By Art Cashin Director of Floor Operations at UBS

November 21 (King World News) - “Great Minds Think Alike - Or - Is The Fed Ineffective – A great discussion has erupted almost as if by spontaneous combustion.  And, it involves some pretty keen minds as did the simultaneous – but separate – development of The Calculus by Isaac Newton and Gottfried Wilhelm Leibniz.  This one concerns the ineffectiveness of monetary policy in snapping the economy back into "normalcy".


For the first great mind, let's cite again Ray Dalio as I did back on November 12th:


The Fed Under Stress – Part II – From Ray Dalio's letter last week (courtesy of another old friend, John Mauldin):


In the old days central banks moved interest rates to run monetary policy. By watching the flows, we could see how lowering interest rates stimulated the economy by 1) reducing debt service burdens which improved cash flows and spending, 2) making it easier to buy items marked on credit because the monthly payments declined, which raised demand (initially for interest rate sensitive items like durable goods and housing) and 3) producing a positive wealth effect because the lower interest rate would raise the present value of most investment assets (and we saw how raising interest rates has had the opposite effect).


All that changed when interest rates hit 0%; "printing money" (QE) replaced interest-rate changes. Because central banks can only buy financial assets, quantitative easing drove up the prices of financial assets and did not have as broad of an effect on the economy. The Fed's ability to stimulate the economy became increasingly reliant on those who experience the increased wealth trickling it down to spending and incomes, which happened in decreasing degrees (for logical reasons, given who owned the assets and their decreasing marginal propensities to consume). ….. the marginal effects of wealth increases on economic activity have been declining significantly. The Fed's dilemma is that its policy is creating a financial market bubble that is large relative to the pickup in the economy that it is producing. If it were targeting asset prices, it would tighten monetary policy to curtail the emerging bubble, whereas if it were targeting economic conditions, it would have a slight easing bias. In other words, 1) the Fed is faced with a difficult choice, and 2) it is losing its effectiveness."


Mr. Dalio goes on to ponder the apparent declining efficacy of Fed policy and what might happen if some exogenous event tipped the economy back into a new recession.


Separately another great mind, Larry Summers (the almost Fed Chair) touched on a nearly identical theme in an IMF speech back on November 8th (unfortunately, I can't find a full transcript of that speech).


Summers maintained that the Great Recession was quite special and damaged the economy far more than most estimates.  Due to that, he suggests that the nominal or natural level of interest rates is actually below zero.  Thus, the economy has not responded to Fed stimulus because the Fed has only moved rates to zero, which is still higher than the “natural” level.  Here's a bit of Summers on that topic as reported by Danny Vinik in Business Insider:


Imagine a situation where natural and equilibrium interest rates have fallen significantly below zero," Summers said. "Then conventional macroeconomic thinking leaves us in a very serious problem because we all seem to agree that whereas you can keep the federal funds rate at a low level forever, it's much harder to do extraordinary measures beyond that forever, but the underlying problem may be there forever.


The use of the word “forever” is intriguing and not particularly optimistic.  That downbeat mood recurs in the speech (again from Business Insider):


I think that [what the] world has underinternalized," he said, "is that it is not over until it is over, and that is surely not right now and cannot be judged relative to the extent of financial panic, and that we may well need in the years ahead to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activities, holding our economies back below their potential.


So both Summers and Dalio feel that with the best of intentions and even some innovative thinking, the Fed is reduced to pushing on a string. 

We think the debate about a negative effective rate has only just begun.  Stay tuned.”

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