EU Warns That Fed Rate Rises Could Lead to World Recession

 The Financial Times reported that the EU warned that Fed rate increases could lead to world recession. It said:

The Federal Reserve is leading a worldwide rush of central bank rate rises that risks tipping the world into a recession, the EU’s top diplomat said, as he warned the union is not fighting its corner in the world.

Borrell’s words on US monetary policy follow the World Bank’s warning last month that rate rises by multiple central banks could trigger a global downturn in 2023, as it argued the “degree of synchronicity” by central banks was unlike anything seen in five decades.

His warnings come as the World Bank and IMF kick off a week of joint meetings in Washington, where officials will discuss the multiple threats to the global economy. The fund is expected to downgrade its global economic forecasts for the fourth consecutive quarter.

Are Central Banks Going Bankrupt?

 The Financial Times-looked at whether central banks like the Federal Reserve can go bankrupt. The answer was no, but there are effects. It quotes from a paper by Seth Carpenter at Morgan Stanley:

Central bank profits and losses matter . . . but only when they matter. Before the 1900s, the subject of economics was called “political economy.” Central bank losses that affect fiscal outcomes may have political ramifications, but the banks’ ability to conduct policy is not impaired . . . . . . 

Starting with the Fed, all the income generated on the System Open Market Account portfolio, less interest expense, realized losses, and operating costs is remitted to the US Treasury. Before the Global Financial Crisis, these remittances averaged $20-25 billion per year; they ballooned to more than $100 billion as the balance sheet grew. These remittances reduce the deficit and borrowing needs. Net income depends on the (mostly fixed) average coupon on assets, the share of liabilities that are interest free (physical paper currency), and the level of reserves and reverse repo balances, whose costs float with the policy rate. From essentially zero in 2007, interest-bearing liabilities have mushroomed to almost two-thirds of the balance sheet.

As the chart below shows, the US central bank’s net income (which have been passed back to the US Treasury) has turned negative, and Morgan Stanley forecasts the losses will rise as interest rates rise.

Money Is Still Free

Real interest rates are still negative, they are way below the rate of inflation.  The last Consumer Price Index (CPI) inflation reading in August was about 8.3%. The current Fed funds rate is about 2.5%.  The current two- year Treasury bond rate is about 4.1%.  The ten-year rate is about 3.75%.  None of the interest rates is nearly as high as the inflation rate.  Many people think the inflation rate is dropping, but even if it has dropped to around 6%, it is still about 2% higher than interest rates.  So, money is still on sale.    

Interest rates have been about zero, and mortgages have been about 3%, but house prices were not going up fast until the pandemic, when they skyrocketed.  If house prices, or other asset prices, increased at a normal rate, the asset price would only go up by about the same amount as the interest rate, about 3%. Of course, the stock market was booming through much of this time, except for the beginning of the Covid pandemic.  In any case, the interest rate, almost zero for big borrowers or a few percent for normal people, was well below the rate of asset appreciation.  That continues today, despite the Fed’s rate increases. 

Now, instead of zero interest, we have 3% or 4% interest, but asset appreciation at 8% or 9% is well above that rate.  Real interest rates are still below zero, although nominal interest rates have gone up.  The economy is out of whack.  Real interest rates should be above zero. 

The Fed should keep increasing interest rates until they are higher than the rate of inflation.  They say they intend to, but Wall Street now thinks the Fed should stop periodically to check the inflation rate, so that interest rates do not get ahead of inflation.  If inflation rates do not slow down, this means that the Fed will continue to maintain a negative real interest rate, which is an enormous gift to investors. 

After the “great recession” of 2008, the Fed embarked on a plan of keeping rates low by buying up trillions of dollars’ worth of bonds, thus keeping interest rates low.  In essence it destroyed the bond market, because the Fed was always buying bonds.  In a normal economy, if there are not customers buying bonds, the interest rate goes up to encourage people to buy bonds.  If a company needs to raise money, they have to offer bonds with a rate that will make people buy them.  But if the Fed will buy anything and everything, there is no reason to offer higher interest.  This has been called quantitative easing, or QE. 

As part of the Fed’s new fight against inflation, it has introduced quantitative tightening, in which it will wind down or sell off its enormous bond holdings.  This will operate in tandem with its raising interest rates the old-fashioned way.  Since QE is relatively new, being used in earnest only after the 2008 recession, QT if even newer.  Janet Yellen tried it in 2017, when it appeared to contribute to a significant stock market fall and was discontinued.  So, we do not have a lot of data on what it likely to happen when the Fed tries it this year. 

The Fed held about $9 trillion of Treasury bonds and mortgage-backed securities on June 1.  It planned to reduce its holdings by $47.5 billion per month for three months, and then to increase reductions to $95 billion per month.  It remains to be seen how interest rate increases and QT work together. 

The one recent example we have was in the UK, where the new government’s economic plan of reducing some taxes led to a run on bonds (“gilts” in Britain), which forced the Bank of England (the British Fed) to step in and buy bonds as it and the Fed had done under QE, in essence a reversal of QT.  QE has been used to increase liquidity, to grease the bond market, in times of economic difficulty.  Could QT create the reverse condition and create market difficulties by removing liquidity?  We may find out by trial and error.  QT might end up being a greater threat to market stability than interest rate increases. 

 

Big National Debt

 

America’s gross national debt exceeded $31 trillion for the first time on October 4.  This happened as interest rates on the debt will be going up and as the US may be sliding into recession.  The debt has grown due to huge government spending during the Covid pandemic and to Trump tax cuts.  Until recently the Administration and Congress were spending like there was no tomorrow, and the Fed was cooperating with them by keeping interest rates historically low.  Low interest rates led to assertions that deficits and debts did not matter.  At higher interest rates, they may matter. 

If the Fed gets interest rates back down to 2%, paying interest on the debt may not be too bac, but if inflation remains at 4% or higher, debt payments will be an increasing burden on paying for other government programs, such as defense or Social Security.  Some programs will have to be cut in order to pay additional interest on the debt.  Otherwise the debt grows bigger. 

An article in the Economist said that unless Congress and the Administration work with the Fed by limiting spending, monetary policy (the Fed) eventually loses traction.  Higher interest rates become inflationary, not disinflationary, because they simply lead governments to borrow more to pay rising debt-service costs, i.e., the Fed has  no way to fight inflation alone. 

In the last few years the US has gone on a massive spending spree.  We may now have to pay for it.  We can pay by instituting some sort of austerity, or we can just get on the inflation bandwagon and ride it into the future.