US Fed is really in the business of running a bubble economy

The US Federal Reserve will cut interest rates this month. The purpose is to manage fears over a bursting artificial intelligence (AI) stock bubble and, if the situation can’t be saved, to prevent the malaise from spreading to all other asset classes. The Fed’s lesson from the 2008 global financial crisis is to prolong a bubble economy by any means possible. A rate cut is a way to keep the animal spirits alive. Talking about a Fed rate cut has been a psychological crutch for asset markets for two years. Markets expected as many as six cuts at the start of the year, but expectations have fluctuated since then. The Fed has played along, because it wants asset prices to stay high, which is key to the US economic model. Teasing can only go so far though. When the AI bubble seemed to be in trouble last month, markets were looking for rate cuts to steady nerves. The Fed is going along with them; it wants speculators to believe that it will always be there for them. Rate expectations are usually accompanied by esoteric discussions about balancing employment against inflation – don’t fall for the marketing. When an economy floats on a huge bubble, both derive from asset inflation. The asset market is the elephant in the room. Inflation is its spillover. Low inflation has been a big lie in the United States. Median home prices in the US have risen by 3.6 per cent per annum over the past two decades, healthcare costs by 3 per cent, and new car prices by 3 per cent. These costs have been on a clear uptrend, implying persistent inflationary pressure. US imports account for roughly 14 per cent of its GDP, mainly consumer goods. Cheap imports have obscured the US’ inflationary tendency. That excuse was good enough for the Fed to undertake US$8 trillion in quantitative easing between 2008 and 2022. Inflation has been high in the past three years because the US government borrowed and spent massively, which translated monetary excess into demand. The status quo ante can be restored if the government cuts back on borrowing; but this is not happening. Inflation does cool on its own, as long as the exchange rate is stable. It doesn’t imply any change in the underlying inflationary dynamics. During the spike of 2021-23, inflation averaged 5.6 per cent, while the Fed funds rate averaged 2.2 per cent. The real interest rate averaged minus 3.4 per cent. Currently, inflation is running at 2.9 per cent while the Fed funds rate stands at 5.3 per cent. Although this yields a positive real interest rate of 2.4 per cent, it isn’t high by historical standards, nor has it stood long enough to make up for the years in negative territory. The Fed cares about perception, not reality. Lower headline inflation changes the conversation on Wall Street, but not Main Street. The cost of living crisis remains the biggest issue in the presidential election. If the price of a burger doubles but then stops rising, a celebration for the end of inflation won’t go down well with burger eaters. If inflation flares up again after the rate cut, which is a distinct possibility, the Fed will be in more trouble. The interest rate story has twists and turns ahead. The cutting trend may not survive for long. The Fed has been running a bubble economy for a long time. Over two decades, US household net worth as a multiple of gross domestic product has risen from 4.5 to about 6. The Fed took advantage of the disinflationary pressure from globalisation and printed massive amounts of money. Both consumers and the government borrowed more and more to spend. The corporate sector has made more money from debt-financed demand. The financial market assigns high valuations to businesses on a good profit trend. Property prices rise because buyers can borrow more when interest rates are lower. The whole thing is essentially a Ponzi scheme. If the US bubble bursts, valuations have a long way to fall. Household wealth needs to decline by two times GDP to normalise. American society could be destabilised for a prolonged period. It is understandable that the Fed wants to maintain the bubble for as long as possible. The US financial sector has been restructured to prevent another 2008-like collapse. The fund management industry has consolidated so much that three firms account for over 80 per cent of the market. A sell-off in the stock market isn’t likely to snowball. If the bond market gets into trouble, the Fed will surely buy. Even if the dollar gets into serious trouble, the US could pressure its allies to buy it up. The US has built a fortress to make the bubble last. The US bubble economy needs foreign funding. The United States runs large current account and fiscal deficits. The dollar’s reserve currency status plays a key role in plugging the holes. Foreign ownership of US securities amounts to 100 per cent of American GDP. The US has become the sinkhole for global liquidity. The fate of the US economy rests on foreign confidence in America. This ought to drive Washington’s foreign policy. Some conflict is good for the US, as it is a safe haven for investment. But a great war would pull down global supply and trigger an unravelling of the US economy. The United States doesn’t want a big war. We can all take some comfort from this.

US Fed is really in the business of running a bubble economy

.css-1c6uqr6{color:inherit;font-weight:inherit;font-size:inherit;font-family:inherit;line-height:inherit;overflow-wrap:break-word;}A rate cut by the US central bank would help asset prices to stay high, which is key to the US model

A rate cut by the US central bank would help asset prices to stay high, which is key to the US model