The Not-So-Invisible Hand

By now it has been well-established that the Federal Reserve is deeply involved in the “stabilization” game of keeping markets from falling off the cliff. Since mid-March, the Federal Reserve has committed trillions of dollars to either outright purchases of US Treasury Bills and Notes or Exchange Traded Funds (ETFs) comprised of corporate bonds of various duration and quality. In past weekly notes, I have discussed ad infinitum the lengths to which Federal Reserve action has distorted asset prices and to a greater degree contributed to the burgeoning divide between the haves and the have nots. Today I’d like to shift the focus away from the moral dilemmas created by Fed action and onto the long-term efficacy of the policies enacted, and try to address the question of whether or not the Fed can actually effectively circumvent the overall direction of the economy and prevent or reduce a recession.

The first step is to address what the impact of direct, monetary injection into the credit markets means to the overall economy. During periods of financial crisis credit markets can have the tendency to “freeze up.” What this means is that when panic begins to hit Wall Street the willingness and capacity for multi-national banks and other financial institutions to extend short-term credit halts. This credit is essential for fueling a variety of things from corporate payrolls to esoteric financial instruments. Should credit be cut-off as a result of this panic, the outcome can spiral out of control leading to severe economic outcomes (see 2008 as an example). When the full impact of the coronavirus became apparent the Fed acted decisively and aggressively to prevent the impact of the virus from turning into a full-blown financial contagion. This is all prudent action designed to tackle problems dealing with the unique design of the financial system—a financial system that collapse without the fuel that is credit. This is what the Fed does well.

If the Fed is adept at reducing the impact of financial crisis, are those same attributes helpful in fending off an economic crisis? One is a crisis of confidence among banks and financial institutions while the other is a crisis of confidence among consumers. One can be tackled by providing a backstop to financial loss by securing and guaranteeing loans, the other is only tackled by improving employment outlook and personal financial situations. Consumers, you see, typically spend more freely when they believe that the dollar they spend today will most likely be replaced by income tomorrow—we’re funny like that. Recessions and depressions are caused and exacerbated by the belief that money is dear and not to be disposed of lightly. What can the Fed do to alleviate this feeling and spur growth? The answer is simple, but the effectiveness is less so, try to make money less dear. By way of lowering interest rates and increasing the money supply, the Fed attempts to spur economic output.

But since the impact of these actions is more immediately felt by institutions and large corporations, the economic benefits depend upon that money flowing down to the consumer. Lowering rates only help the consumer if banks feels secure in their ability to be repaid for the money they lend. Banks, like consumers, also need to believe that the money they are letting go of today will be replaced tomorrow. Ultimately, economic improvement depends upon the psychological improvement of lenders and spenders. If either of these two are worried about their income flows the economy is likely to struggle. To this end, the Fed is not a very adept psychiatrist. If the magic elixir for fear is faith, believing that the Fed is like our old uncle always handing out $20 bills on our birthday can be helpful, but it is not a cure all, especially if we need more than $20.

The economic crisis that we are currently in is not one where our fear is absolved with a $20 bill. The fear caused by the virus prevents us from freely walking around and conducting business as usual. So long as workers in hotels, airplanes, and shops are wearing masks to prevent the spread of an unseen menace the less likely we are to spend freely. The Fed cannot solve these fears—only a vaccine or an effective therapeutic can reduce those fears. The Fed has the power to delay the impacts of economic collapse from showing up in financial markets for a time, but should the vaccine and therapeutic solution be slow to materialize, the economic reality will soon cascade and overwhelm the Fed’s generous hand.

Currently, the actions by the Fed have pushed investors into riskier and riskier actions. By most valuations, the stock market appears very richly valued and pricing in little negative forward economic impact caused by virus imposed shutdown. This seems much too optimistic given the challenges of securing either a vaccine or a widely distributed therapeutic. Between the Fed and Congress it seems likely that continued efforts will be made to make money appear less dear by the oldest method available, the printing press. As governments at home and abroad print money in order to stimulate the economy it seems that value will continue to be sought by way of the oldest store of value, gold. As all currencies fight to devalue, precious metals should provide protection against the potential of reduced dollar buying power.

Thanks for reading,

Zach and Dave   

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