Powell: In 2015, normalize the Federal Reserve
Ordinarily, the plunging oil prices experienced during the last three months would be welcomed as beneficial for the economy — lowering transportation costs and stimulating consumer spending. But these are not normal times, and the sharp 45 percent drop in oil prices can trigger a larger financial market crisis and a recessionary contraction.
The debt crisis that brought the U.S. economy to its knees in 2008 has been largely absorbed and papered over by prolonged deficit spending and the Federal Reserve’s easy money policies of debt monetization and zero interest rates. Consider that when the subprime debt crisis unfolded in 2008, total U.S. Treasury debt, including IOUs to HHS and Social Security, stood at about $10 trillion. Today, just six years later, it exceeds $18 trillion, with the Federal Reserve’s balance sheet having grown by 425 percent — all in Treasury and mortgage debt.
In the years following the 2008 financial crisis, when the European debt crisis was headline news, U.S. sovereign debt grew silently at a rate considerably higher than that of other European countries with the exception of Greece. In 2011 Moody’s reported that the U.S. debt-to-tax-revenue revenue ratio was over 400 percent — more than twice that of Germany, France, the U.K., and Canada. Today, only Japan and Greece have higher debt-to-revenue ratios than the U.S.
We now sit atop the largest debt bubble in history, which has fueled rising asset prices — most visible in extended stock prices — and which provide the appearance of a healthy economy. The Fed’s easy money policies have made the 2 percent richer on paper, while the vastly larger middle class has been almost entirely left behind. Fifty million Americans remain below the poverty line and food stamp recipients have increased 38 percent in the last six years.
The debt, real estate and stock market collapse of 2008 started from a relatively small class of subprime mortgage bonds going bad. Today, the most likely trigger for financial market trouble in the U.S. could come from the leveraged finance and high yield junk bond sector that has facilitated the shale oil explosion — the very sector that has been main engine of economic growth in recent years.
According to Deutsche Bank and JPMorgan, the energy sector currently accounts for about a third of all capital expenditures in the U.S. and about 18 percent of all high yield debt issuance. It turns out that the shale boom commenced and has been concurrent with Fed’s zero interest policy, which began at the end of 2008. During the last six years banks have extended some $400 billion of leveraged loans to oil and gas fracking companies, while high yield bond issuance reached $175 billion, much of it hedged with derivatives.
The fourth quarter of 2014 witnessed a collapse in the U.S. energy high yield sector, with some issues plummeting more than 50 percent. What we know from other debt crises is that it is important to pay attention to how one sector of the bond market affects other sectors.
Indeed, trouble with bad loans and distressed junk bonds in the energy sector may have prompted money center banks led by Citibank to take concerted action to sneak into Congress’ government funding bill, passed just before Christmas recess, a provision that effectively restores taxpayer guarantees on risky derivatives trading. Dodd-Frank never succeeded in its primary justification — to protect the taxpayer from too-big-to-fail banks.
Given the current high level of risks in the U.S. economy and specifically the asset bubbles induced by the Fed, 2015 will be a very challenging year. The Fed has basically come to the end of line. Zero interest rates cannot be cut further, and further debt monetization on top of a $4.5 trillion balance sheet is too risky to contemplate.
What is essentially needed is more economic growth from fiscal policies of tax reform and regulatory relief, which would help the Fed expedite normalization of interest rates and selling assets to shrink its balance sheet. This needs to be done to break the cycle of economic malaise, but also to restore the nation’s economic insurance policy of having a central bank equipped with essential tools needed to cope with the next inevitable crisis.
Scott Powell is senior fellow at the Discovery Institute in Seattle and managing partner at RemingtonRand LLC.