Measuring money... faster, cheaper, cleaner

As we've long suspected, the Federal Reserve's ultra-low interest rate policies are doing more harm than good argues a recent paper by J.P. Morgan Funds Chief Global Strategist Dr. David Kelly. The "Market Bulletin," entitled, "Two Problems with Easy Money," says, "Probably the oldest maxim in economics is that there is no such thing as a free lunch. Less frequently observed is that even large, expensive lunches can be very unhealthy. Sadly, the monetary fare currently being served up by the Federal Reserve suffers from both vices -- it is unhealthy for the current growth of the U.S. economy and could prove very expensive in the long run. While it would be better for everyone if the Federal Reserve realized this today, for investors it is important to understand the consequences of it continuing on its current path."

Kelly explains, "In this paper, we make two basic points. The first, and the more controversial, is that easy money has now gone well beyond the point of being ineffective in stimulating the economy and is now, in fact, a significant drag on U.S. economic growth. The second is that when, despite the misguided efforts of monetary policy, U.S. economic conditions improve, the Federal Reserve will find it very difficult to tighten policy in an appropriate way, potentially leading to a bout of higher inflation that may, in turn, force aggressive tightening and a new recession."

He continues, "We should say, at the outset, that while we are critical of current Federal Reserve policy, we do recognize the crucial role played by the Fed in limiting the damage from the financial crisis. We also accept that, unlike many Washington policymakers, the members of the Federal Reserve are solely motivated to do the right thing for the economy. Unfortunately, we believe their actions are exactly the wrong thing for the economy today."

Kelly writes, "So, why has monetary policy been so ineffective? To understand this, it is first necessary to review the mechanisms by which easy money is supposed to help the economy.... First, contrary to the assumptions of most commentators, the Fed's policy of super-low interest rates is actually reducing consumer discretionary income relative to the alternative of raising interest rates. As shown in Chart 2 on the right, as of September 30, 2012, American households had $78.2 trillion in assets, of which we estimate roughly $15.2 trillion were interest-bearing, compared to $13.4 trillion in debt."

He adds, "Based on mortgage data from the Census Bureau, over 90% of outstanding mortgages carry a fixed rate, as well as the vast majority of auto loans, allowing us to assume that approximately 70% of liabilities are fixed rate debt. Determining the exact amount of variable rate assets is more difficult, but given that more than one-half of deposits are comprised of time deposits, savings deposits and money market funds, it may be reasonable to assume that more than 70% of household interest-bearing assets could be considered to be variable rate. Therefore, as an approximation, a +1% increase in interest rates could increase consumer interest income by $106 billion (on 70% of assets) and interest expense on household liabilities by $40 billion (on 30% of liabilities). While definitive numbers are more difficult to calculate, what is clear is that interest income would rise more than interest expense."

Crane Data asked Kelly about his recent paper. He tells us, "Well, I have been talking about it for a while, but I haven't written anything comprehensive. I've talked about different pieces of it. But I just want to put it all down on a one piece of paper.... What I find happens is that a lot of relatively orthodox economists agree and say, "Yeah, that is true, and, yeah, that is true." But they don't add it all up. If you add it all up, I think the conclusion is inescapable. The Federal Reserve is actually slowing the economy down. The answer to the mystery of why this economy is growing so slowly is in part because the Federal Reserve is trying to help it so much."

Finally, when asked if he really believes the Fed is hurting the economy, he adds, "I do. It took me a while to come to that conclusion. I didn't start out [it]. I recognized that ... all attempts to manipulate the economy can have some negative side effects.... It is actually harming the economy.... The key issue is that we are not just pushing on the string, we are actually strangling ourselves with the string."

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