Like a puppeteer trying to control his puppet without realizing the strings have been cut, the Federal Reserve has been taking extraordinary measures to affect the economy without understanding its policy levers cannot reach their targets.
That, in essence, is the message of an unusual letter from John Hussman to shareholders — part economic treatise and part cri de coeur, but not the usual discussion of the stock market per se.
The portfolio manager of Hussman Funds, a former academic, went to unusual length — 13 pages — to explain what he suggests is a profound disconnect between Wall Street and Main Street as indicated by several factors.
Among them are the fact that the stock market is at record highs, yet the economy has but modestly improved; or that 40% of Americans say they are “just getting by,” and 60% don’t even have savings sufficient for three months’ expenses despite years of massive Federal Reserve intervention in the economy.
“Something remains terribly wrong, and [Americans] can’t quite put their finger on it,” Hussman writes, and he answers that “much of this perplexity reflects the application of incorrect models of the world.”
Hussman covers a number of links between policy and outcome with a view toward showing that some but not all of these links are supported by the data.
Even a well-founded link — such as that between the monetary base and short-term interest rates — is problematic for Fed policy. That is because the monetary base now stands at 24% of GDP, yet a chart he includes shows that “less than 16% was already enough to ensure zero interest rates.”
That means “the past trillion and a half dollars of QE” merely promoted speculation, and that “the Fed would have to contract its balance sheet by about $1 trillion just to raise Treasury bill yields up to a fraction of one percent.”
A weak relationship that Hussman argues the Fed and many economists rely on is the supposed link between low interest rates and stronger economic activity.
Hussman says that strong economic activity is actually quite compatible with high rates, which can serve to discourage nonproductive investment.
But by keeping rates low in order to stimulate loan demand, the Fed is not only lowering the cost, but also the quality of loans. That, Hussman says, is what triggered the global financial crisis to start with. So Fed policy is punishing savers, increasing interest-rate speculation and encouraging the indebted to take on more debt.
Despite these hazards, Hussman’s charts show there is no clear relationship between low rates and subsequent economic growth.
Yet, paradoxically, higher real rates do generate faster, subsequent economic growth as economic actors choose highly productive investments targeting high expected rates of return.
As he sees it, the fallacy in Fed policymaking — the disconnect between Wall Street and Main Street — is in not appreciating that companies will borrow only if they expect future output to profitably cover their expenses, which include but are not limited to interest rates.
By suppressing interest rates, the Fed is favoring business for whom the cost of funds are the primary cost of doing business, i.e. the financial sector.
The Fed seems to think that distorting the economy in this way will create a “wealth effect” that will kickstart the rest of the economy.