Federal Reserve Needs To Normalize Interest Rates In 2015

Ordinarily, the plunging oil prices experienced during the last three months would be welcomed as beneficial for the economy — lowering transportation costs and stimulating consumer spending.

But these are not normal times, and the sharp 45% drop in oil prices can trigger a larger financial market crisis and a recessionary contraction.

Prolonged deficit spending and the Federal Reserve’s easy-money policies of debt monetization and zero interest rates have largely absorbed and papered over the debt crisis that brought the U.S. economy to its knees in 2008.

Consider that when the subprime debt crisis unfolded in 2008, total U.S. Treasury debt, including IOUs to Health and Human Services and Social Security, stood at about $10 trillion. Today, just six years later, it exceeds $18 trillion (more than U.S. GDP), with the Fed’s balance sheet having grown by 425% — all in Treasury and mortgage debt.

In the years following the 2008 financial crisis, when the European debt crisis was headline news, U.S. sovereign debt grew at a rate considerably higher than that of other European countries, with the exception of Greece.

In 2011, before the S&P’s downgrade of U.S. government debt from AAA to AA+, Moody’s reported the U.S. debt-to-tax-revenue ratio at over 400% — more than twice that of Germany, France, the U.K., and Canada. Today, only Japan (A1/AA-) and Greece (Caa1/B-) have higher debt-to-revenue ratios than the U.S.

Middle Class Left Out

We now sit atop the largest debt bubble in history, which has fueled rising asset prices — most visible in extended stock prices — and which provides the appearance of a healthy economy.

The Fed’s easy-money policies have made the 2% richest richer on paper, but the bigger reality is that the vastly larger middle class has been almost entirely left behind. Fifty million Americans remain below the poverty line, and the number of food stamp recipients have increased 38% in the last six years.

The debt, real estate and stock market collapse of 2008 started from a relatively small class of subprime mortgage bonds going bad. Today, the triggers for financial market trouble in the U.S. could be a hiccup in a Treasury bond auction, trouble in the settlements of derivatives contracts held by major banks or default on leveraged finance loans or high-yield junk bonds that have facilitated the shale oil explosion — the very sector that has been the main engine of economic growth in recent years.

According to Deutsche Bank and JPMorgan, the energy sector currently accounts for about a third of all capital expenditures in the U.S. and about 18% of all high-yield debt issuance.

It turns out that the shale boom commenced and has been concurrent with Fed’s zero-interest policy, which began at the end of 2008. During the last six years, banks have extended some $400 billion of leveraged loans to oil and gas fracking companies, while high-yield bond issuance reached $175 billion, much of it hedged with derivatives.

The fourth quarter of 2014 witnessed a collapse in the U.S. energy high-yield sector, with some issues plummeting more than 50%. We know from other debt crises that it is important to pay attention to how one sector of the bond market affects other sectors.

Dodd-Frank Failure

Indeed, trouble with bad loans and distressed junk bonds in the energy sector may have prompted money-center banks, led by Citibank, to take concerted action to ensure insertion of language in Congress’ government funding bill, passed just before Christmas recess, that effectively restores taxpayer guarantees on risky derivatives trading. Citibank reportedly has become the largest holder of derivatives among money center banks.

Remember that Dodd-Frank reform priorities were to increase transparency, decrease risk and protect the taxpayer from too-big-to-fail banks. None of those imperatives has been accomplished.

But five years later, the legacy of Dodd-Frank has saddled banks and the economy with increased uncertainty and compliance costs of more than 400 new regulations, many of which aren’t yet finalized.

Given the current high level of risk in the U.S. economy, and specifically the asset bubbles induced by the Fed, 2015 will be a very challenging year. The Fed has basically come to the end of the line. It cannot cut zero-interest rates further, and further debt monetization on top of a $4.5 trillion balance sheet is too risky to contemplate.

What is essential for 2015 is more economic growth from fiscal policies of tax reform and regulatory relief, which would help the Fed expedite normalization of interest rates and selling assets to shrink its balance sheet.

This is absolutely imperative not only to break the cycle of economic malaise but also to restore the nation’s economic insurance policy. As long as it exists and if for no other purpose, the Fed should have the essential tools needed to cope with the next inevitable financial crisis.