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The Truth Arrives: JPM Slams ZIRP - "It Has Been Impeding Rather Than Promoting Economic Recovery"

Earlier today Bill Gross joined the ever louder chorus of voices saying that "unconventional" monetary policy in its current iteration is not working to boost the economy (even if it is quite effective at boosting asset price inflation), however a far more prominent critic of the Fed's status quo emerged last week when JPM's economist David Kelly released a paper titled "Avoiding the Stagnation Equilibrium" in which he flat out rejects the conventional wisdom canon and says that "zero interest rate policy actually reduces demand in the economy, prompting the Federal Reserve to prescribe even further doses of a medicine that, for a long time, has been impeding rather than promoting economic recovery."

Of course, there were no such calls by JPM in 2008 and 2009 when it was QE - a logical continuation of ZIRP whose effects were insufficient to boost asset prices and the stock of JPM - that saved not only his employer but the entire financial industry together with taxpayer-backed loans and guarantees that backstopped the western way of life as we know it.

It is also odd how such calls for a rate hikes emerge only after there has been a 200-some point rally in the S&P500, following a drop resulting precisely due to concerns of a tighter Fed.

We doubt, however, that his recent refutation of all that is Neo-Keynesian will be sufficient to brand him a tin-foil hatter: he merely admits what others such as this website have said all along: the epic build up in debt may have helped holders of assets but has dramatically hurt the overall economy and the middle class.

There is, as usual, a footnote: while traditionally rising rates would be seen as negative for stocks as the swoon that started with the release of the Fed's August minutes showed, and culminated with the ETF flash crash of Monday August 24, Kelly thinks this time rising rates will be accepted by the market as a sign things are improving.

Here, JPM resorts to the traditional formulation: what does the Fed know about the economy (that nobody else supposedly does), if it is willing to get off the emergency lower bound? To wit:

Nothing is more important to the health of a free-enterprise economy than confidence. Confident consumers and businesses, at the margin, spend a little more, hire a little more and invest a little more. If this causes demand to exceed supply in the economy even by a small amount, it helps the economy grow. Because of this, one of the biggest drawbacks of the Fed’s aggressively easy monetary policy in recent years has been its negative impact on sentiment. On each occasion when the Fed announced a new quantitative easing strategy, hesitated to taper bond purchases or postponed a movement from zero interest rates, it undermined confidence. The typical question has been: What bad thing does the Fed know that we don’t? Conversely, when the Fed raises rates from very low levels, it generally acts to boost confidence.

The implication being that a rate hike will imply a "good" thing which only the Fed knows which the rest don't. Like subprime being contained for example.

Whether or not the Fed will listen remains a different question, although judging by the creep higher in December fed fund futures, the probability of a rate hike in just over 1 month is increasingly entertained.

Here, for those interested, are the key points from Kelly's argument:

At their September meeting, the Federal Reserve decided, for the 54th consecutive time, to leave short-term interest rates unchanged at a near-zero level. While only one voting member of the Federal Open Market Committee (FOMC) dissented, the Fed’s action, or rather inaction, was hotly debated.


Those advocating an immediate hike argued that the economy had progressed far beyond the emergency conditions that had led to the imposition of a zero interest rate policy in the first place and that the Fed was already dangerously “behind the curve.” Those lobbying for further delay pointed to a lack of wage inflation and signs of weakness in the global economy.


However, frustratingly, we believe this argument, like all monetary policy debates in recent years, has been waged on a false premise, namely that increasing short-term interest rates, even from these extraordinarily low levels, would hurt aggregate demand. We believe that the opposite is true. The real-world relationship between interest rates and aggregate demand is non-linear and an examination of the transmission mechanisms suggest that the first few rate hikes, far from depressing aggregate demand, would actually boost it.


The true relationship may, in fact, be as portrayed in Exhibit 1. As we outline in the pages that follow, raising short-term interest rates from very low levels could actually increase aggregate demand as positive income, wealth, expectations and confidence effects outweigh relatively innocuous negative price effects and ambiguous exchange rate effects. However, as interest rates increase further, the price effects of rate increases become more damaging while wealth, expectations and confidence effects eventually turn negative, causing rate increases to drag on economic demand. In other words, monetary tightening from super-easy levels can actually accelerate the economy beyond its potential growth rate before slowing it, ideally to a soft landing at a higher level of output and interest rates.


Raising short-term rates from near zero should boost economic demand,
although raising rates from higher levels could reduce it


There is, of course, more to the story. All of these effects have changed over the decades so that this argument might not have been as strong had a zero interest rate policy been employed, say, in the 1960s. In addition, the impact of interest rates on the economy is  asymmetric — a cut in interest rates from a normal level that had been sustained for some time might well boost demand even if an increase to that level didn’t dampen it. Finally, on the supply side, there is likely a significant long-term cost in lost economic efficiency from holding the price of money at an artificially low level. All of these issues are worth further research. However, for the Federal Reserve, the basic point is the most important one. The reason it should have raised rates in September and the reason, failing that, that it should do so in October isn’t that the economy can handle the pain but rather that it could do with the help.

A rate hike, JPM claims, would work favorably through the following 6 mechanisms:

• The income effect: Higher interest rates increase the interest income of savers while increasing the interest expenses of borrowers. In the household sector, in particular, short-term, interest-bearing assets are far larger than variable rate interest-bearing liabilities so that increasing short-term interest rates should boost income and thus aggregate demand.

• The price effect: Higher interest rates make it more rewarding to save and more expensive to borrow. In theory, raising interest rates will encourage households to save rather than consume and cause some businesses to forgo investment projects because they are unlikely to generate the cash flow to justify the higher interest cost. Higher rates could also reduce the number of families that qualify for home mortgages, thus slowing the housing market. All of these effects should reduce demand in the economy.

• The wealth effect: The value of an asset is generally  determined by the discounted value of future cash flows that that asset will produce. Higher interest rates increase the discount rate in these calculations and thus could reduce wealth and thereby consumption through a negative wealth effect.

• The exchange rate effect: Short-term capital flows are important in determining exchange rates. In theory, currency traders like to park their money in currencies with higher overnight interest rates. In this way, higher interest rates could increase the demand for dollars, thereby boosting the exchange rate and, by doing so, suppress exports and slow the economy.

• The expectations effect: When a central bank begins to raise rates and signals an intention to gradually increase them further, households and businesses may try to borrow ahead of further rate hikes, boosting both consumption and investment.

Finally, the conclusion, which warns about all those ZIRPy things we have been cautioning about since 2009. Better late than never:

There are, of course, many other problems with a zero interest rate policy. It may, over time, lead to growth in both debt and asset prices that exacerbate inequality in the short run and can end badly when rates return to more normal levels. More fundamentally, interest rates play a crucial role in the allocation of resources in the economy. Artificially low interest rates lead to credit being assigned inappropriately, whether, for example, through the application of unreasonably tough lending standards on small business loans and or unreasonably easy ones on student loans.


However, the most urgent point is simply that, right now, the economy could do with a little more demand. We believe that the positive impacts of income, wealth, confidence and expectations effects are only slightly offset by negative price effects and thus the first few rate increases would actually boost demand.


It is immensely disheartening that, in 2015, this point is not only not generally accepted but has to be argued on each occasion. Federal Reserve officials ponder the effectiveness of monetary stimulus in helping the economy but never consider that, at near-zero interest rates, the question is not one of degree but rather of direction. Politicians either assail the Fed for too much stimulus or too little, but never contemplate whether the supposed stimulant is actually a sedative. Academic economists largely avoid the messy arithmetic of positives and negatives on this crucial issue in favor of more mathematically challenging inquiries into more obscure topics. Meanwhile, most media coverage, often aimed at the lowest common denominator of financial understanding, feels little compulsion to advance beyond the assumptions of Econ 101.


But the dismal recent history of monetary stimulus demands a more thoughtful analysis. Japan has wallowed for 20 years with zero interest rates without showing the slightest evidence of “stimulated” demand. The mild U.S. recessions of 1991 and 2000 were followed by anemic economic recoveries, even though the Federal Reserve in both cases lowered rather than raised interest rates even as the economy was healing. Perhaps most damning of all has been this miserably slow expansion — the slowest of all the economic recoveries since World War II. While some will argue that this is due to extensive damage to the financial system, it isn’t. American financial institutions have been very well capitalized for years. Rather, America’s recovery may well have been hobbled by repeated bouts of monetary “stimulus” that have starved households of interest income, undermined confidence and undercut any incentive to borrow ahead of higher rates.


We do not propose a complete rejection of traditional economic assumptions. Steadily, if the Federal Reserve raised rates to normal levels and beyond, the effects of rate hikes on wealth, confidence and expectations would turn from tailwinds to headwinds and the price effects of higher rates would become more biting. Beyond a certain level, rising rates would slow demand and the economy could, with some luck, achieve a “growth” equilibrium, where the economy grows at its potential pace, facilitated by a normal level of interest rates.


However, today after almost seven full years of a zero interest rate policy, this seems like wishful thinking. Sadly, it is probably more likely that we get stuck in a “stagnation equilibrium” where a zero interest rate policy actually reduces demand in the economy, prompting the Federal Reserve to prescribe even further doses of a medicine that, for a long time, has been impeding rather than promoting economic recovery.


It is unlikely that policy-makers will recognize this but it still doesn’t mean that the situation is hopeless. In the fall of 2015, while demand is still only growing slowly in the U.S. economy, very low labor force and productivity growth are producing both further labor market tightening and some mild upward pressure on core inflation. If this continues, the Fed may feel an obligation to follow its latest guidance to raise interest rates to slow the economy. We don’t believe this would actually slow the economy, but in order for interest rates to regain their normal role as an efficient allocator of capital and a governor of aggregate demand, interest rates will have to rise through a region where they could actually help the economy grow faster.

Besides, as the economy weathers the impact of slow global growth, a high dollar and an inventory cycle, it will likely grow a little more slowly over the next few quarters anyway.

"If" - and if it doesn't, well the Fed will just do what it always does when it is out of other options, and cut right back to zero (or below) and boost QE.

Full presentation below