Macro Factors and their Impact on Monetary Policy, the Economy, and Financial Markets

Central Bank’s 2% Inflation Fetish

Throughout history banks have been at the epicenter of every financial crisis. That notoriety of failure led to the formation of Central Banks. In the wake of the 2008 financial crisis, global banks have repaired and strengthened their balance sheets, especially in the U.S. The majority of European banks have shored up their balance sheets but there are some banks where there is room for further improvement, especially in Italy. While the global financial system is more financially sound, Chinese banks are likely to experience their day of reckoning during the next global downturn.

The Federal Reserve was established on December 23, 1913 after Congress passed ‘The Federal Reserve Act’ to provide the nation with a safer, more flexible, and more stable monetary and financial system. The Federal Reserve Act was the response to a number of financial crises in the preceding 20 years that resulted in bank runs, bank failures, and economic contractions. The worst economic crisis began in 1893 and lasted until 1897 and was considered a Depression given its length and the depth of the contraction in the economy. The Panic of 1901 was the first Crash in the stock market and was triggered by a battle between E.H. Harriman, who owned the Union Pacific Railroad, and a group financed by J.P Morgan over the control of the Northern Pacific railroad. The Panic of 1907 began in mid October and led to a 50% decline in the New York Stock Exchange index within 3 weeks. A run on New York banks spread to banks throughout the country and ended when J.P. Morgan pledged his personal fortune, along with other prominent bankers, to shore up the banking system and provide liquidity to the financial system.

In the lead up to the Great Depression, the Federal Reserve expanded the money supply by 61% from 1921 to 1929. After the economy sunk into recession in 1930, the Federal Reserve allowed the money supply to contract by more than 30%, which led to bank runs and failures. As liquidity dried up, commodity prices plunged, the value of farms fell, and bank farm auctions soared. In an effort to stiff banks, neighbors would enter low bids for the property being auctioned so they could return the property to the family being foreclosed on. These auctions became known as Penny Auctions. Congress compounded the Fed’s monetary miscue by passing the Smoot-Hawley Tariff Act in June 1930 which added high tariffs to 20,000 imported products. World trade plummeted by 40% within 18 months of the passage of the Tariff Act, as our trading partners responded with their own higher tariffs. In 1932, Hoover pushed Congress to pass an increase in the top personal tax rate from 25% to 63% and the lowest tax rate to 4.0% from 1.1%. The Great Depression was the result of a number of policy mistakes.

In the run up to the Great Recession in 2008, the Federal Reserve maintained negative interest rates from 2001 through 2004, failed to supervise large banks after they increased their leverage from 12 to 1 in 2004 to 30 to 1 in 2007, allowed no-doc and liar loans to become the norm in 2005, 2006, and 2007, and publicly expressed confidence in May 2007 that the sub-prime problem would be contained. Congress encouraged the Housing of Urban Development (HUD) to push Fannie Mae and Freddie Mac to make mortgage loans to less qualified buyers so lower income families could participate in the American Dream. The 2004 HUD regulations established a set of sub-goals tied to the total number of mortgages purchased by each GSE. In 2007, both Fannie and Freddie were to allocate 47 percent of their respective purchase activity to low and moderate income housing, 18 percent to so-called special affordable housing, and 33 percent to so-called underserved areas. Mortgage originating firms like Countrywide Financial and large banks, like Pigs at the trough, created an assembly line of low quality mortgage pools rating firms Moody’s, S&P, and Fitch rubber stamped with a AAA blessing. This activity took place in plain sight of everyone, including the Federal Reserve which had a ring side seat.

Financial crises are always preceded by excesses that appear reasonable and justifiable. The intervention by the Federal Reserve and its launch of the first Quantitative Easing (QE) program in 2008 clearly prevented another Great Depression. Maintaining QE for another six years so QE could boost asset values without discernible benefit in the real economy, as a number of Federal Reserve District bank analysis’s has indicated, is why the number of negative unintended consequences have increased. An analysis by Stephenson Williamson, an economist at the Federal Reserve of St. Louis, recently concluded “With respect to QE, there are good reasons to be skeptical that it works as advertised, and some economists have made a good case that QE is actually detrimental." In theory, QE is expected to boost economic growth and inflation. Williamson compared the U.S. and Japan which utilized QE to Canada, which only used low interest rates rather QE and low rates as was done in the U.S. and Japan. As noted by Williamson, "If QE were effective in stimulating aggregate economic activity, we should see a positive difference in economic performance in the U.S. relative to Canada since the financial crisis. There is little difference from 2007 to the fourth quarter of 2016 in real GDP performance in the two countries. Indeed, relative to the first quarter of 2007, real GDP in Canada in the fourth quarter of 2016 was 2 percent higher than real GDP in the U.S., reflecting higher cumulative growth, in spite of supposedly less accommodative monetary policy.”

The Bank of Japan has conducted the most aggressive QE program of any central bank but inflation has not responded as the accepted QE theory proposed. As Williamson concluded, "Thus, in these two natural experiments, there appears to be no evidence that QE works either to increase inflation, if we look at the Japanese case or to increase real GDP, if we compare Canada with the U.S."

The Bank of England followed the Federal Reserve’s lead and launched the first of its three QE programs on March 5, 2009, followed by other Central Banks. Due to various political constraints, the European Central Bank didn’t launch its QE program until March 2015 but has been very aggressive in expanding its balance sheet. From December 2007 to May 2017, the Fed’s total assets increased from $882 billion to $4.473 trillion—a fivefold increase. Total Fed assets increased from 6.0% of U.S. GDP in the fourth quarter of 2007 to 23.0% of GDP in the second quarter of 2017. In June 2017 the Bank of Japan had a balance sheet that was 92.2% of GDP, Switzerland’s was 115% of GDP, the Swedish Riksbank’s was 19% of GDP, the Bank of England’s was 24% of GDP, and the European Central Bank’s was 37.8% of GDP.