Monetary Policy, QE3, Printing Money and the Longer Term ...The "Fed Cliff" Ahead Could Be a Scary Thing

The Federal Reserve is printing lots of money these days in an effort to get the U.S. economy growing solidly and improve the nation's jobs situation.

In the short term the extra money and liquidity will probably cause asset prices such as stocks to increase and aid the housing market as well. This will happen as short term interest rates remain at historically low levels for several more years, and stocks look to be better buys than most other asset classes, including bonds.

Over the long term, however, what goes around comes around. When it eventually comes time to soak up the excess money supply, interest rates will climb, and perhaps rapidly, but hopefully not to excessively high levels.

That's all in the future, of course, but we do need to understand that there will be a day of reckoning down the road. The best thing we can do is to get our fiscal house in order and get the private sector growing consistently in the 3% or greater real inflation adjusted range.

Stated another way, if we use today's loose monetary policy which is keeping interest rates low to take the time to get our government spending and tax policies in order, it will prove to have been a good thing to do. On the other hand, if we just keep printing money and spending more than we'll ever collect in taxes as a result of weaker than necessary economic growth, it will prove to be a very bad and inflationary thing to have done.

The answer to the question of whether QE3 is a good or bad thing, accordingly, is a definite 'IT DEPENDS.'

Fed Print Run Disguises Deficit is instructive about the dangers ahead for the U.S. economy:

"There is plenty of worry over the looming "fiscal cliff." Less talked about is the potential for a "Fed cliff."

The fiscal cliff refers to tax increases and reductions in government spending set to occur at the end of the year. If these take effect, they are expected to pose an economic hit possibly equal to as much as 4% of gross domestic product, likely throwing the U.S. into recession in 2013.

The Fed cliff is further off, but also daunting. It arises from the expansion of the Fed's balance sheet and the challenge that will come for the government when the central bank one day has to rein it in.

The Fed's balance sheet has risen to nearly $3 trillion from less than $1 trillion before the financial crisis and will grow further following Thursday's announcement that it will begin buying $40 billion a month in mortgage-backed securities.

The Fed's superlow interest-rate policies have already lowered government borrowing costs, even as the size of the overall debt has spiraled, and so have helped lower the annual deficit. And the central bank's stash of U.S. government debt—it held $1.64 trillion as of early September—along with its mortgage-securities portfolio have helped further reduce government interest expense. That is because of the extraordinarily circular process, where the Fed prints money to buy bonds, takes the interest it receives from the Treasury and mortgage securities, and returns most of it to the Treasury—$75 billion in 2011.

In fiscal 2011, net interest expense for the government was equal to 1.5% of gross domestic product, according to budget data. That is well below the average for the past 30 years. When the Fed remittances are taken into account, though, the expense fell to about 1% of GDP. This also helps to reduce the size of the government's annual operating deficit, which the administration said was $1.164 trillion for the first 11 months of fiscal 2012.

The government should continue to enjoy this Fed-induced benefit in the coming year. Even if rates on the 10-year Treasury note increase somewhat from current levels, so too should Fed remittances as its balance sheet expands further.

For the moment, it is tough to see this situation changing anytime soon. Indeed, the Fed left the timing of its monthly purchase open ended, and it also extended to mid-2015 the period for which it expects to keep interest rates at near-zero levels.

Eventually, though, assuming the economy one day recovers, rates will have to rise. In a February speech, New York Fed President William Dudley noted that once the economy improves, the Fed will pursue a different monetary policy, leading to higher short-term rates and a shrinking of its balance sheet. "These actions will tend to increase the Treasury's net interest costs and pull down the Federal Reserve's remittances to the Treasury," he said. "Together, these two effects will sharply push up the Treasury's net interest burden."

To illustrate his point, Mr. Dudley outlined an economic scenario in which monetary policy is normalized by 2017 and the interest rate for three-month Treasury bills rises to about 3.8% in 2020, compared with 0.10 percentage point currently. With the government's interest expense rising, and the Fed's remittances shrinking, net interest expense would rise to about 3.3% of GDP in 2020, the highest level since 1948.

All the more reason for the government to quickly tackle the country's long-term fiscal issues, not just the immediate "fiscal cliff." The danger is that politicians dither, figuring the Fed is there to support both the economy and their profligate ways.

In that case, the government may find it is the recovery that really hurts."

Summing Up 

Our nation's net interest bill today is approximately 1% of GDP. It's likely that it will be closer to 3.3% of GDP in 2020. And here's what that means for us --- an interest bill that's probably going to be at least $400 billion higher than it is today.

And that's based on a resumption of normalized rather than inflation induced high interest rates in future years. Of course, we can't afford existing trillion dollar deficits indefinitely, let along another $400 additional billion dollars.

Since our annual deficit today is roughly $1.2 trillion, adding another ~$400 billion or more means we'll be looking at annual deficits considerably greater than $1.5 trillion as far as the eye can see. That would kill chances for sustained and stable economic growth, job creation and financial stability.

And that, my friends, is why We the People will have to get very serious really soon about dealing with our deficits and national debts.

So WHEN, and not if, interest rates rise, the hit to the budget deficits will be huge unless we as a nation begin to deal with our fiscal issues.

The risk, of course, is that we'll waste the next few years by doing nothing serious about our fiscal and debt burdens. Then as rates rise over the next several years, we'll reach the point of no return.

We simply can't let that happen, and the Fed is betting our politicians will come to a compromise agreement on a way out of this financial debacle.

But the reality is we can't know what will happen until it actually happens. Let's hope and believe that grown-ups will do what's right soon after this fall's elections.

We simply can't afford to wait much longer.

Thanks. Bob.