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Macroeconomic Policy and Zero Interest Rates


Jon Rugg, CFA

Last quarter we explored and looked to explain the gap investors are experiencing between recent stock market performance (“Wall St.”) and the economic data we are experiencing in the broader economy (“Main St.”).  In this article we will expand on the path of the economic recovery, provide an update on some of the key economic data we’re watching, and tackle the risks and potential long run effects we believe macroeconomic, and in particular monetary, policy will pose in the not too distant future.  But first, we will provide a primer on macroeconomic policy and how we see these levers affecting the economy in the short, intermediate, and long- term.

Macroeconomic Policy is Constructed by Three Pillars:  

  1. The first is Fiscal Policy which is conducted by the government. The “tools” to conduct this policy are usually either in the form of hiring more government workers for projects like infrastructure, or direct payments that could be made to citizens.  Infrastructure is a current policy being discussed by both presidential candidates. We have already experienced direct payments in the form of higher unemployment benefits or direct support for businesses through the PPP loan forgiveness program. While the fiscal policy response early on was swift and decisive, political gridlock has effectively shut down further stimulus for the past four months. We expect this to change after the election, regardless of which party wins. But, while this impasse may be temporary, we fear the damage done to many small businesses and employment may be much longer lasting.
  2. Monetary Policy is conducted by the Federal Reserve, whose mandate is to maintain price stability (stable currency and inflation) and strong growth (full employment).  The tools to conduct monetary policy are usually in the form of short- term rate control, such as the Fed Funds Rate, or more recently programs such as Quantitative Easing (“QE”) and the repo remuneration rate. The Fed actions earlier this year prevented the economy from falling off a cliff. The cutting of rates to near-zero has fueled a strong stock market recovery despite weak stock market fundamentals in the form of earnings growth (down over 30% over the past year).  However, the Fed recently made a significant shift in its policy by changing their inflation target to an average of 2.0% instead of a 2.0% target.  While the change seems subtle, the long-run implications are significant.  This shift means the Fed will let the economy run hot, and inflation increase beyond 2.0% for extended periods of time.  This is of great concern to us, particularly because the Fed has done a very poor job estimating inflation for the past 20 years. In our opinion, and as we have written about in past newsletters, the Fed has failed to recognize that the low inflation we have experienced is in part a result of the Digital Revolution, where we have had good deflation in the form of technological innovation.  A new theory of Monetary Policy called Modern Monetary Theory (“MMT”) is being openly discussed with a key tenet being that both debt levels and deficits do not matter.  This failure to recognize the true cause of low inflation during the Digital Revolution has the potential to ignite inflation in the years to come.
  3. The third pillar is the least known but is Incentive Structure Policy or more plainly, the rules of the game. These “laws of the land” utilize the tools of both regulatory and tax policy to create the incentives (rewards) and disincentives (penalties) upon which businesses and individuals rely and operate. This pillar is the most complex and hardest to measure - especially because its effects are often felt most over multiple business cycles.  However, in the current context we would characterize the current regulatory environment as strict (ie. bureaucratic red tape such as lockdown and reopening guidelines) and expect tax policy to be heading in a negative direction should Biden win his presidential bid.

In the long run, these three pillars need to be working together to reach strong growth and full employment. However, we fear that in the recent past and immediate future too much has been asked of Monetary Policy while our government, including both Fiscal and Incentive Structure, are effectively at a standstill. As we discussed above, we are concerned about the Fed’s shift in their inflation mandate, but we are equally concerned about the impact of near zero interest rates on the broader economy as the Fed appears to be quite focused on what happens on Wall Street.  

The Federal Reserve's Mandate

We believe the Fed’s mandate is intended to primarily help Main St. through price stability and strong growth, but programs such as QE and near-zero interest rates appear to us to help Wall St. much more than Main St. The writing for this shift has been ‘on the wall’ for a couple of years. If we look back to 2018 (which seems like ages ago!), we had an environment where the Federal Reserve was normalizing (meaning raising) interest rates--increasing rates four times that calendar year. This came on the heels of 10 years of near-zero interest rates. Over the holiday period in late 2018, we experienced a sharp correction with the S&P 500 going down -19.8%. What we then witnessed was a fairly sharp reversal in Fed Policy. By January of 2019, the Fed had reversed course significantly, eventually cutting rates later that year. This was puzzling to many market experts at the time who believed the Fed had either made a policy mistake or were privy to data that we in the public were not. In hindsight, it appears this action was perhaps the first major step the Fed took to prevent (or backstop) a stock market correction and support Wall St. over Main St. Indeed, in hindsight, this reversal could have been seen as a signal that the Fed would intervene to prevent future stock market corrections. In other words, they went all in supporting the stock market like they did during the initial COVID-19 bear market earlier this year.  

Potential Effects of Zero Interest Rates

We believe that low / near zero interest rates today and for much of the past 10 years has led to excess risk-taking and leverage, which are perhaps the greatest risks our stock market and broader economy face today. With rates so low, the prospects of buying government bonds and cash becomes fairly unattractive and leaves the stock market as the only game in town. We, and many professional investors, have been surprised by both the magnitude and duration of the stock market rebound. The market keyed off of Fed actions and low rates to drive stocks higher despite falling earnings and weak fundamentals. We have also seen a strong uptick in leverage. Corporate debt has increased $1.7T since the pandemic began and we see signs of excessive leverage and risk taking being made by individual investors as well. What is ironic is that these low rates created the environment to take on additional leverage, and now they are dependent on each other. The result is a fragile system where cracks in leverage result in lower rates to offset those risks, and the resulting lower rates create the incentives to take on more risk. This is not an enviable, or strong place to be.

In this environment, it seems equally likely that we could see a material market correction due to fundamentals or that stock market multiples will expand further (become more expensive) since there is no other game in town. What we would point out is that we still believe the UU shaped recovery is firmly in place - meaning we were thrown into a deep recession by the pandemic, and now we are experiencing a second and more traditional recession. We are seeing weakening employment data with permanent layoffs increasing, another wave of shutdowns as infection rates again begin to increase, a rise in bankruptcies, and continued weak earnings data. As additional fiscal stimulus is not available to help at this time, we fear that there is a growing probability that this shutdown could pose a significant risk to existing businesses who, while able to survive 2-3 months of shutdowns, are struggling to survive 8-9 months of shutdowns and restrictions.  However, not all is lost, as we continue to be impressed by the ingenuity of people to come up with new businesses and creative solutions to new shocks and problems.  This creativity is what will create new businesses and jobs in the future and pull us out of this recession.

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