"Kee Points" with Jim Kee, Ph.D.

In prior Kee Points I mentioned that investors, both amateur and professional, tend to think a market collapse is about 20 times more likely than it really is (University of Chicago Booth School of Business) . I would say the same is true of economic collapse, where the house-of-cards analogy dominates a lot of thinking when in fact a more resilient frame of reference is far more often appropriate.


In fact, economist Edwin Cannon of the London School of Economics wrote his book, Economic Scares, in order to dispel the “scaremongering” that he claimed was aimed at non-economists. In particular, Cannon arranged his book into four parts, one for each of four economic scares - alleged to lead to catastrophe - that he noted have been around for centuries. They are (1) fears over an adverse balance of trade, (2) fears about running out of jobs, i.e. automation (3) fears over too little savings, and (4) fears of overpopulation. Sound familiar? The remarkable thing is that Cannon’s book was published in 1933!


I think that’s worth keeping in mind with a lot of the “gathering storm” references going around lately, particularly following the US missile strikes on a Syrian government airbase last Friday. Geopolitical concerns are definitely serious business, and Churchill’s gathering storm phrase was certainly on the mark during the 1930s as he warned of Germany’s rearmament. But I’ve been hearing it applied to current events my entire adult life (over 3 decades), just like currency collapses. I was in college in the early 1980s, and President Reagan’s Star War missile defense proposals led to gathering storm references in every class, whether it was Art History, Philosophy, Logic, Literature, Government, or History (no exaggeration). The same references have been common during the Iraqi invasion of Kuwait and the US response (1990-91), the wars in Iraq and Afghanistan (post- 9/11), Russia’s invasion of Ukraine, Chinese military build-up, North Korean provocations, etc. In fact, about the only time we haven’t been under a gathering storm cloud was the brief “peace dividend” period in the US in the late 1990s. And yet markets have more or less chugged along (housing finance collapse notwithstanding), and that’s my point. Geopolitical tension is the norm, and lack of geopolitical tension the exception.


Finally, a few quick words on the Federal Reserve. I saw a forecast recently that called for a recession in the US beginning in 2019 - the delayed effect of the current regime of interest rate hikes that began December, 2015. Using the Fed, or more specifically increases in short-term interest rates, to forecast the future economy was a strategy that worked pretty well until around the turn of the century (late 1990s/2000s), at which point the relationship between short-term rates and the economy apparently weakened. A plausible explanation would be that much of the economy’s financing activities moved to the growing global financial system, which began to evolve to a large degree outside of the Fed’s control. Indeed, arguments to repeal parts of the (1933) Glass-Steagall banking act in 1999 were based upon recognition of this fact. Now, there is a case to be made that the implementation of the Dodd-Frank banking legislation has reeled in global finance and restored the historical importance of Fed actions, but I have my doubts.


Here’s one way to think about it: Back in 2005 Fed Chairman Alan Greenspan talked of a “conundrum,” which was the fact that long-term interest rates remained low despite the Federal Reserve's campaign to raise rates at the short-end. I think that’s where we are today, although I am not sure it is a conundrum. Federal Reserve Economist David Altig (then at the Cleveland Fed) noted at the time of Greenspan’s comments that in 2001 the Fed had lowered the federal funds rate target a full 475 basis points, the biggest decline in over 25 years, and yet the yield on 10-year treasuries barely budged. Most economists at the time would have thought that such a policy loosening would surely lead to higher inflation expectations and consequently higher long-term interest rates. Altig argued that it was precisely because monetary policy had been so effective in recent years that long rates held solid while short-rates plunged. “The effectiveness of monetary policy is ultimately measured by the Central Bank’s ability to provide liquidity without raising the specter of inflation, that is, without causing inflation expectations to increase.” That describes almost exactly what we just went through…extraordinarily low rates for a long period of time, followed by hyperinflation forecasts that have not materialized (so long rates never rose dramatically). Notice that the low rates were never followed by anything that could be considered a “boom,” which calls into question the notion that high rates have to be followed by a bust.


Right now the Fed would like to get the federal funds rate from the current 1% levels up to more normal 2%-3% levels so it can start reducing its balance sheet (i.e. unwinding the security purchases from the various prior QE programs) with some ability to cut rates should problems arise. Growth and/or inflation numbers certainly aren’t forcing this, so it would seem that raising rates would tighten credit markets unnecessarily. But prior Fed studies (particularly at the San Francisco Fed) have shown that credit markets (borrowing and lending) have been more constrained by regulation (e.g. Dodd-Frank) that the level of interest rates or the size of excess reserves in the banking system (which at $4.5 trillion are near all-time highs). Finally, the Fed can always rationalize higher rates by pointing to the low 4.5% unemployment rate, even though some of that may be driven by a low civilian labor force participation rate (a topic for another time).