The More ZIRP Distorts, the Greater the Disaster
In early January 2011, the ISM announced its non-factory index, which covers approximately 90% of the economy, had increased in December 2010 to a high not seen since May 2006. The implication for that comparison was that the recovery was firmly entrenched and the high times of an economic boom had finally and belatedly returned. This was smack in the middle of QE 2.0, an asset price fiesta of enthusiasm for the miracle of "liquidity". Confirming that fantasy, also in early January 2011, Federal Reserve Vice Chairman Janet Yellen crowed about the undoubtedly successful monetary engineering. Most famously (infamously) she proclaimed that the Fed's actions of the day would end up creating 3 million jobs by 2012.
She was a little short in her projections, nearly as much as enthusiasm for the recovery was premature. The cheer of the December 2010 ISM was torpedoed only a few months later when Q1 GDP came in far weaker than expected (weakness is never expected in this recovery), and then completely sunk that July, when the Bureau of Economic Analysis re-estimated Q1 2011 GDP as amounting to zero growth. It is proof, rather unambiguous proof at that, the Federal Reserve's models continue to struggle with reality - to put it kindly. After all, every single pronouncement of that period (just like any other pronouncement of any other period) is based on quantitative simulations of economic parameters and inputs.
Beyond the empirical economic reality, Ms. Yellen also forecast that day her expectations, again based on mathematical simulations, that by mid-2012 the Fed would begin a process of balance sheet normalization. If the Federal Reserve System unwound or rolled off about $80 billion in assets per quarter, by 2017 the system would be normalized and the whole episode would be relegated to study of historians. Much like her economic pronouncements this one proved equally troubling, particularly as we now approach that mid-2012 expectation. Does anyone actually believe the Fed will be initiating exit policies next month?
We already know, via the FOMC, that expectations for the Zero Interest Rate Policy (ZIRP) have been extended into 2014. Assuming that simulation actually proves correct (and it will likely undershoot again since we have already heard noise about 2015 and may still be under the thumb of ZIRP by the time 2017 rolls around) it will have meant almost six full years of zero bound monetary stimulation. This is striking not only because these same Fed models predicted an insignificant chance of the Fed funds rate actually achieving zero for any length of time as late as 2008, but it was also at one time not long ago a publicly avowed monetary position that monetary policy must consist of only temporary measures to help clear perceived imbalances. Temporary measures were stated as the only way to be consistent with a market-based economy (what can we then infer of more-than-temporary measures?). It was widely believed that anything outside of that temporary range, whatever might constitute temporary, would introduce permanent perversions to both financial intermediation and the real economy.
There has to be a growing realization outside of the bowels of authority-making that ZIRP and monetary stimulus is a trap that has no exit, at least not one contained within conventional thinking. Once the zero bound is reached and even breached, there is no recovery without paying the piper for printing and monetizing. As we embark on another springtime filled with economic uncertainty (that same ISM non-factory index fell "unexpectedly" yesterday to a level not at all consistent with robust growth), right on course for the pattern established in both 2010 and 2011, the inevitable calls for more monetary stimulus grow once again. At what point does someone finally say "enough"?
Given the dramatic shift taking place in Europe, this is a question that deserves an immediate response. Austerity is comatose, with its coffin now being fitted out. In its place are renewed calls, indeed political movements, for "growth", a dastardly euphemism for central bank-directed inflation. Apparently central banks have not been active enough (why is it always that these programs, both fiscal and monetary, are never big enough at the outset?).
Monetary distortions, as it turns out, seem to be proportional to the scale of the emergency that drives their implementation. Part of that is naturally due to expediency; if a situation is dire, meaning imbalances are already large for whatever reason, clearing that imbalance likely means a contra-distortion of proportionate size and measure. That is certainly the basis for constructing "stimulative" policies, both fiscal and monetary, something that appears to be wholly logical and sensible.
But that is a problem considering that there is little effort to isolating the source of the imbalance in the first place. In the case of 2008, it seems rather obvious to most impartial observers that the imbalances present then were actually due to previous episodes of monetary distortion, especially asset prices (from real estate on down). The enlarged financial economy ceased to function because it could no longer sustain that pricing regime without persistent and exponentially continuous monetary distortion in pricing. The very nature of asset bubbles is that they need a steadily growing/compounding supply of new money, something operationally and logistically impossible, meaning asset bubbles have a definite upper bound or expiration. Once the bubble collapses, all that is left is imbalance and a desperate need to clear it. So we end up in an infinite loop of circular logic: imbalance causes the need for monetary distortion, which creates imbalance, causing the need for monetary distortion, etc. I think that accurately describes the 2007-2012 period.
If the logical basis for monetary thinking is to create contra-distortions to counterbalance existing imbalances, it stands to reason to at least try to make sure planned and intended distortions are actually contrary to pre-existing condition.
The first version of QE is a perfect example. Purportedly the banking system was suffering from a widespread dispersal of "toxic" assets. So much so that the interbank wholesale money markets and the shadow banking system that depends on it essentially froze. As much as that might be descriptive in a general or generic sense, it was really about the mechanism by which continued monetary distortion was transmitted throughout the system.
It is well known now that AAA-rated mortgage bonds served as the collateral grease to the interbank reserve wheel. The process of imparting monetary stimulation, interest rate targeting by the Federal Reserve, flowed directly through the wholesale money market, both Fed funds and eurodollars. As much as the Fed intervened in the early part of the last decade, it did so distorting the balance of money flowing into the banking system. Depository institutions had little place in a system of interest rate targeting. Marginally, the system was intentionally left to investment banks and shadow bank entities, the very creations and creatures of wholesale money. As long as the Fed kept the interest rate low, meeting any and all demand for "reserves" at low target rates, the shadow system outgrew any previous proportion - the definition of distortion. The longer rates were artificially imposed, the more that disruption grew.
By 2007, it became worrisome that the collateral upon which so much of this wholesale money transmission was based may have a taint of "toxicity", or at least it was not worth its AAA-rating, the system itself engaged in a contra-distortion of financial economy deflation (not real economy deflation). The true interbank currency, "quality" financial collateral, withdrew to such short supply against continuously high demand that it resembled a second derivative bank run and deflation - deflation being a currency disease first and foremost. The contra-distortion the Fed put in place to counter this natural contra-distortion simply cancelled each other out. In other words, monetary policy in late 2008 and 2009 did not clear the previous imbalance, rather it was designed to maintain it .
Indeed, the system itself simply reconstituted under the cover of QE. The mortgage collateral was drained onto the balance sheet of the Federal Reserve (from the US and Europe), only to be replaced by sovereign bonds. Sovereign bonds were the "logical" alternative to mortgage bonds - low risk-weighted securities that were afforded a regulatory seal of approval, as well as high acceptance within the interbank markets. The financial economy, if this process had been successful, would have been able to maintain its previous size distortion, and it was believed that this successful intervention would have restored the real economy enough to alleviate the leftover price imbalance. Outside of some losses and a minimal amount of failures, the system that emerged from this would have largely looked the same. The only change was the specific class of preferred interbank collateral.
The problem at this stage was that sovereign bonds were subject to the same monetary imbalances that had plagued mortgage bonds, but had yet to undergo the same pricing contra-disruption that mortgage bonds had. The sovereign market was still operating as it had in the bubble period despite the fact that fundamentals and true risk were beginning to return to that market. If central banks had allowed the mortgage bond contra-distortion to run its course naturally, the banking system would never have been able to support the artificial prices of the sovereign markets.
So the intertwined nature of the sovereign needs of governments with monetary distortions continued long past where it otherwise would have collapsed (and should have collapsed, before the imbalance grows so big it becomes less and less solvable without drastic coincident economic and financial damage). The ability of sovereigns to borrow far beyond anything reasonably resembling sustainable, especially in the European periphery, was a fact of monetary distortion enabled under the previous monetary regime. That central bank policies enacted after the crisis seem to foster a return to the previous unstable system is not a coincidence. The symbiosis of the banking system with government bonds as collateral means the two are directly related to each other. It is no longer possible to sort one from the other, to fix one without damaging the other, just as it became impossible to separate the banking system from real estate prices.
If sovereign governments drastically reduce their fiscal deficits, reducing the amount of debt they need to finance, they simultaneously reduce the availability of collateral for their own national banks. We have seen examples of Italian banks issuing their own debt, taking it to the Italian government for a guarantee so that the ECB will accept that debt as proper collateral in the LTRO's. The converse to that relationship is also true. If banks reduce their lending capacity, they will no longer support government borrowing, and they both collapse. This is not the kind of financial economy that exists in the modeled assumptions of monetary policymakers - it is a massive distortion in the basic functioning of finance, especially in how it relates to the real economy.
In the US, the banking system has regenerated into a derivative-addicted system that bypasses the real economy altogether. When not buying US government debt to immediately flip back to the Federal Reserve, the largest banks have gotten bigger on an appetite of interest rate swaps (which also require periodic collateral postings). Distorted by the near-certainty that ZIRP is semi-permanent, especially as the Fed and its various members continue to telegraph that fact, banks continue to use interest rate swaps as "no-risk" carry trades. Why wouldn't a bank pay a floating rate to receive fixed in this environment where they are all but assured to continue to win the rate game. In fact, the more trillions in new derivatives they take on, the more it guarantees that the Fed will not be able to raise rates at all. If rates did rise, the crowded trade of these swaps would sink these banks, meaning another round of financial economy deflation as collateral becomes in short supply once again. This is not the kind of financial economy that exists in the modeled assumptions of monetary policymakers - it is a massive distortion in the basic functioning of finance.
Governments themselves continue to issue new debt at lower and lower rates, meaning that if rates eventually rose interest costs would be disastrous.
The more ZIRP distorts the financial economy, the less likely it will ever be removed without disaster. It is a trap simply because the distortions it seeks to create actually counteract the natural distortions we need to take place. Because central banks are actually trying to maintain the status quo of bank and finance enlargement, these distortions in bank-related activity continue to confound the real economy. Why would a US bank engage in lending in the real economy, which entails actual risk, when it can simply collect the fixed side of a swap from some party that actually believes rates will be able to rise someday before 2017? The swap actually offers a reasonable return given the leverage involved, something a 4% mortgage cannot do under ZIRP. This is not the kind of financial economy that exists in the modeled assumptions of monetary policymakers - it is a massive distortion in the basic functioning of finance.
The monetary trap is sprung by Ms. Yellen's continuously askew predictions. Since monetary models are creatures of their own assumptions (Garbage In Garbage Out), they cannot actually isolate the one, true independent variable driving this continual divergence: central bank policy itself. They presuppose success and discount the possibility of contra-distorting otherwise healthy contra-distortions: they automatically assume that low interest rates, even negative interest rates and inflation expectations, will always create a growing real economy. If monetary policy is always assumed to be effective, in times when it is not or even a drag (commodity price pressures), these models will always call for more, becoming a positive feedback loop of growing distortions because the primary distortions and imbalances are never resolved. The real economy and the financial economy get locked into this disruptive sphere of continual dysfunction and volatility, something economists call uncertainty. Chairman Bernanke refers to it as vague and unspecified headwinds.
However, if they were to accept the premise that the previous imbalance, the actual cause of our current tribulations, was an artifact of previous central bank distortions, then what follows from that is a more natural course of clearing imbalances in prices. The consequences are certainly dire, but there is at least a possibility for real success as the infinite loop of GIGO is broken by common sense. Another presupposition of monetary policy is that deflation is always and everywhere bad. But given that most of the imbalances upon which we suffer are financial in nature, deflationary contra-distortion in the financial economy is not the end of the world - you can ignore the loud protestations to the contrary from those that recklessly engaged in financial distortion in the first place, and are now squarely in the corrective price crosshairs, as fake and purely biased contra-indications. I have said this many times, and I will say it again, deflation was not building in the real economy - there was no shortage of currency. The only currency that was in high demand/short supply was financial economy collateral, a telltale sign of exactly where the primary imbalance was/is located.
The appeal to "growth" policies is doomed right from the start, especially since the US has been engaged in the same type of "growth" policies since late 2008 (to what avail?). The very mechanism by which those growth policies are supposed to be transmitted into the real economy have been so tortured by continuously applied monetary doses, the only possible outcome is confusion for economists. How on earth are the European authorities going to create inflation in the PIIGS economies? Inflation may be showing up in Germany as Target II imbalances grow greater and greater, where it is not welcome by any stretch, but there is no way banks in those nations can be a source of "growth". Those banks are no longer banks in any meaningful sense, they are now just financial warehouses of monetary artifacts.
Monetary policy is really about prices, especially the systemic price of risk or money. All financial problems trace back to the fact that prices were not representative of true values, an imbalance that was embedded by prolonged and outsized monetary intervention. At some point in the past economists knew this would happen. Perhaps the Greenspan-generation of economists and policymakers were only paying lip service to that ideal, maintaining the appearance of tradition (like the pretense of a strong dollar policy) while they busily tore apart that tradition, and with it the conventional, boring banking system. Ironically, what they replaced it with is still subject to that tradition. Unfortunately, current policymakers have yet to realize it.
