Debt… And Why The Fed Is Trapped

Authored by Lance Roberts via The Epoch Times,

The massive debt levels provide the single most significant risk and challenge to the Federal Reserve. It is also why the Fed is desperate to return inflation to low levels, even if it means weaker economic growth. Such was a point previously made by Jerome Powell:

“We need to act now, forthrightly, strongly as we have been doing. It is very important that inflation expectations remain anchored. What we hope to achieve is a period of growth below trend.”

That last sentence is the most important.

There are some important financial implications to below-trend economic growth. As we discussed in “The Coming Reversion to the Mean of Economic Growth“:

“After the financial crisis [of 2008–09], the media buzzword became the ‘new normal’ for what the post-crisis economy would be like. It was a period of slower economic growth, weaker wages, and a decade of monetary interventions to keep the economy from slipping back into a recession.

“Post the ‘COVID crisis,’ we will begin to discuss the ‘new new normal’ of continued stagnant wage growth, a weaker economy, and an ever-widening wealth gap. Social unrest is a direct byproduct of this ‘new new normal,’ as injustices between the rich and poor become increasingly evident.

“If we are correct in assuming that PCE [Personal Consumption Expenditures price index] will revert to the mean as stimulus fades from the economy, then the ‘new new normal’ of economic growth will be a new lower trend that fails to create widespread prosperity.”

As shown, economic growth trends are already falling short of both previous long-term growth trends. The Federal Reserve is now talking about slowing economic activity further in its inflation fight.

(Source: St. Louis Federal Reserve, Refinitv; Chart: RealInvestmentAdvice.com)

The reason that slowing economic growth, and debilitating inflation, is critical for the Fed due to the massive amount of leverage in the economy. If inflation remains high, interest rates will adjust, triggering a debt crisis as servicing requirements increase and defaults rise. Historically, such events led to a recession at best and a financial crisis at worst.

(Source: St. Louis Federal Reserve, Refinitv; Chart: RealInvestmentAdvice.com)

The problem for the Fed is trying to “avoid” a recession while trying to kill inflation.

Recessions Are an Important Part of the Cycle

Recessions are not a bad thing. They are a necessary part of the economic cycle and arguably a crucial one. Recessions remove the “excesses” built up during the expansion and “reset” the table for the next leg of economic growth. Without “recessions,” the build-up of excesses continues until something breaks.

In the current cycle, the Fed’s interventions and maintenance of low rates for more than a decade allowed fundamentally weak companies to stay in business by taking on cheap debt for unproductive purposes, such as stock buybacks and dividends. Consumers have used low rates to expand consumption by taking on debt. The federal government increased debts and deficits to record levels.

The assumption is that increased debt is not problematic as long as interest rates remain low. But therein lies the trap the Fed faces.

The Fed’s mentality of constant growth, with no tolerance for recession, has allowed this situation to inflate rather than allowing the natural order of the economy to perform its Darwinian function of “weeding out the weak.”

The chart below shows total economic system leverage versus gross domestic product (GDP). It currently requires $4.82 of debt for each dollar of inflation-adjusted economic growth.

(Source: St. Louis Federal Reserve, Refinitv; Chart: RealInvestmentAdvice.com)

Over the past few decades, the system has not been allowed to reset. That has led to a resultant increase in debt to the point that it impaired the economy’s growth. It is more than a coincidence that the Fed’s “not-so invisible hand” has left fingerprints on previous financial unravellings. Given that credit-related events tend to manifest from corporate debt, we can see the evidence below.

(Source: St. Louis Federal Reserve, Refinitv; Chart: RealInvestmentAdvice.com)

Given the years of ultra-accommodative policies following the financial crisis of 2008–09, most of the ability to “pull forward” consumption appears to have run its course. This is an issue that can’t, and won’t be, fixed by simply issuing more debt, which, for the last 40 years, has been the preferred remedy of each administration. In reality, most of the aggregate growth in the economy was financed by deficit spending, credit creation, and a reduction in savings.

(Source: St. Louis Federal Reserve, Refinitv; Chart: RealInvestmentAdvice.com)

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