When the Federal Reserve sets its baseline interest rate (the Federal Funds rate) well below the real-world rate of inflation (and below understated government-measured inflation), it leaves the door open for above-trend inflation. It also creates incentives for economic actors to borrow and spend money on speculative and unproductive activities – those that don’t add to the productive capacity of the economy. And that is precisely what happened for years, certainly since the 2008-9 Great Financial Crisis. Kevin Warsh has been pointing this out for years. Now he’s in a position to do something about this long-term monetary policy error. Despite the institutional and political resistance to raising interest rates to positive real territory, investors betting against Warsh are likely underestimating his determination to raise real rates. His criticism of the Fed’s policy errors is longstanding, principled, and evidence based. He is moving deliberately to correct these errors by organizing five “task forces” to reconsider different aspects of Fed policymaking in an effort to return to “first principles” of monetary policy from which the Fed has diverged. He wants to establish a more intellectually robust regime that reflects economic reality rather than the politically distorted process (including misleading government data) that led to years of monetary policy errors. If he succeeds, it will be a sea-change in monetary policy. Many Fed watchers on Wall Street initially argued that Warsh would not challenge the status quo and instead conform to politicized calls for lower rates that have no basis in the data; they are now coming to realize that Warsh meant what he said when he criticized Fed policy in the past and has the intellectual and intestinal fortitude to back up his words regardless of resistance. Investing on that basis will prove to be the better course in the period ahead.
The massive growth of debt creates the illusion that economic growth is strong and healthy by flattering corporate earnings and stock prices. But without $2 trillion annual U.S. deficits and huge government borrowing in Europe, China and Japan, economic growth would be much lower as would corporate earnings and stock prices. Economies are growing in nominal terms, but real (inflation-adjusted) growth is much lower - and most of the growth we see is dependent on a concomitant build-up in debt that can never realistically be repaid in constant dollars. That consigns the world to future inflation. Accordingly, the wealth created by this process is less than it seems and wholly dependent on the Ponzi-like structure of public and private sector financing where debt is incessantly refinanced and extended into the future. Any breakdown in that process will materially reduce if not destroy wealth, but even before that happens, the value of the fiat currencies in which that wealth is denominated keeps eroding steadily under the pressure of rising inflation.
Rising global interest rates, especially those at the long end of the curve, are signaling that we are above the levels where current levels of borrowing can be maintained without moving us toward crisis. Yields are reacting to strong economic growth, but that growth would not be happening without epic government and private sector borrowing. As such, arguments that higher yields are a purely positive reflection of a healthy economy are incomplete at best and misleading at worst. At the end of the day, the growing economy is going to have to deal with the debt that made it look so healthy. Readings like the ISM Services Index hitting 58.7, its highest level in 59 months, and the ISM Manufacturing Index hitting 56.7, its highest in 33 months, reflect economic strength. But those figures have to be read in the context of all the debt employed to reach those levels that are rarely mentioned in any analysis. Growth is not organic because it is debt dependent. Absent massive borrowing, it would be much lower.
