Long before the Fed was humiliated into reversing its hawkish rate hike policy in January and then again in March, we published – back in June 2015 – “The Blindingly Simple Reason Why The Fed Is About To Engage In Policy Error“, in which we predicted, correctly, that the neutral rate of interest is far too low to allow a lengthy tightening campaign by the Federal Reserve, as the real Fed Funds rate would promptly rise above the neutral rate, further depressing demand, resulting in a policy error.
More importantly, instead of some arcane calculation of the infamous, convoluted r-star (or neutral rate of interest) we said that one might argue for low “implied” equilibrium short rates via debt ratios. For example, if nominal growth is 3 percent and the debt GDP ratio is 300 percent, the implied equilibrium nominal rates is around 1 percent. This is because at 1% rates, 100% of GDP growth is necessary to service interest costs.
So to help the Fed and pundits calculate just where r star is in an economy where total debt/GDP is 350% and rising, and where GDP is 2% and falling, we presented – all the way back in 2015 – a sensitivity table which looks at just two simple variables: nominal growth, or GDP, and total debt/GDP. Assuming the current leverage of the US and assuming 2% in nominal growth, the short-run equilibrium real interest rate is just about 0.57%, something which the Fed now appears to have discovered on its own.
As an aside, we also said that such a policy error could reinforce itself by causing structural damage that puts additional downward pressure on the equilibrium real rate adding that “in this case the yield curve would flatten meaningfully, at least until the Fed actually reversed course by cutting rates.” This is precisely what happened.
Now, nearly four years later, some of the brightest minds in the business have reached the same conclusion which this tinfoil blog came to long before the Fed had even started its hiking process. Case in point – Citi’s special economic advisor, Willem Buiter published a report on Tuesday titled “The neutral real interest rate is going nowhere” in which, using a far more convoluted methodology, the career academic concluded that today’s real neutral policy rate for the US is roughly 0.52%, or more generally, between 0.5 and 1.0%.
We could have told him that four years ago.
Of course, none of this is news either to us, or to our readers – although it certainly appears to be news to Fed Chair Powell who less than 6 months ago stated that there is a “long way” to the neutral rate, when in reality the real Fed Funds rate was already on top of it, as the Fed found out the very hard way in November and December.
What was news, however, is what conclusion Buiter derived from this simple observation. And, in a time when MMT, which as we discussed previously is merely the political camouflage for enacting helicopter money or direct debt monetization by the government, the respected Citi strategist comes to the conclusion that just because the economy now appears to be structurally depressed, it is as good a reason as any to proceed with, drumroll, helicopter money, i.e., MMT. Here is what he “found”:
Most estimates of today’s neutral real policy rate for the US hover between 0.5% and 1%. For the euro area and Japan many estimates are negative. That represents a dramatic decline from the levels seen before 2000. This situation is unlikely to be reversed any time soon. Despite the fourth industrial revolution lurking in the wings, economy-wide productivity growth is stagnant at best. Ageing populations boost private saving rates and weaken the incentives to invest. Fiscal dissaving and enhanced public sector capital formation can raise the neutral real rate but are constrained, especially in the US, by already excessive general government deficits and a rising public debt burden. A lower real interest rate does, of course, make public debt servicing easier, other things being equal. If the lower neural real interest rate is the reflection of a lower underlying growth rate of potential output, fiscal space may not be enhanced significantly once both drivers of fiscal sustainability are allowed for.
One implication for monetary policy is that this may be the time for helicopter money drops, a temporary fiscal stimulus funded by a permanent increase in the stock of central bank money. This makes even more sense when inflation continues to undershoot the inflation target, as is the case in the US and even more so in the euro area and Japan. – Source
And just like that the first official endorsement of helicopter money, pardon, MMT has arrived. It won’t be the last. As Alan Ruskin, chief international strategist at Deutsche Bank AG said during a Bloomberg interview on Wednesday, “don’t count on the hubbub over modern monetary theory dying down soon” adding that “it could get a lot bigger.”
Here’s why: “What happens if the economy slows down, what happens if we go down to zero interest rates again? The Fed is going to be back in there again responding in essence to what’s gone on on the fiscal side. You get sort of an MMT-lite- type situation.”
Or, alternatively, scratch the lite part and get full blown helicopter money as one government after next throw in the towel on fiscal conservatism and unleashes the biggest debt-funded spending spree in history, which as so many tragic examples in the past have shown, ends in tears.
As Ruskin concluded, “The natural constraints are inflation. The question is, what point do you hit inflation?” Well, when it comes to traditional risk assets, we already have runaway inflation. When it comes to conventional inflation as measured by the flawed CPI or PCE baskets, by the time it does register, it will be too late to reverse it, and the consequence will be the end of the monetary system as we know it.
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Author: Tyler Durden