The Fed Has Been It's Own Worst Enemy

Deflation can be intuitively thought of as a sustained fall in the prices of consumer goods and services.  In this environment, consumers decide to postpone current purchases for some time in the future, when those goods or services can be purchased for lower prices.   However, if every consumer behaved similarly, it would create a sustained slowdown in any economy.  This is the reason the Fed fears deflation.  The Fed does not have the tools to fight deflation.

Therefore, since the Great Financial Crisis, the Fed has taken on various forms of Quantitative Easing (or QE) to pump more money into the economy.  The goal has been to create cheaper financing options – make borrowing more attractive – which would stimulate demand by consumers and businesses. This higher level of activity would ultimately create an acceptable level of inflation – 2% per the Fed’s mandate.

However, there are good kinds of deflation.  When Amazon drops prices to gain market share, the consumer wins.  When Uber launches a new service with lower prices and better features, the consumer wins.  Why is this type of deflation considered bad?  After all, is there such a thing as a postponed Amazon Prime purchase 😉.  The chart below, from no other than the SF Fed, shows you how acyclical inflation - spending on staples - has more than offset cyclical inflation to keep overall inflation below Feds targets.

Ignoring the distinction between good and bad deflation, and with the fear of upsetting the economic expansion, the Fed has maintained an ultra-low rate policy.  This policy is misguided.  Hurdles on investment are important.  Hurdles brings discipline.  Ultra low-interest rates remove most hurdles on investment.  Therefore, lots of capital has flooded the investment game. This is what the Fed wanted! If investors make bad bets, they lose.  It’s a big boy/girl game, so we can ignore the unintended consequences.   However, the majority of this capital has funded disruptors!  These disruptors have introduced new products/services to market, at ultra-low prices, to gain market share.  Cumulatively, the byproduct of this investment is very low inflation (green line above), exactly what the Fed does not want.  Therefore, by keeping rates low, the Fed has been its own worst enemy.

Ultra-low rates are also a boon for long-duration assets.  Therefore, investors are incentivized, by the Fed, to forgo near-term profitability, and focus on very long term results.  This isn’t a bad thing either.  However, when taken to an extreme, it creates companies that are focused on growing revenues -  maintaining unsustainably low prices - without ever having a chance at profitability. Today, we have a record-number of profitless companies that are selling products/services for unsustainably low prices, exactly what the Fed does not want. Therefore, by keeping rates low, the Fed has been its own worst enemy.

If I ever run into a Fed Chairman - the only question that I have any interest in asking is - Why has the Fed been its own worst enemy?

This is what I believe.

What do you believe?