is a “liquidity trap,” which we have discussed previously. Here is the definition:

“When injections of cash into the private banking system by a central bank fail to lower interest rates and fail to stimulate economic growth. A liquidity trap occurs when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war.

Signature characteristics of a liquidity trap are short-term interest rates remain near zero. Furthermore, fluctuations in the monetary base fail to translate into fluctuations in general price levels.”

Pay particular attention to the last sentence.

Even though the Fed tried to increase rates in 2017-2018, the tightening of monetary policy led to negative economic consequences. In response, the Fed lowered rates back to the zero bound. (Recently, Fed Fund futures have been teasing “negative” rates.)

(Click on image to enlarge)

Fed Trap, #MacroView: Is The Fed Walking Into A Trap?

Inflation Conundrum

What monetary policy did not do was lead to “general fluctuations in price levels.” Despite the annual call by the Fed of higher rates of inflation and economic growth, the realization of those goals remains elusive.

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Disclaimer: Real Investment Advice is powered by RIA Advisors, an investment advisory firm located in Houston, Texas with more than $800 million under management. As a team of certified and ...

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