MainStreet Macro: No Free Lunch

There’s a saying in economics – there’s no such thing as a free lunch. The idea is that things that look free often have hidden cost.

The cost of borrowing, for both Main Street and Wall Street, isn’t exactly free, but it is really, really cheap right now thanks to the Federal Reserve’s easy-money policy, which has kept interest rates at rock-bottom levels.

But all that cheap money can come at a high cost to all of us down the road. When Fed governors meet this week to take their regular measure of the economy, they’ll be weighing three of the biggest tradeoffs of cheap money.

1. Less room to maneuver

Interest rates have been low in the U.S. and around the world for more than a decade. The Fed’s main policy tool, the federal funds rate, peaked at only 2.5% in the decade between 2010 and 2020, far lower than the historical average since the 1950’s of roughly 5%. 

By the time the pandemic arrived, rates already were so low that there wasn’t much left for the Fed to cut. Beginning in March 2020, the Fed has lowered the federal funds rate by 1.5 percentage points, to almost zero. By comparison, it cut rates by 5 percentage points during the Great Recession. 

The lesson here is that the lower rates are in good economic times, the less wiggle room the Fed has to stimulate the economy during bad times.

Source: St. Louis Federal Reserve Economic Research

2. Bigger Balance Sheet

During the pandemic, the Fed has whipped out its proverbial credit card (it’s actually more like Venmo) to purchase $4 trillion in government bonds to drive down the cost of long-term borrowing for Main Street businesses and consumers. As a result, the central bank’s balance sheet has doubled in less than two years.

Before the Great Financial Crisis of 2007, the Fed’s portfolio had never exceeded $1 trillion. In a process known as quantitative easing, the Fed began buying Treasurys and government-backed mortgages, effectively lowering long-term rates by creating new, continuous demand for bonds.

The program was intended to be temporary, but it’s lingered ever since. The Fed pared back its purchases in 2013 and 2014, and even briefly whittled down its asset stash in 2017. But in 2019 it returned to bond-buying to boost the then-tepid economy.

Shortly before the pandemic, the Fed’s balance sheet stood at $4 trillion. Less than two years later, it stands at more than $8.4 trillion.

The upshot: Even after a decade of growth following the financial crisis, the Fed was unable to completely remove the extra support it had given to financial markets and the economy. Now the balance sheet is even bigger, and it’s become even harder for the Fed to disentangle heavy-handed monetary stimulus from the economy.

Which leads to the third cost of cheap money – the potential for mistakes.

3. Potential for a policy mistake

The Fed prefers to warm interest rates in a crock pot rather than a microwave – low and slow. So when the central bank wants to back off on the stimulus, it doesn’t just sell off $8.4 trillion in bonds all at once. Its first step typically is to slowly reduce monthly bond buying.

Only after the Fed tapers its asset purchases does it bring interest rates up slowly, over a period of months or even years, to get back to a more neutral level that won’t push the economy into overdrive.

The spoiler to this playbook is inflation. Inflation has cooled over the past two months, but at 4% in August it’s still way above the Fed’s 2% target. Keeping cheap money in place for too long could allow inflation to build to levels that are harmful to the economy. That would force the Fed to aggressively hike rates again sooner rather than later.

My Take

The Fed moved aggressively in the wake of the pandemic. Slashing interest rates and buying bonds were just two necessary actions that effectively stifled economic fallout from the health crisis when the economy nose-dived by 30% in the second quarter of 2020.

Since then, the U.S. economy has surpassed its pre-pandemic trajectory. This is almost entirely due to the Fed’s healthy serving of monetary stimulus and more than $5 trillion in fiscal support from Congress.

When Fed officials hold their regularly scheduled September policy meeting this week, they’ll certainly discuss how to normalize policy at a time when all is not back to normal. The coronavirus is still a front-burner health and economic concern, the labor market is still recovering, and supply bottlenecks continue to push up prices. 

Withdrawing stimulus too quickly could slow the jobs recovery. Waiting too long could lead to even higher inflation.

If the Fed makes the wrong choice, Main Street will be picking up the check for all that cheap money.