Will Any of the Fed’s Stimulus Money Ever Trickle Down to Us?

Strategies, The Fed, U.S Investments

With all the political hoopla going on sometimes it is hard to separate fact from fiction.

In 2019 the Fed made a quick U-turn, from raising interest rates to cutting them. The stock market continues to hit all-time highs, and the drums are beating louder about when the stock market bonanza will end.

Dr. Lacy Hunt is chief economist Hoisington Investment Management Company (HIMCo). He’s a straight shooter!

HIMCo has over $5 billion under management, composed of pension and profit-sharing plans for both corporate and government entities, charitable organizations and insurance companies. HIMCo is also the sub-advisor for the Wasatch-Hoisington U.S. Treasury Fund (WHOSXX), a no-load mutual fund distributed by ALPS Distributors, Inc. They were rated the #1 Government Bond Fund in 2019.

Their quarterly newsletter is a must-read. Much like the old EF Hutton commercial, when Lacy speaks, I recommend we all listen. If you want to understand what is going on from the big picture perspective, and what the effects are likely to be, this is a terrific source. The most recent newsletter, which is for the fourth quarter of 2019, highlighted some facts I felt our readers should see.

I caught Lacy while he was traveling but he kindly agreed to an interview.

DENNIS: First of all, thank you for your time. Let’s start with something we discussed in the past; the Fed cutting rates to stimulate the economy. You indicated this is a process of diminishing returns. Eventually the Fed’s magic elixir will have little effect.

Have your views changed on this subject?

LACY: Dennis, thanks for inviting me.

Absolutely not. Moreover, debt-financed fiscal programs are also equally ineffective. Based on the available 2019 stats, each dollar of private nonfinancial debt generated only 40 cents of GDP, down 25% in the past twenty years.

DENNIS: In your recent issue you told us, “Five considerations indicate that inflation, real growth, and interest rates will be less in 2020 than in 2019.” The consideration that grabbed me was, “Domestic and worldwide debt overhang became even greater in 2019.”

The remarks about government debt are alarming:

“While the aggregate debt problem is not as bad in the U.S. as in other major economies, debt levels are unprecedented in the government and corporate sector, and thus should serve as a major constraint on U.S. economic growth. Gross U.S. government debt outstanding increased to 107% of GDP late last year, the highest since the 1940s.

…. Substantial peer reviewed economic research indicates that the U.S. economy loses one-third of its trend economic growth rate when the government debt ratio rises above 90% for a period of five years. The U.S. has met that condition since 2014. When viewed from a cyclical perspective, the increase in Federal debt in 2018 and 2019 is even more serious.

In late stage expansions, economic theory indicates that budget deficits should be reduced and with it the ratio of debt to GDP should fall.

Deterioration in economic conditions would lead to a quick worsening in the ratio, pushing the debt ratio further into uncharted waters, even without new fiscal measures that would likely be enacted in such circumstances.” (Emphasis mine)

Lacy, I’m concerned. Wall Street controls the Fed. In a downturn, “new fiscal measures would likely be enacted.” My fear is the “fiscal measures” they enact would be the opposite of what needs to be done.

If you were put on a government advisory board, what would you tell them to do?

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LACY: I favor a constitutional amendment that the Federal budget be balanced annually unless there is a 60% vote of support in both the House and Senate and agreement of the President.

DENNIS: Amen to that! It would take a constitutional amendment with some severe penalties to get the job done.

The “Real 10-year government bond yields” are in negative territory.

Most of our readers are trying to make their 401k grow and last through their retirement. Negative yields will destroy all pension plans growth projections.

Talk about “unchartered waters”, wow.

I asked what you would advise the government to do. Let’s reverse it. What would you suggest hard-working Americans, who have played by the rules, saved their money and hope to be able to retire comfortably do under the circumstances?

LACY: My recommendation is to remain employed if your health permits. I personally believe that most folks will be happier and healthy if they do so. Then, they will be in better shape to enjoy retirement and or help children who may be struggling in a job market that is not providing the employment opportunities that were available to the baby boomers.

DENNIS: As a person who flunked retirement the first time, I would agree. Most seniors I know who continue to work, even if it is an encore career, are still in the game and better off for it.

One final question. You concluded; this slower growth will continue to subdue core inflation in 2020. Historically governments have used high inflation to whitewash their debt problems. What economic conditions would cause rising inflation to become a concern?

LACY: If the Federal Reserve Act were rewritten so that the Fed could directly pay the bills of the US government, this would lead to rampant inflation. Such a measure would make the Fed’s liabilities legal tender. Moreover, the inflation would spread worldwide since the dollar is the world’s reserve currency. Such inflation would make economic conditions miserable for the vast majority of Americans.

DENNIS: Lacy, in a recent article I outlined how the Treasury is selling bonds to “Primary Dealers”, many of which are owners of the Fed. Three days later, the “Primary Dealers” are selling the US debt to the Fed at a profit. While the Fed isn’t paying the bills, they are quickly buying up the US debt after the treasuries were sold.

Perhaps I am missing a technicality. Isn’t that doing the same thing? If so, eventually that would have to start the inflationary cycle, wouldn’t it?

LACY: Yes, the technical nature is pretty complicated as more factors are involved.

Brunner and Meltzer proved that M2 = mb x m where mb is the monetary base and little m is the money multiplier. Bruner/Mletzer proof is universally accepted. It is for example in the Bernanke text written with Abel of Wharton and also in Greg Mankiew’s text. Mankiew is a professor at Harvard.

The Fed has control of the base but it does not control little m, which should not be confused with the velocity of money, which they also do not control. Little m is determined by the reserve requirement ratio, which the Fed controls, and the excess reserves, currency, time deposit ratios that the Fed does not control.

When the Fed expands the base, they increase excess reserves of the banks, but the banks must have the capital and other incentives to take the risk of turning the excess reserves into loans and money. This the Fed does not control. The preference that households and businesses hold the proper mix of currency and time deposits is also not controlled by the Fed.

When the Fed executed QE1,2 and 3, excess reserves soared but m fell and M2 growth did not accelerate except for a brief time in the early phase of QE1 when Bernanke was incorrectly saying the Fed was printing money. Even before Bernanke corrected what he said it was a misspeak.

Thus, when the Fed buys governments under the current legal structure, the only effect is to reduce the average maturity of the aggregate government debt, i.e. the debt of the Fed and the Treasury. If, for example, Fed buys a 3-year note from the banks, three-year maturity debt declines and the banks now hold one-day deposits at the Fed banks. Those reserves do not leave the banking system unless the money supply process is engaged.

If the Fed’s liabilities are made legal tender, the fractional reserve banking system would have to end to permit the Fed’s liabilities to serve as legal tender. This is what I believe the Modern Monetary Theory (MMT) folks want to do and it is exactly what was done in about 60 cases of hyperinflation, including Germany after WW1, China in the 1930s and 1940s and in the great Yugoslavian and Bolivian inflations that have been studied extensively.

DENNIS: On behalf of our readers, thank you for your time.

LACY: My pleasure Dennis.

Dennis here. As you can see, Dr. Hunt deals with the FACTS from a true economic perspective. For a more in-depth understanding about his comments, you can read their 4th Quarter 2019 Review & Outlook. Each quarterly publication is packed with several pages of FACTS and solid economic analysis. I hold their “outlook” in high regard. The newsletter is FREE and I highly recommend it

I have no financial arrangements with Dr. Hunt or his firm. He is a highly respected economist, a good friend, and a very busy guy who is kind enough to share his time and thoughts for our benefit.

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