The Fed’s Stealth Stimulus Has Arrived

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It’s not so stealthy.

This is the transcript from my podcast, THE WOLF STREET REPORT:

Let me just throw this out there for us to kick around: The Fed has already accomplished more with its verbiage so far this year than it had in the past when it actually cut rates multiple times, all the way down to near zero, and did trillions of dollars of QE. We’re already seeing the first results. Here’s why.

The US government can directly stimulate the economy by borrowing trillions and spending them in the US on infrastructure, on its employees, armaments, etc. The Fed cannot do this. It can only try to manipulate the credit environment in a credit-based economy.

The way the Fed tries to stimulate the economy is to loosen up credit, meaning it wants to encourage banks and other entities to lend, and encourage or force investors to invest more by taking larger risks for less return, as they begin to chase yield. The hope is that this will result in easy access to borrowed money for businesses and consumers, that they can borrow cheaply, and that they will go out and spend and invest this money. This spending and investment stimulate the economy.

But when the Fed cuts its target range for the federal funds rate, its only moves an overnight rate that consumers and businesses don’t have access to. So it hopes that short-term credit market rates, such as the one-month Treasury yield and the three-month Treasury yield or various LIBOR rates will follow the federal funds rate. And they usually do.

But short-term rates have only limited impact as a stimulus. The transmission channel for these short-term rates to the real economy are loans that are pegged to LIBOR, for example, and those loans will be become cheaper.

But most lending is done over longer terms, with fixed rates, such as mortgages, bonds, and the like. And those rates are much more impacted by the 10-year Treasury yield.

So what the Fed really wants to accomplish by cutting rates is to encourage market participants to bid up long-term bonds and thereby push down long-term yields. The benchmark for this is the 10-year Treasury yield.

If you want to stimulate housing, you need to bring down mortgage rates, and the interest rate of the most common mortgage in the US, the 30-year fixed-rate mortgage, tracks the 10-year yield.

And if you want to stimulate business investing and business spending, you need to bring down corporate bond yields, from top investment grade bonds all the way down to the riskiest junk bonds.

And if you want to stimulate business investing and business spending, and consumer spending, you can boost the stock market and the IPO market. Companies with high stock valuations have more financial options and can borrow more easily.

For example, Tesla: it has a mega-stock price despite billions in losses, and investors keep giving it more and more money when it needs it. So Tesla sells more bonds and more stocks, and then takes this money and burns it.

This act of burning investor cash in a money-losing operation means that Tesla spends or invests all this investor money, and this is a stimulus for the economy. If Tesla could no longer borrow and could no longer sell new shares to raise more funds, it could no longer spend and invest all this money, and it could therefore no longer stimulate the economy with this money.

And this happens over and over again across the corporate sector.

High asset prices – such as record inflated stock market valuations – also are said to cause the Wealth Effect to where those that benefit from the high asset prices, including homeowners, bondholders, and stockholders, are now feeling flush and more secure, and so they’re spending a little more. They might finally replace the roof, or put solar panels on it, or repave the driveway, and they might redo the kitchen, or buy more clothes or that $90,000 4×4 crewcab, all of which stimulate the economy.

These are part of the “transmission channels” of monetary policy…. the channels by which the Fed hopes its rate cuts will stimulate investment and spending.

So, the last time the Fed cut rates, it started in September 2007. The Fed cut 50 basis points, from 5.25% to 4.75%, and then it cut, cut, cut as the economy and the financial system was spiraling down, and by the end of 2008, its target rate was near zero %.

So when was all this rate cutting at the short end transmitted to long term rates and the real economy? Let’s see.

By October 2008, when the Fed’s target rate was down to 1%, the 10-year yield was still around 4%. In other words, after cutting rates for an entire year, and cutting by over 4 percentage points on the short end, the long-term yields had come down only about 1 percentage point.

In late 2008, as Lehman imploded and as the US financial system was on the brink, the Fed cut its target to near zero percent. And briefly, with markets in a panic, the 10-year yield dropped from 4% to a low of 2.08% about the same as today. But then it snapped back, and just a few months later, by June 2009, the 10-year yield was back in the 3.5% to 4% range – despite the Fed’s near-zero rate and QE, where it actually bought Treasury securities and mortgage-backed securities.

And it took the Fed years and trillions more of QE to bring long-term yields down, but it had trouble keeping them down because, after they’d finally dropped, they’d suddenly surge again.

So where are we today?

The Fed’s target range for the federal funds rate is between 2.25% and 2.5%. The effective federal funds rate is right in the middle of that target range, at 2.37%.

Short-term Treasury yields have plunged, pricing in with near-certainty a rate cut in July, and more later in the year. The three-month dollar LIBOR has dropped in parallel to 2.4% from 2.8% at the end of last year.

The Fed still hasn’t cut rates, but already via the dropping Libor, the floating-rate loans are getting cheaper.

OK, the real action is with the 10-year yield. By last October and early November, it had risen to 3.2%. And it had driven the average 30-year fixed rate mortgage rate above 5%. And it caused corporate borrowing costs to surge as well.

But just by the market’s interpretation and imagination, the 10-year yield has now dropped to 2.08%.

This is lower than it was for most of the time when the Fed’s rate target was near 0%, and when it was buying trillions of dollars of securities under QE specifically to get long-term rates down.

Now the Fed is doing neither – in fact, it’s still unwinding QE and shedding securities.  And yet, the 10-year yield has dropped this low.

This has a very stimulative effect on the economy. Mortgage rates have plunged, and home buying has picked up, though it remains lower than last year at this time. Home prices which had been dropping in some of the most overpriced markets have stabilized in some markets and are rising in others.

Consumer spending has picked up in recent months.

Financial services, the largest sector in the US economy, are growing at a hot pace. Most other services are growing at a good pace.

Business investment is weak, it has gotten hit hard by investment in the huge US oil-and-gas sector that has dropped sharply due to the plunge in oil prices since last fall. This impacts in a big way manufacturing and other sectors that supply the oil-and-gas business. But investment in oil-and-gas depends much more on the prices of oil and gas than on interest rates.

Stock prices are at all time highs. So the “Wealth Effect” is active, stockholders feel flush and they’re spending.

Corporate investment-grade bond yields have plunged in parallel with the 10-year Treasury yield. The average AA-yield is about 2.7%. Junk bond yields have come down too. All this is very stimulative. Credit is easy to get and cheap, and companies are borrowing, and so are consumers.

Last time the Fed cut rates, and instituted QE, it took years to get these long-term yields this low, and achieve that kind of economic stimulus. There was a lot of discussion about the transmission channels back then, about the lag between cutting short-term rates and when long-term rates would finally come down, and when this would finally impact the real economy.

But now, the Fed hasn’t even cut, and it has already accomplished everything it could ever want to accomplish to stimulate the economy. And the economy is starting to show it. In other words, the Fed is already stimulating the economy more with its verbiage so far this year than it was able to do in the past by actually cutting rates multiple times and doing trillions of dollars of QE.

Which poses a question: As these low market rates are stimulating the economy and boosting economic growth, why would the Fed actually cut rates? And what would rate cuts accomplish at this point? I don’t know either. It just doesn’t make sense. And the Fed might just be kind of patient to see where this is going, while patting itself on the back for having accomplished all this just by deploying its verbiage. You can listen to and subscribe to my podcast on YouTube.


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