Monetary Policy at a Crossroad--Testing the Limits of the Fed's Financial Engineering

Decisions to change official rates can no longer be made exclusively on economic growth and price considerations as the dynamics of business cycles have changed. The new business cycle consists of growth and financial leverage (debt), replacing the old cycle of growth and price leverage.

As such, decisions to provide more monetary accommodations to sustain growth or lift inflation to the preferred target has to be weighed against growing financial vulnerabilities associated with the sharp rise in private sector debt. Promises by policymakers to provide additional monetary accommodation to sustain the growth cycle is more likely to do more long-term harm than good as it will only increase the scale of financial vulnerabilities.

In recent decades, monetary policy through its adjustments and control of short-term interest rates has had more influence on financial transactions than economic ones as individuals and nonfinancial corporations have engaged in active management of the liability side of their balance sheet, taking on record amounts of debt at relatively low rates, elevating real and financial asset prices in the process, while providing only modest benefits to overall economy.

For example, since 2011 nonfinancial corporations have added to $5.2 trillion in debt to their balance sheets. Corporations used this debt for a variety of purposes, such as acquiring other companies, purchasing real estate, buying back their own stock, while also investing in plant and equipment to run their regular business operations. Yet, the incremental growth in nonresidential investment has been a little more than $1 trillion. In other words, for every $5 borrowed by nonfinancial corporations only $1 has found itself redeployed in the real economy.

In the 2000s cycle, households also went on a borrowing binge, adding over $7 trillion in new debt over the span of seven years. Most of the new debt was invested in real estate. Over the course of the 2000's growth cycle households added $2 of debt for every $1 increase in consumer spending and investment in housing. Much higher ratios of debt to new investment occurred during the dot.com boom of the late 1990s and the the commercial real estate boom of the late 1980s.

All of these episodes highlight the new linkages and tradeoffs between monetary policy and financial activities. Yet, the failure to adapt, and even recognize, the changing linkages caused policymakers to miss, or downplay, the buildup of financial vulnerabilities in the system and the adverse shocks to the economy and the financial system were repeated time and again.

Each period of excessive credit and financial leverage was followed by a long bout of debt-deleveraging forcing the Fed to engage in a "financial engineering" campaign to cushion the economy and bring stability to the financial system. Following the commercial real estate crash of the early 1990s the Federal Reserve lowered official rates 650 basis points; 550 basis points following the dot-com bubble; and 500 basis points (and probably an extra 200 basis points of easing occurred with the Fed’s asset purchase program) after the housing bubble.

Today, even though the current environment has similar characteristics---large increases in debt and elevated asset prices--that preceded each of the past three recessions policymakers do not seem to be concerned about the growing buildup of financial vulnerabilities. Yet, the financial markets with Treasury yields out to 10 years trading well below the target on the federal funds rate suggests that the limits of the Fed's "financial engineering" have been reached and additional monetary accommodation will have a negative trade-off between costs and benefits. In fact, it would not be a surprise if market yields stay near current levels even if the Fed decides to lower official rates since encouraging more debt growth would only tip the scale more so to a bad outcome down the road.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.