The Black Horse of the Apocalypse

Revelation 6:5 When the Lamb opened the third seal, I heard the third living creature say, “Come!” I looked, and there before me was a black horse! Its rider was holding a pair of scales in his hand. 6 Then I heard what sounded like a voice among the four living creatures, saying, “Two pounds of wheat for a day’s wages, and six pounds of barley for a day’s wages, and do not damage the oil and the wine!”

Consider first my brief post, citing John Mauldin’s concerns (to put it mildly) regarding the potential actions currently being contemplated by central bankers around the world.

Now, consider this from Ambrose Evans-Pritchard:

An ominous paper by the US Federal Reserve has become the hottest document in high finance.

David Reifschneider's analysis - 'Gauging the Ability of the FOMC to Respond to Future Recessions' - more or less concedes that the Fed has run out of heavy ammunition.

The world should be so lucky.  For example: referring to the aforementioned Mauldin piece, there are many who are figuring out how to force the issue regarding negative interest rates – potentially significantly negative. 

Apparently, over the last nine recessions the Fed has reduced rates on average by 550 basis points to (supposedly) combat the downturn.  When rates are already microscopic (as they are today), this may not be so easy.  Equally as ominous:

Quantitative easing (QE) in its current form cannot compensate, and nor can forward guidance. (Emphasis added.)

“In its current form….”  What other forms are possible?  More on that shortly.

What is needed is a significant increase in short term rates, such that the Fed has ammunition for the next downturn:

The Reifschneider paper argues that the Fed can probably muddle through, so long as it succeeds in pushing interest rates back up to 3pc or so before the next recession hits.

Hahahaha,  hohohoho, hehehehe.  Keep in mind how the markets reacted at the beginning of 2016 when the Fed moved the target rate up by 0.25%.  The likelihood of the Fed moving to 3% – absent the markets forcing the move – is exactly 0%.  Anyone who thinks otherwise does not understand the tools to increase interest rates that the Fed has at its disposal, and how these tools (if utilized) will inherently crush the markets (see my previous work on this, parts one, two, three, and four).

And too many powerful people do not want markets crushed.

Even then it might have to launch a further $4 trillion of QE and stretch its balance sheet to a once unthinkable $8.5 trillion.

This is virtually a certainty; nothing “unthinkable” about it.

Remember those melancholy days, when Bernanke said the Fed would be able to shrink the balance sheet to a more normal level – anytime now, real, real soon.  I laughed then, and I laugh today.  I find nothing “unthinkable” about this number of $8.5 trillion.  It is merely double the current balance sheet.  Last time the Fed increased the balance sheet five-fold – and guess what?  No measurable price inflation.

What might be considered in addition to these “unthinkable” steps?

The Fed acknowledges that fiscal policy will have to come to the rescue when push comes to shove. Keynesian tax cuts and spending will be the last line of defence.

A novel idea – deficits without end, and growing to infinity!  US Debt to GDP is already a little over 100%.  AEP sees no real limit to this ratio for a country with deep bond markets and its own printing press:

Britain's public debt was over 200pc after the Napoleonic Wars. Japan is over 250pc today, and the sky has yet fall in Tokyo.

Why is he wrong?  Absent significant price inflation (and one other possibility, touched on below), I cannot think of a reason.  As long as politicians and bureaucrats can kick the can for even one more day, they will.

His prescription?  Lather, rinse, repeat:

The winners - or survivors - will be those most willing to seize on the cheapest borrowing costs in history to fight back, preferably combining fiscal and monetary in a radical fashion. Call it helicopter money if you want, or 'overt monetary financing' of deficits.

Print, borrow, and spend; print, borrow, and spend; print, borrow, and spend.  Where have we heard that tune before?  Probably from some defunct economist.

There is another way out, according to David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution:

"If we had a huge exogenous shock like Lehman Brothers or 9/11, they would act. But what if it were not quite that bad? We would have prolonged argument," he said.

I say you can count on such an “exogenous shock” if that’s what it will take; no “what if” about it.  The state is well-skilled at creating demand for its “services.”

Conclusion

I hold firmly to the view: as long as consumer price inflation remains politically acceptable, there is no reason for the Fed to increase rates to any meaningful extent; there is no reason to stop increasing the balance sheet, let alone decrease it.  Absent such unacceptable consumer price inflation (which will cause havoc to markets), I suggest that the Fed cannot do it without causing complete havoc in financial markets.

It may end via such price inflation, but we may not see this for many, many more years given the numerous (price) deflationary forces in play today. 

There is another possibility: it may also end when the ratio of unproductive to productive overwhelms the productive’s ability to enjoy a decent standard of living.* I don’t have my brain wrapped around how this might play out: ballot box, civil unrest, death panels (not just for the elderly).  I don’t know.

There may be other reasons that might bring this to an end, but I don’t see any.

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*Productive = those who earn a living by providing goods and services primarily demanded by market forces at prices primarily determined by market forces.

Unproductive = everyone else (government employees, most on Wall Street, defense and other government contractors, all living primarily on government benefits, retirees (even those who have legitimately saved are dependent today on the production of others).)