It was Winston Churchill who said, “However beautiful the strategy, you should occasionally look at the results.” Fact is, the lack of wage growth among the bottom 70–80% of workers (the Unprotected class) constitutes a real weaknesses in the US economy. If you are a service worker, competition for your job has kept wages down.
The black-swan risk here is that the Fed will tighten too much, too soon. We know from recent FOMC minutes that some members have turned hawkish in part because they wanted to offset expected fiscal stimulus from the incoming administration. That stimulus has not been forthcoming, but the FOMC is still acting as if it will be.
What happens when the Fed raises interest rates in the early, uncertain stages of a recession instead of lowering them? I’m not sure we have any historical examples to review. Logic suggests the Fed will extinguish any inflation pressure that exists and push the economy in the opposite direction instead, into outright deflation.
Deflation in an economy as debt-burdened as ours is could be catastrophic. We would have to repay debt with cash that is gaining purchasing power instead of losing it to inflation. Americans have not seen this happen since the 1930s. It wasn’t fun then, and it would be even less fun now.
Worse, I doubt Trump’s FOMC appointees will make a difference. Trump appears to be far more interested in reducing the Fed’s regulatory role than he is in tweaking its monetary policies. I have no confidence that Yellen’s successor, whoever that turns out to be, will know what needs to be done or be able to do it fast enough.
Let me make an uncomfortable prediction: I think the Trump Fed – and since Trump will appoint at least six members of the FOMC in the coming year, it will be his Fed – will take us back down the path of massive quantitative easing and perhaps even to negative rates if we enter a recession. The urge to “do something,” or at least be seen as trying to do something, is just going to be too strong.
Black Swan #2: ECB Runs Out of Bullets
Last week, news reports said that the Greek government is preparing to issue new bonds for the first time in three years. “Issue bonds” is a polite way of saying “borrow more money,” something many bond investors think Greece is not yet ready to do.
Their opinions matter less than ECB chief Mario Draghi’s. Draghi is working hard to buy every kind of European paper except that of Greece. Adding Greece to the ECB bond purchases program would certainly help.
Relative to the size of the Eurozone economy, Draghi’s stimulus has been far more aggressive then the Fed’s QE. It has pushed both deeper, with negative interest rates, and wider, by including corporate bonds. If you are a major corporation in the Eurozone and the ECB hasn’t loaned you any money or bought your bonds yet, just wait. Small businesses, on the other hand, are being starved.
Such interventions rarely end well, but admittedly this one is faring better than most. Europe’s economy is recovering, at least on the surface, as the various populist movements and bank crises fade from view. But are these threats gone or just glossed over? The Brexit negotiations could also throw a wrench in the works.