The Fed Is Raising the Price Of a Free Lunch
Fed policy has fostered the delusion that cheap money is a free lunch. Such thinking results from years of interventionist monetary policy during which time the financial cost of credit has become conflated with the economic cost of real capital resources. After six years, quantitative easing and zero rate policies have impaired the recovery and exacerbated wealth disparities.
Central banks conjure money into existence to adjust the price and availability of credit in order to manufacture demand and raise asset prices, producing a "wealth effect." But there are no short cuts to true wealth. Wealth and incomes grow when labor and capital are adapted into competent combinations. Improvements are a result of households and businesses bettering their prospects by working, saving, and risk-taking. For this to work, proper incentives must exist within the context of good price signals. Greece isn't going to become prosperous through helicopter drops of money.
QE programs expand the supply of loanable funds, but do nothing to increase the availability of capital resources like steel, energy, brains or patents. Worse, QE and zero rate policies mask price signals that would otherwise inform investors and borrowers how to deploy their resources.
Monetary policy has its uses, primarily as a crisis management tool. When financial markets self-immolated in 2008, the intervention of a lender of last resort was wise and essential. But the expertise to put down a house fire isn't the same as that used to build a construction business.
A wealth effect has a disparate impact on households and businesses depending upon whether they belong to the wealth economy or the income economy. Households in "super zips" have seen property values soar while many middle income neighborhoods have languished. Stock- and bondholders have prospered while bank deposit rates have been nullified. Consequently, the creditworthiness of the wealth economy has become more attractive to lenders while the creditworthiness of the income economy has been held in check. The result? A self-reinforcing misallocation of capital that has impaired growth.
Say a borrower from a super-zip wants to improve his home by adding a swimming pool. While it may enhance his property value, a pool is not a unit of productive capital. Plus, its upkeep makes it a financial liability on the homeowner's balance sheet. Regardless, bankers today would happily supply low-cost financing to enable the consumption of the new pool.
Meanwhile, Main Street businesses populating the income economy live in a world of sluggish wage and income growth. When these businesses seek to borrow, they encounter loan terms with onerous covenants rendering expansion untenable. It is easy to miss the connection between excesses of "swimming pool" credit formation on the one hand, and a dearth of income generating loan origination on the other. Capital resources are scarce and an expanded supply of loanable funds doesn't mean that everyone gets expanded access to them.
The Fed has essentially disabled the price mechanism for allocating a scarce resource. So instead of borrowers bidding for capital, credit allocation becomes predicated on terms and conditions. Capital is preferentially those with allocated to those with artificially inflated balance sheets rather than those who can most productively employ it. The economic landscape becomes simultaneously less equal and less efficient.
Fed policy is now at a crossroads. Life needs to be improved on Main Street and many voices counsel against raising rates fearing the pain it will cause. The assumption is that artificiality in credit pricing is a "remedy" to the malady of poor wage growth and low labor force participation rates.
Salvation cannot be found by travelling the low road of the credit printing press, but rather along an avenue of capital deepening. More and better capital has traditionally bolstered the competitiveness of businesses while creating new and better paying employment. Those who have a proper grasp of our monetary system's strengths and weaknesses recognize that even as the benefits of zero rates have petered out, ill effects in the form of mal-investments and poor credit choices grow by the day.
Rates have to normalize to rebalance the underlying economic costs of capital with financial market pricing. If the Fed carries through on its intention to raise rates, it will begin a process of crowding out marginal lending and initiate a long delayed clean-up of capital misallocations. Such a process is painful, so the incentives to defer normalization have been powerful. However, a decision to delay a rate rise simply means the can is being kicked down the road.
Unfortunately, no one can say how far the can might be kicked before it goes over a cliff. In that event, the reality of a world of scarce capital will collide with the fantasy of the monetary free lunch. Either way, the price of our "free lunch" is going up and whether that news is delivered by the Fed or by a market de-leveraging event will matter little to the investor caught short-changed at the lunch counter.
