Debt & Why The Fed Is Trapped – Investment Watch

Massive levels of debt provide the most significant risk and challenge for the Federal Reserve. It’s also why the Fed is desperate to get inflation back to low levels, even if that means weaker economic growth. This was a point previously made by Jerome Powell:

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

This last sentence is the most important.

There are some important financial implications for below-trend economic growth. As we mentioned in “The Next Reversion to the Mean in Economic Growth:”

“After the ‘financial crisis,’ the media buzzword became the ‘new normal’ for what the post-crisis economy would want. It was a period of slower economic growth, weaker wages and a decade of monetary interventions to prevent the economy from falling back into recession.

After the “Covid crisis”, we will start talking about 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 rich and poor become ever more apparent.

If we are correct in assuming that PCE will revert to the mean as the stimulus fades from the economy, then the ‘new new normal’ of economic growth will be a new downward trend that fails to create widespread prosperity” .

As shown, economic growth trends are already below the previous two long-term growth trends. The Fed is now talking about further slowing economic activity in its fight against inflation.

Debt, Debt & Why the Fed is Stuck

The reason slowing economic growth and killing inflation are central to the Fed is because of the large amount of leverage in the economy. If inflation remains high, interest rates will adjust, leading to a debt crisis as servicing needs rise and defaults mount. Historically, these events led to, at best, a recession and, at worst, a financial crisis.

Debt, Debt & Why the Fed is Stuck

The Fed’s problem is trying “avoid” a recession while trying to kill inflation.

Recessions are an important part of the cycle

Recessions are not bad. They are a necessary part of the economic cycle and undoubtedly crucial. Recessions eliminate the “excess” built during the expansion and “reset” the table for the next stage of economic growth. without “recessions”, the accumulation of excess continues until something breaks.

In the current cycle, Fed interventions and keeping rates low for more than a decade have allowed fundamentally weak companies to stay in business by taking on cheap debt for unproductive purposes like share buybacks and dividends. Consumers have used low rates to expand consumption by borrowing. The Government increased debts and deficits to record levels.

The assumption is that increasing debt is not a problem as long as interest rates remain low. But here lies the catch.

The Fed’s constant growth mindset, with no tolerance for recession, has allowed this situation to fester instead of allowing the natural order of the economy to fulfill its Darwinian function of “remove the weak”.

The chart below shows the total leverage of the economic system against GDP. It currently requires $4.82 of debt for every dollar of inflation-adjusted economic growth.

Debt, Debt & Why the Fed is Stuck

More debt doesn’t solve problems

For the past few decades, the system has not been allowed to reboot. This has led to an increase in the resulting debt to the extent that it has harmed the growth of the economy. It’s more than a coincidence that the Fed “not so invisible hand” has left fingerprints on previous financial events. Since credit-related events tend to manifest themselves from corporate debt, we can see the evidence below.

Debt, Debt & Why the Fed is Stuck

Given the years of “ultra accommodating” post-financial crisis policies, most of the ability to do so “pull forward” consumption seems to have run its course. This is a problem that cannot and will not be solved simply by issuing more debt. Of course, for 40 years, this 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 reduced savings.

Debt, Debt & Why the Fed is Stuck

In turn, this increase in debt reduced both productive investments and the output of the economy. As the economy slowed and wages fell, the consumer became more leveraged, lowering the savings rate. As a result, rate increases divert more of your disposable income to pay down debt.

Debt, Debt & Why the Fed is Stuck

A long history of terrible results

After four decades of growing debt in the face of falling inflation and interest rates, the Fed now faces its most difficult position since the late 1970s.

The US economy is more heavily leveraged today than at any other time in human history. Since 1980, debt levels have continued to rise to fill the income gap. Larger homes, TVs, computers, etc. required cheaper debt to finance them.

The chart below shows the average inflation-adjusted standard of living and the difference between real disposable income (DPI) and the debt needed to support it. From 1990 onwards, the gap between DPI and the cost of living was negative, leading to an increase in the use of debt. By 2009, DPI could no longer support living standards without using debt. Today, it requires nearly $7,000 a year in debt to maintain the current standard of living.

Debt, Debt & Why the Fed is Stuck

The rise and fall of stock prices has little to do with the average American and their share of the national economy. Interest rates are an entirely different matter. Since interest rates affect “payments”, Rising tariffs quickly hit consumption, housing and investment, ultimately deterring economic growth.

Debt, Debt & Why the Fed is Stuck

Since 1980, every time the Fed tightened monetary policy by raising rates, inflation remained “Well contained.” The chart below shows the Fed Funds Rate compared to the Consumer Price Index (CPI) as an indicator of inflation. The current bout of inflation is completely different, and as the Fed raises interest rates to curb economic demand, they are very likely to adjust too much. History is littered with previous failed attempts that created economic shocks.

Debt, Debt & Why the Fed is Stuck

The challenge of the Fed

The Fed has a tough challenge ahead with very few options. Although rising interest rates may not “initially” impact asset prices or the economy, it’s a very different story to suggest they won’t. There have been absolutely ZERO times in history that the Federal Reserve has embarked on a campaign to raise interest rates that did not ultimately lead to a negative outcome.

The Fed is now starting to taper off accommodation at precisely the wrong time.

  • Growing economic ambiguities in the US and abroad: peak autos, peak housing, peak GDP.
  • Excessive valuations that exceed earnings growth expectations.
  • The failure of fiscal policy to “price itself”.
  • Geopolitical risks
  • Declining yield curves amid slowing economic growth.
  • Record levels of public and private debt.
  • Exceptionally low junk bond yields

These are the essential ingredients needed for the next “financial event”.

when will that be We do not know.

We know the Fed will make one “policy error” how “This time is different.”

Unfortunately, the result probably won’t be.

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