Fed’s US Debt Bomb

With the Federal Reserve’s first rate-hike cycle in nearly a decade looming, traders are working overtime trying to divine its timing and impact on the markets. They are closely monitoring the same employment and inflation data the Fed will use to start tightening. But there’s another little-discussed concern for the Fed, the solvency of the US government. The Fed’s zero-interest-rate policy has spawned a grave US debt bomb.
Back in late 2008, the US stock markets suffered their first true stock panic since 1907. This once-in-a-century fear superstorm proved catastrophic. In a single month leading into October 2008, the flagship S&P 500 stock index plummeted 30.0%. Over 6/7ths of these losses happened in 2 weeks, a massive 25.9% cratering! That exceeded the threshold for a stock panic, which is a 20% plunge in a couple weeks.
Such extreme selling catapulted fear so high that the S&P 500 had fallen another 11.4% less than a month later! The American central bankers certainly weren’t immune to this epic fear, so they joined the traders in panicking. The Fed feared that the stock panic’s wealth effect, the tendency for weaker stocks to retard consumer spending, would cast the entire US economy over a cliff right into a new great depression.
So the central bankers acted quickly to try and restore confidence through shoring up the devastated stock markets. The Fed slashed its key federal-funds rate two separate times in October 2008 for 50 basis points each. This certainly didn’t stop the extreme stock selling, so the Fed desperately made an enormous 100bp cut in December! That blasted the federal-funds rate to zero, beginning the ZIRP era.
Running a zero-interest-rate policy is an extreme measure that central banks rarely use. It is reserved for dire economic emergencies, and then promptly reversed soon after. Indeed upon panicking into ZIRP, Fed officials promised that highly-distorting condition would be temporary. Yet here we are, 6.9 years later, and ZIRP is still in place! The Fed has lacked the courage to normalize its extreme stock-panic policies.

This post was published at ZEAL LLC on October 30, 2015.