Don't Be Fooled: The Fed's Exit Won't Be Easy

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The celebration of the second quarter growth "rebound" to 4 percent will be short lived as Thursday's brisk stock market sell-off has already signaled. The headline number's strength exaggerates the growth pace. It would be dangerous if it speeds up Fed tightening as Philadelphia Fed President Charles Plosser appears to have suggested it should by dissenting from the July 30th FOMC statement's call for a continued "considerable period" of accommodation.

Growth Remains Weak

How robust is US growth? First, its best to average two choppy quarters especially when the first quarter was said to have been depressed - now to a minus 2.1 percent pace - by special factors like weather. The average growth rate of the first half of 2014 was 0.95 percent, quite a lot weaker than the 3 percent pace expected early in the year by the Fed and most analysts and is actually pretty close to stall speed.

Inventory changes, changes in the stock of unsold goods, exaggerated the volatility of first half growth numbers, accounting for nearly half (1.7 percentage points) of the second quarter growth "rebound." Final sales, the best measure of demand growth, rose at a modest 2.3 percent pace after having fallen at a 1 percent pace during the first quarter. Those figures put the average pace of US demand growth during the first half of 2014 at 0.65 percent. We need four times that pace to sustain a recovery, especially when the Fed is tapering and talking about raising interest rates next year - as if to declare its confidence in the as yet nonexistent, sustainable recovery.

Despite the temporary distraction of misleading headline growth numbers, the biggest question facing investors, producers, and households in today's low volatility, yet largely trendless, global economy is this: Will we witness the bursting of the "mother-of-all-bubbles" that creates global economic chaos as the Bank for International Settlements (BIS) suggests in its June Annual Report? Or, alternatively, will the current Yellen Federal Reserve path of holding the federal funds rate at zero for a "considerable period" after the asset purchase program ends enable the Fed to successfully exit its extraordinarily easy money policy?

Bubbles Are Dangerous

It is important to approach this question with humility. At the very least, deciding between the stances of Yellen and the BIS on correct policy now, almost 6 years after the Lehman bubble, requires understanding what happens in markets when a bubble bursts.

The main result of a bursting financial bubble and attendant falling prices of financial assets is a surge in the demand for cash/liquidity among households, producers, and financial institutions, many of which are experiencing runs on their deposits. Cash means unconditional liquidity which is quite scarce at all times but virtually unobtainable after a bubble has burst. In monetarist terms, where the growth of money plus the growth of velocity equals the growth of nominal GDP, velocity collapses as less liquid assets are dumped to raise cash. The result is the equivalent of a collapse in the money supply just as the money supply itself is being cut by a surge in disintermediation as depositors flee banks.

Therefore, a bursting bubble, and the ensuing collapse of liquidity, creates an unstable, self-reinforcing downward spiral in asset prices and economic activity. Absent aggressive money printing by the central bank, financial panic ensues. The US faced financial panic after the September 2008 collapse of Lehman Brothers. The Fed responded by printing money and by March 2009, financial markets began a strong recovery. The real economy would not have achieved sustained growth absent large doses of fiscal and monetary stimulus.

Now, 6 years later, the fiscal stimulus has been over for nearly 2 years and monetary stimulus is being reduced by way of a "tapering" of Fed asset purchases and the Fed signaling that the federal funds rate will start to rise in a year or so.

No Easy Exit

Yellen is betting that growth will rebound before a rise in inflation forces a Fed tightening to cut the inflationary excess supply of cash. Lacking evidence of inflation, the BIS view is that too much cash has already boosted prices of risky assets too high so that when/if fighting inflation forces the Fed to tighten, asset markets will collapse as the demand for cash resurges. The Fed, under this scenario, will be seen to have created a bubble that bursts once a predictable rise in inflation forces it to tighten.

Alternatively, the Fed, facing a collapse of asset prices, may delay tightening even in the face of rising inflation. The result would be a rise in inflation expectations, accompanied by a further surge in the demand for risky assets and for goods and services. The economy would boom for a time, but the bubble would grow even larger, only to create even more chaos once the Fed is forced to tighten to avoid a potential inflation spiral.

Humility and Caution

First we need to admit that we still don't know how to exit the extreme monetary accommodation required to avoid a financial and economic collapse after a crisis like that which hit the US financial market in September 2008.

Secondly, the most formidable exit problem lies with timing and pace. Yellen critics say that the time to have begun exiting has already passed, but persistent sub-trend growth and sub-target inflation raises serious questions.

Thirdly, the Yellen approach obeys a basic rule of policy. When you don't know what will follow from an attempt to employ monetary policy to deflate a bubble, proceed with extreme caution unless/until rising inflation forces your hand. BIS's suggestion that asset prices are too high and thereby suggesting an even larger future bubble is not without merit, but an abrupt Fed move toward more tightening risks a sharp drop in asset prices, creating even more instability than that felt during the May 2013 "taper tantrum."

Going forward, humility and caution are crucial. A Schumpeterian "cold shower" market-cleansing could just be too risky, especially given that US demand (final sales) growth averaged a very weak 0.65 percent during the first half of 2014. Based on what we know about cold showers during the Great Depression, the pain for a weak economy from an abrupt cold shower could exceed that from an overextended warm bath of monetary accommodation.


American Enterprise Institute resident scholar John Makin writes AEI's monthly Economic Outlook.

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