The Fed’s “One Weird Trick”

Authored by Charles Hugh Smith via OfTwoMinds blog,

The U.S. economy has been saved time and again over the past two decades by this one weird trick:

“Bringing Demand Forward” by lowering interest rates and lending standards so Americans could continue to buy stuff they didn’t really need because the monthly payment dropped as interest rates were pushed toward zero.

Every time the economy faltered, the Federal Reserve would push interest rates down to “Bring Demand Forward” by goosing debt-based consumption: OK, so you don’t actually need a new car, but come on, the new car loan is only 1.9%, you can afford the monthly nut.

Or hey, it’s zero-percent financing for a couple years. Just go for it, get that new vehicle. Live large, you can swing it.

Flooding the economy with low-cost credit doesn’t just “Bring Demand Forward”; it also juices speculative bubbles across the entire spectrum, from cryptocurrencies to commercial real estate.

As bubbles inflate, punters feel wealthier and so they’re willing to borrow and spend more — the infamous “wealth effect.”

Nothing “Brings Demand Forward” like a speculative bubble and so inflating credit-based bubbles is all part of the plan to encourage people to buy stuff they don’t need on credit to keep GDP expanding.

“Bringing Demand Forward” with speculative bubbles is joyous until the bubble pops — and all bubbles pop. When bubbles deflate, gains are replaced by losses and the reverse wealth effect kicks in.

The solution for the past two decades has been to drop interest rates even further and expand credit even more to generate a new bubble in one asset class or another.

Now that central banks have pumped up the Everything Bubble and unleashed inflation, the weird trick of dropping interest rates/juicing liquidity no longer works. It no longer works in China, Japan, Europe, the U.S. or the developing world: Diminishing returns are systemic.

Economies that become dependent on zero interest rates juicing liquidity habituate to this constant stimulus and become dependent on speculative bubbles rather than on organic growth funded by earnings, savings and the advances of productivity.

“Bringing Demand Forward” always had an expiration date. You can’t bring demand forward forever. Eventually consumers tap out, bubbles pop, speculative gambles go bust, debt service eats up consumers’ disposable income, credit cards get maxed out and enterprises bloated by decades of bubbles and credit-funded spending implode under their fixed costs and debt loads.

The fantasy is that inflation will plummet to zero and we can all go back to “Bringing Demand Forward.”

The reality is what’s plummeting is demand. The Everything Bubble is popping, credit is tightening, stimulus that worked in the past is no longer saving stagnating economies and the higher cost of credit is drowning consumers and enterprises that have grown complacent after 20 years of continuous “saves” via zero interest rates and tsunamis of cheap credit.

Sure, those households bringing in $250,000 and up are doing just fine — if they bought houses and other assets ages ago and can reap the gains to subsidize their lifestyles. But everyone living off average earnings without the cushion of Everything Bubble gains — how much “demand” will they be able to afford after paying $300 for a couple bags of groceries?

It’s going to hurt when we hit the rocks at the bottom and unfortunately few are taking measures to reduce their risk while such measures are still within reach.