Central Banks Have Lost Firepower, Kaufman Says
Recent rate cut won’t address a crisis, former Salomon Brothers economist says
Economist Henry Kaufman earned the sobriquet of “Dr. Doom” for his gloomy but accurate forecasts of rising interest rates in the late ’70s and early ’80s.He apparently is still deserving of that nickname.
The 92-year-old Dr. Kaufman, who was chief economist and senior partner at the old Salomon Brothers, which he joined in 1962 after serving on the Federal Reserve Bank of New York, argues that the Fed has been keeping rates lower than it should in an ill-conceived bid to prop up markets. And the result, he says, is that the central bank is now going to be hard-pressed to respond appropriately to economic and market crises that are arising.
Specifically, Dr. Kaufman fears that central banks have lost sight of one of their main jobs: allowing markets to correct. Periodic market and economic contraction is essential, he believes, for washing out excesses and normalizing key market relationships. In the search for yield, for example, bond investors shouldn’t be crossing over en masse from debt into equities to find income, driving up stock valuations well beyond their true worth and increasing market risk.
In the large picture, Dr. Kaufman thinks central banks are also failing to help financial institutions balance their focus between their fiduciary responsibility to preserve society’s wealth and their own entrepreneurial drives for profit. There has been too much focus on the latter, in Dr. Kaufman’s view.
The Fed’s reluctance to raise rates, Dr. Kaufman believes, also means that it has little room left to cut to meet a crisis head on—like one that could result from the current fears over the coronavirus.
With the 10-year Treasury having closed Friday yielding just 0.709%, Dr. Kaufman said, “Across my entire professional career, I’ve never seen anything like this. This interest-rate structure is unprecedented. It suggests central banks will not be able to deal with the current crisis, and all of this unnerves me.”
Since leaving Salomon in 1987, Dr. Kaufman has managed his consulting firm and has written several books on money and markets. He recently spoke with The Wall Street Journal about central banks, securities markets and the crisis surrounding the coronavirus. While the Fed cut its target rate a half percentage point on March 3 to combat economic fears related to the coronavirus, he says this will do little to address the underlying crisis.
Edited excerpts of the conversation follow:
WSJ: In your last book, “Tectonic Shifts in Financial Markets,” you labeled a chapter: “You Can’t Go Home Again.” Please explain its relevance to today’s markets.
DR. KAUFMAN: Broadly speaking, central banks around the world have been making interest-rate decisions that are based on market—rather than sound economic policy—concerns. Their goal, especially since the last recession, has been to keep markets rallying instead of to allow rates to reach more traditional levels after economies recovered. Higher rates would have recalibrated risk, having made borrowing more expensive, forcing restructuring, perhaps even defaults, while encouraging savings due to higher yields on risk-free assets. This approach would likely have taken some of the steam out of stock markets, which central banks didn’t want to do.
WSJ: Is having less market cyclicality necessarily a bad thing?
DR. KAUFMAN: By losing cyclicality, major central banks have lost their economic benchmarks on which their decisions are based. Without traditional guideposts in place, central banks are in unknown territory. This has complicated monetary policy and may prevent banks from effecting desired change, which in the past they were able to deliver.
WSJ: If the coronavirus causes a sustained collapse of market capitalization, business reinvestment and consumer confidence, can central banks help?
DR. KAUFMAN: It’s too early to know how far the virus will spread. But it does enhance the risk of global recession, especially given the interconnectedness of national markets and economies.
Central banks do not have the firing power they had when markets were permitted to be more cyclical. With interest rates at historic lows, I seriously doubt we can see any material stimulus from further interest-rate cuts. Even if the Fed brought rates down to zero, it’s hard to see how that would revive a global economy infected by a pandemic virus. The only impact the Fed could have is to give a psychological boost to equity markets. So far, the Fed’s recent 0.5% rate cut hasn’t even done that.
WSJ: Where do you think interest rates should have risen to after the financial crisis?
DR. KAUFMAN: Several years after the financial crisis of 2008, I would have liked to have seen the Fed move sooner and more aggressively than it did, pushing the fed-funds rate to 3.5% instead of having topped out at 2.42%. This might have pushed three-month Treasury bills to a more desirable level of 3.5% and 10-year yields to around 4.5%. Instead, these two benchmarks peaked at 2.4% and 3.23%, respectively. Had rates moved up accordingly, this would have given the Federal Reserve some firing power to deal with the current crisis.
WSJ: Where are we in terms of quantitative easing as a monetary tool in the Fed’s belt? [QE is another way the Fed can alter interest rates by significantly buying bonds to drive prices higher and rates lower.]
DR. KAUFMAN: The Fed hasn’t fully unwound past easing, and the Fed again used its balance sheet to deal with the recent liquidity problems in the repo market [the Fed’s repurchase agreement operation]. If the Fed returned to an aggressive use of QE, it could well push 10-year Treasurys to 0%. But I’m not sure what good that would do.
WSJ: If we can’t rely on monetary policy to respond to the crisis, can we look to federal spending to provide a boost to the economy?
DR. KAUFMAN: Unless something extraordinary happens, a meaningful increase in spending is not likely during an election year.
WSJ: Given the scenario you’ve laid out, what should investors do to protect themselves?
DR. KAUFMAN: Most people’s money is managed by large institutions. How they fare during this free fall has been predetermined by the way managers have structured their asset exposure—how they’ve balanced their search for return and management of risk. Most individual and institutional investors do not have the capacity or the flexibility to significantly alter that exposure over the near term.
WSJ: If equity prices take a major, protracted hit, how will it affect the economy and the prospects for growth?
DR. KAUFMAN: It will significantly slow down consumption, it will prevent recovery of capital spending by business, and likely cut into housing sales and prices. And this reconfirms my belief in the ineptness of monetary policy over the last couple of decades. The Fed could resort to buying corporate debt like the Japanese central bank has done. Right now I don’t think that’s in the cards. But it may well be inevitable.
WSJ: Do you fear if the Fed pushes rates down much further we could end up locked into the kind of stagnation that has vexed Japan and now Europe, where monetary and fiscal policies have lost their effectiveness?
DR. KAUFMAN: As monetary easing continues, credit quality will worsen in the private sector, and U.S. government borrowing will further rise with the annual budget deficit likely to surpass $1 trillion in the coming years. [Dr. Kaufman notes the U.S. has only two companies with AAA ratings; in the 1980s, there were more than 60.] I fear this scale of deficit will likely become the norm. This is not a healthy combination for the economy and future growth.
WSJ: Do deficits matter anymore?
DR. KAUFMAN: Not sure. But the system cannot afford to have significantly higher interest rates because of the impact it will have on both indebted companies and the government. And this may result in a cut of the U.S. government’s credit rating.