Lacy Hunt Warns Federal Reserve Policy Failures Are Mounting

Tyler Durden's picture

Authored by Lacy Hunt via Casey Research,

The Fed's capabilities to engineer changes in economic growth and inflation are asymmetric. It has been historically documented that central bank tools are well suited to fight excess demand and rampant inflation; the Fed showed great resolve in containing the fast price increases in the aftermath of World Wars I and II and the Korean War. In the late 1970s and early 1980s, rampant inflation was again brought under control by a determined and persistent Federal Reserve.

However, when an economy is excessively over-indebted and disinflationary factors force central banks to cut overnight interest rates to as close to zero as possible, central bank policy is powerless to further move inflation or growth metrics. The periods between 1927 and 1939 in the U.S. (and elsewhere), and from 1989 to the present in Japan, are clear examples of the impotence of central bank policy actions during periods of over-indebtedness. 

Four considerations suggest the Fed will continue to be unsuccessful in engineering increasing growth and higher inflation with their continuation of the current program of Large Scale Asset Purchases (LSAP):

  • First, the Fed's forecasts have consistently been too optimistic, which indicates that their knowledge of how LSAP operates is flawed. LSAP obviously is not working in the way they had hoped, and they are unable to make needed course corrections.
  • Second, debt levels in the U.S. are so excessive that monetary policy's traditional transmission mechanism is broken.
  • Third, recent scholarly studies, all employing different rigorous analytical methods, indicate LSAP is ineffective.
  • Fourth, the velocity of money has slumped, and that trend will continue—which deprives the Fed of the ability to have a measurable influence on aggregate economic activity and is an alternative way of confirming the validity of the aforementioned academic studies.

1. The Fed does not understand how LSAP operates

If the Fed were consistently getting the economy right, then we could conclude that their understanding of current economic conditions is sound. However, if they regularly err, then it is valid to argue that they are misunderstanding the way their actions affect the economy.

During the current expansion, the Fed's forecasts for real GDP and inflation have been consistently above the actual numbers. Late last year, the midpoint of the Fed's central tendency forecast projected an increase in real GDP of 2.7% for 2013—the way it looks now, this estimate could miss the mark by nearly 50%.

One possible reason why the Fed have consistently erred on the high side in their growth forecasts is that they assume higher stock prices will lead to higher spending via the so-called wealth effect. The Fed's ad hoc analysis on this subject has been wrong and is in conflict with econometric studies. The studies suggest that when wealth rises or falls, consumer spending does not generally respond, or if it does respond, it does so feebly. During the run-up of stock and home prices over the past three years, the year-over-year growth in consumer spending has actually slowed sharply from over 5% in early 2011 to just 2.9% in the four quarters ending Q2.

Reliance on the wealth effect played a major role in the Fed's poor economic forecasts. LSAP has not been able to spur growth and achieve the Fed's forecasts to date, and it certainly undermines the Fed's continued assurances that this time will truly be different.

2. US debt is so high that Fed policies cannot gain traction

Another impediment to LSAP's success is the Fed's failure to consider that excessive debt levels block the main channel of monetary influence on economic activity. Scholarly studies published in the past three years document that economic growth slows when public and private debt exceeds 260% to 275% of GDP. In the U.S., from 1870 until the late 1990s, real GDP grew by 3.7% per year. It was during 2000 that total debt breached the 260% level. Since 2000, growth has averaged a much slower 1.8% per year.

Once total debt moved into this counterproductive zone, other far-reaching and unintended consequences became evident. The standard of living, as measured by real median household income, began to stagnate and now stands at the lowest point since 1995. Additionally, since the start of the current economic expansion, real median household income has fallen 4.3%, which is totally unprecedented. Moreover, both the wealth and income divides in the U.S. have seriously worsened.

Over-indebtedness is the primary reason for slower growth, and unfortunately, so far the Fed's activities have had nothing but negative, unintended consequences.

3. Academic studies indicate the Fed's efforts are ineffectual

Another piece of evidence that points toward monetary ineffectiveness is the academic research indicating that LSAP is a losing proposition. The United States now has had five years to evaluate the efficacy of LSAP, during which time the Fed's balance sheet has increased a record fourfold.

It is undeniable that the Fed has conducted an all-out effort to restore normal economic conditions. However, while monetary policy works with a lag, the LSAP has been in place since 2008 with no measurable benefit. This lapse of time is now far greater than even the longest of the lags measured in the extensive body of scholarly work regarding monetary policy.

Three different studies by respected academicians have independently concluded that indeed these efforts have failed. These studies, employing various approaches, have demonstrated that LSAP cannot shift the Aggregate Demand (AD) Curve. The AD curve intersects the Aggregate Supply Curve to determine the aggregate price level and real GDP and thus nominal GDP. The AD curve is not responding to monetary actions, therefore the price level and real GDP, and thus nominal GDP, are stuck—making the actions of the Fed irrelevant.

The papers I am talking about were presented at the Jackson Hole Monetary Conference in August 2013. The first is by Robert E. Hall, one of the world's leading econometricians and a member of the prestigious NBER Cycle Dating Committee. He wrote, "The combination of low investment and low consumption resulted in an extraordinary decline in output demand, which called for a markedly negative real interest rate, one unattainable because the zero lower bound on the nominal interest rate coupled with low inflation put a lower bound on the real rate at only a slightly negative level."

Dr. Hall also wrote the following about the large increase in reserves to finance quantitative easing: "An expansion of reserves contracts the economy." In other words, not only have the Fed not improved matters, they have actually made economic conditions worse with their experiments. Additionally, Dr. Hall presented evidence that forward guidance and GDP targeting both have serious problems and that central bankers should focus on requiring more capital at banks and more rigorous stress testing.

The next paper is by Hyun Song Shin, another outstanding monetary theorist and econometrician and holder of an endowed chair at Princeton University. He looked at the weighted-average effective one-year rate for loans with moderate risk at all commercial banks, the effective Fed Funds rate, and the spread between the two in order to evaluate Dr. Hall's study. He also evaluated comparable figures in Europe. In both the U.S. and Europe these spreads increased, supporting Hall's analysis.

Dr. Shin also examined quantities such as total credit to U.S. non-financial businesses. He found that lending to non-corporate businesses, which rely on the banks, has been essentially stagnant. Dr. Shin states, "The trouble is that job creation is done most by new businesses, which tend to be small." Thus, he found "disturbing implications for the effectiveness of central bank asset purchases" and supported Hall's conclusions.

Dr. Shin argued that we should not forget how we got into this mess in the first place when he wrote, "Things were not right in the financial system before the crisis, leverage was too high, and the banking sector had become too large." For us, this insight is highly relevant since aggregate debt levels relative to GDP are greater now than in 2007. Dr. Shin, like Dr. Hall, expressed extreme doubts that forward guidance was effective in bringing down longer-term interest rates.

The last paper is by Arvind Krishnamurthy of Northwestern University and Annette Vissing-Jorgensen of the University of California, Berkeley. They uncovered evidence that the Fed's LSAP program had little "portfolio balance" impact on other interest rates and was not macro-stimulus. A limited benefit did result from mortgage-backed securities purchases due to the announcement effects, but even this small plus may be erased once the still unknown exit costs are included.

Drs. Krishnamurthy and Vissing-Jorgensen also criticized the Fed for not having a clear policy rule or strategy for asset purchases. They argued that the absence of concrete guidance as to the goal of asset purchases, which has been vaguely defined as aimed toward substantial improvement in the outlook for the labor market, neutralizes their impact and complicates an eventual exit. Further, they wrote, "Without such a framework, investors do not know the conditions under which (asset buys) will occur or be unwound." For Krishnamurthy and Vissing-Jorgensen, this "undercuts the efficacy of policy targeted at long-term asset values."

4. The velocity of money—outside the Fed's control

The last problem the Fed faces in their LSAP program is their inability to control the velocity of money. The AD curve is planned expenditures for nominal GDP. Nominal GDP is equal to the velocity of money (V) multiplied by the stock of money (M), thus GDP = M x V. This is Irving Fisher's equation of exchange, one of the important pillars of macroeconomics.

V peaked in 1997, as private and public debt were quickly approaching the nonproductive zone. Since then it has plunged. The level of velocity in the second quarter is at its lowest level in six decades. By allowing high debt levels to accumulate from the 1990s until 2007, the Fed laid the foundation for rendering monetary policy ineffectual. Thus, Fisher was correct when he argued in 1933 that declining velocity would be a symptom of extreme indebtedness just as much as weak aggregate demand.

Fisher was able to make this connection because he understood Eugen von Böhm-Bawerk's brilliant insight that debt is future consumption denied. Also, we have the benefit of Hyman Minsky's observation that debt must be able to generate an income stream to repay principal and interest, thereby explaining that there is such a thing as good (productive) debt as opposed to bad (non-productive) debt. Therefore, the decline in money velocity when there are very high levels of debt to GDP should not be surprising. Moreover, as debt increases, so does the risk that it will be unable to generate the income stream required to pay principal and interest.

Perhaps well intended, but ill advised

The Fed's relentless buying of massive amounts of securities has produced no positive economic developments, but has had significant negative, unintended consequences.

For example, banks have a limited amount of capital with which to take risks with their portfolio. With this capital, they have two broad options: First, they can confine their portfolio to their historical lower-risk role of commercial banking operations—the making of loans and standard investments. With interest rates at extremely low levels, however, the profit potential from such endeavors is minimal.

Second, they can allocate resources to their proprietary trading desks to engage in leveraged financial or commodity market speculation. By their very nature, these activities are potentially far more profitable but also much riskier. Therefore, when money is allocated to the riskier alternative in the face of limited bank capital, less money is available for traditional lending. This deprives the economy of the funds needed for economic growth, even though the banks may be able to temporarily improve their earnings by aggressive risk taking.

Perversely, confirming the point made by Dr. Hall, a rise in stock prices generated by excess reserves may sap, rather than supply, funds needed for economic growth.

Incriminating evidence: the money multiplier

It is difficult to determine for sure whether funds are being sapped, but one visible piece of evidence confirms that this is the case: the unprecedented downward trend in the money multiplier.

The money multiplier is the link between the monetary base (high-powered money) and the money supply (M2); it is calculated by dividing the base into M2. Today the monetary base is $3.5 trillion, and M2 stands at $10.8 trillion. The money multiplier is 3.1. In 2008, prior to the Fed's massive expansion of the monetary base, the money multiplier stood at 9.3, meaning that $1 of base supported $9.30 of M2.

If reserves created by LSAP were spreading throughout the economy in the traditional manner, the money multiplier should be more stable. However, if those reserves were essentially funding speculative activity, the money would remain with the large banks and the money multiplier would fall. This is the current condition.

The September 2013 level of 3.1 is the lowest in the entire 100-year history of the Federal Reserve. Until the last five years, the money multiplier never dropped below the old historical low of 4.5 reached in late 1940. Thus, LSAP may have produced the unintended consequence of actually reducing economic growth.

Stock market investors benefited, but this did not carry through to the broader economy. The net result is that LSAP worsened the gap between high- and low-income households. When policy makers try untested theories, risks are almost impossible to anticipate.

The near-term outlook

Economic growth should be very poor in the final months of 2013. Growth is unlikely to exceed 1%—that is even less than the already anemic 1.6% rate of growth in the past four quarters.

Marked improvement in 2014 is also questionable. Nominal interest rates have increased this year, and real yields have risen even more sharply because the inflation rate has dropped significantly. Due to the recognition and implementation lags, only half of the 2013 tax increase of $275 billion will have been registered by the end of the year, with the remaining impact to come in 2014 and 2015.

Additionally, parts of this year's tax increase could carry a negative multiplier of two to three. Currently, many of the taxes and other cost burdens of the Affordable Care Act are in the process of being shifted from corporations and profitable small businesses to households, thus serving as a de facto tax increase. In such conditions, the broadest measures of inflation, which are barely exceeding 1%, should weaken further. Since LSAP does not constitute macro-stimulus, its continuation is equally meaningless. Therefore, the decision of the Fed not to taper makes no difference for the outlook for economic growth.


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markmotive's picture

The world economy is not derived from finance. Finance is derived from real activity, which is derived from resource availability. The Fed has zero control over resource availability and therefore has zero control in the long run.

MeMadMax's picture

The writer of this article misunderstands the feds actions: It has gone political, not economically driven.

It would take a complete idiot to not understand that the money they are dumping goes straight into the assest dump, maintaining the illusion of prosperity in the country for the sheeple, and keeping the big banks/corps happy...

This IS what the dems want. Dems have the big banks in the palm of their hands: They don't prosecute, they don't cut off the flow of money, they give them a tongue lashing once in a while to keep the sheeple happy, and they get reelected...


Everyone is happy until it comes to a screeching halt...

King_of_simpletons's picture

Everytime the Federal Reserve policy fails, a select few make it out like bandits. The Fed "failure" is by design.

Oldwood's picture

And don't forget those "tribute" fines the banks are paying. Does anyone know whee that money goes? Direct to the revenue bucket or does it end up in the attorney General special purpose fund. I'm thinking about how police departments get to keep their impounded properties to use in further "enforcement".

ElvisDog's picture

And every so often they trot out people like Elizabeth Warren to make a fiery speech about how bad the banks are, but when push comes to shove she votes along the "keep the party going" Democratic party line. She is the darling of the progressives for her supposed independence but in truth is one of the biggest hypocrites around.

RaceToTheBottom's picture

I doubt it is a Dems/Repubs thing.

zorba THE GREEK's picture

I don't care what Lacy Hunt says, Fed policies have not been a failure,

they have been a huge success, just ask any billionaire.

Yenbot's picture

Sign seen in California:






Yen Cross's picture

   Haven't you done enough damage Chairsatan? Gently drift into the " Jimmy Carter" Library...

Landrew's picture

I think I am well read however before calling your comment strange. What's with the Jimmy Carter? Stagflation=Miller? Wouldn't it be two evils Bernanke=Bush Library?

Landrew's picture

Down arrows for history? Jimmy Carter into office Miller, then appointed Volcker, Bush in office Greenspan, appionted Bernanke, O'Bummer in office Bernanke, appionted Yellen. That's history what is to down arrow about that? I would like to know the meaning of the Bernanke Jimmy Carter comment before I said you are a FUCKING MORON. Now I will just say it, fucking moron, as I see it. It would be like me saying Reagan and O'Bummer are one in the same for tripling the national debt while in office?

LetThemEatRand's picture

How is it a failure when you've made billions for your employers?  They stole our money by hijacking our government and using the Treasury as their own private source of revenue for doing nothing other than lending our own future tax liabilities back to us with interest.  They should be prosecuted for fraud if not treason.

Bangin7GramRocks's picture

Jamie Dimon saved 16 billion and didn't need to admit guilt after he met with Obama. Most profitable meeting in history. They don't even try to hide the corruption anymore!

Anusocracy's picture

Let's see, the government steals money from the public, then somebody else steals the stolen money from government.

Looks like two parasitic organisms vying for a resource that's not theirs.

pavman's picture

Let's see, the government steals money from the public, then somebody else steals the stolen money from government.

Looks like two parasitic organisms vying for a resource that's not theirs.

So the only solution is to then go work for the Fed and get your money back!  Full employment comrade!

Debt-Is-Not-Money's picture

"Hyman Minsky's observation that debt must be able to generate an income stream to repay principal and interest,"
"as debt increases, so does the risk that it will be unable to generate the income stream required to pay principal and interest."

Another BS finance article that refers to money, debt and income without ever defining these terms (does this guy work for the IRS?). If the "income stream" consists of debt based currency loaned into circulation at interest, then how is it possible to pay "principal and interest" on a loan??? Answer: It Isn't, Debt must either be paid off in money (which by definition has no interest attached to it) or extinguished in a bankruptcy.

We have no money (except for our coin) so the debt and interest can not only never be retired, but must grow exponentially until the giant crash comes!

P.S. LTER, "They should be prosecuted for fraud if not treason."

     A big greenie on this one!
     I've noticed over the past several weeks that your posts are making more and more sense- are you feeling OK? /sarc

blindman's picture

cancer has an admirable growth rate.

dogmete's picture

us gov = cancer


(but I state the obvious)



DrDinkus's picture

walked past the nyfed today on way home from work...bizarre metal bar pattern around the windows...almost looks like baphomet...maybe it is...idk...#trolled

Zero Point's picture

Another article that assumes all this is a mistake.


jeff montanye's picture

I draw the parallel with 9-11.  It is progress to go from the "9-11 report" or the editorial page of the New York Times to thinking "oh, they knew this might very well happen, or was going to happen, and let it because they wanted the results that would flow from it".  Similarly, it is progress to critique, rather tellingly, the effectiveness of Fed policy since 2008 to improve the economy generally and the positions of the working and middle classes, etc. specifically.

That there was likely a far more intimate involvement in 9-11 by aspects of the national security states of the U.S. and Israel and the points Let Them Eat Rand and others made above are, indeed, further steps out of illusion.

But progress has been made even with the first step.

mvsjcl's picture

Yes, Let It Happen On Purpose is an important first step. With the implication being that it's only the first step on a long and genuinely mind-blowing journey.

Blankenstein's picture

You are giving the central planners WAY too much credit in the intelligence department.   See LTCM.  

tao400's picture

It is messed up, and so is how much I am underwater in my gold stocks. On some of them, like gdxj, I am down 80 percent, others not so bad only Down 40 percent. I'm buying the market. Don't fight the fed but do try to jump out of the way before the collapse

OldPhart's picture

The gold and silver in my cabinet seem to float on water.

Any chnce that silver will one day be $4-$5 an ounce or gold $300 to $400?

If it ain't in your hand, you don't own it.

Serfs_Up's picture

Is it me or that pic of Berzerky looks like his face when takes a dump.....on our economy?

ebworthen's picture

You CANNOT centrally plan an economy, nor inflation and employment.

You MUST allow failure, the settlement of risk, reward for saving, and the masses to set prices.

If you do not allow the invisible hand of the working responsible savers to operate and at the same time ignore the rule-of-law you guarantee:  graft, failure, and tragedy.

Simple fucking ideas, morals, and ethics - that get lost in the fog of high-thinking, equivocation, and lust.

BlobbyBlueBland's picture

Could not have said it better. The problem is cultural as well - we cannot let anyone or anything fail, no matter the consequences. Everybody gets a trophy, lest somebody's feelings get hurt. By the same token, the stock market/banking sector must not be allowed to fall because it wouldn't be fair to see somebody lose on a deal. Welp, now we all lose.

Zero Point's picture

Of course you can centrally plan an economy.

You just can't do it overtly (yet), and have to take into account the generational cycles of human behaviour (the apparent "natural" forces you refer to, like risk and reward).

Something our bankster overlords have being doing for hundreds (perhaps thousands) of years.

The cold, dead, guiding hand of the ancient world order.

mvsjcl's picture

Yep. Generational memories that span centuries. How greatly does evil embrace the past, while inculcating a society that can't remember yesterday.

Nothing but the truth.'s picture

And what you cannot do is fool all the people, all the time about the state of the economy and the misallocation of their money.

RebelDevil's picture

Ask yourself this question - What is the "invisible hand"? What the fuck is it? Anyone? Bueller?

If it can be logically defined and proved, then it exists a real force.
If not, it is analogous to "The Lord".

Here's a simple law of universe:
"What is rational is real, what is real is rational." - Hegel

I contend that one can centrally plan a good economy, it's just that every central planner we've had so far in the Fed have been irrational and disconnected from reality.  

rustymason's picture

I guess it can go on like this forever.

are we there yet's picture

This time forever is different?

dogmete's picture

Over indebtedness may be the primary reason for slow growth.  But it seems that too much burden on small business is an enormous problem. The government is destroying the very engine of our economy while it runs up its debts.

ebworthen's picture

Small business is the enemy of the soul-less corporations.

Just look at WalMart and the bling franchise eateries. 

Corporations set up layers of bureacracy, a cultish culture, and an army of lawyers. 

They can grind an individual into dust and break their spirit with their gutless, heartless, mind-numbing procedures, paperwork, and HR departments.

This is why .gov and corporations collude; they understand each other.

A small business with ties to a community is their worst enemy.

dick cheneys ghost's picture

''A small business with ties to a community is their worst enemy.''


thats why I love the craft beer movement in this country......they are stickin to the Man......if this could be replicated on a mass scale, with other products........we might have a chance...


dick cheneys ghost's picture

what a story.........Thanks, never heard of him before........cant wait to try his likker

q99x2's picture

I want to know how, if the FED has made fellow bankers more money than at any other time in the history of the world, they don't know what they are doing?

Quit listening to that type of reasoning. That is based on the way things partially worked sometime in the past.

But yes the FEDs failures are mounting based on old school ideas of the way things worked.

CrashisOptimistic's picture

I'll offer up for ZH Friday night consideration a perspective too rarely heard.

Okay, the Fed has QEed enormous amounts of money and we don't have job growth, significant GDP growth, or any semblance of return to "normalcy". 

Why is it always presumed that if the Fed didn't print money, this would somehow be better?  Why don't people instead recognize the systemic forces creating destruction of society and then subsequently recognize that printing money is the only thing concealing that relentless death and slowing it?

EROEI erosion is deadly.  Automation is defining about 1/2 of society as permanent burdens for the other half.  Demographic erosion is global.  India's average age is 27 and 60 million of their citizens are over 65 years old -- with no Social Security program to speak of.  Relentless, grinding burden that is never going to stop until population totals are eviscerated.

When faced with this, does Fed printing really represent anything significant?  Positive or negative?

dick cheneys ghost's picture

QE is the TELL that the dollar is on its death bed..........

Bazza McKenzie's picture

Since the ECB, BOJ, and BOC are all rapidly printing money also, are you claiming fiat in general is on its death bed?

dick cheneys ghost's picture

it sure looks that way.........the sooner the better

infinity8's picture

"Why is it always presumed that if the Fed didn't print money, this would somehow be better?  Why don't people instead recognize the systemic forces creating destruction of society and then subsequently recognize that printing money is the only thing concealing that relentless death and slowing it?"

Because THAT, along with "Relentless, grinding burden that is never going to stop until population totals are eviscerated." is Scary.

RaceToTheBottom's picture

"Why is it always presumed that if the Fed didn't print money, this would somehow be better? "

1)  If you believe Keynesian thought, you are thinking that the economy is like a cash for clunkers deal, you print money to even out the bottom of the cycle, not really talking about the fact that you are stealing future economic growth. 

2)  That is the best case, but since printed money was not allocated to the economy, instead it went to the banksters who applied it for their profits not the economy well being.  Therefore we stole future economic growth and mis-applied it to the wealth class that both needed it least and invested it to the least effect (stock-market fictional growth).

You can see why people are saying it is both generational and economic class warfare.