The Federal Reserve Does Not Have Magic Powers
Jerome “Jay” Powell, the Chairman of the Federal Reserve, is not a wizard, and the Federal Reserve does not have magic powers.
We point this out because — based on arguments we are hearing as to why everything will be “back to normal” soon — a fair chunk of analysts and investors appear to think otherwise.
Of course, they don’t spell out the “magic” part in so many words.
But a popular v-shaped recovery argument relies on magical thinking just the same: The notion that, because the Federal Reserve has backstopped every corporate bond in sight — and sprayed trillions of dollars around in partnership with the U.S. Treasury — the U.S. economy will soon be humming again, and corporate profits will snap back like a rubber band.
This doesn’t make sense. We’ll start with a question to explain why.
If the Federal Reserve, in conjunction with Congress, had the magical ability to erase recessions, don’t you think they would use it every time?
To put it another way, if it were possible to press a button and make an economic crisis disappear — like the memory eraser pen from the Men in Black movies — wouldn’t politicians demand that the mechanism be used for every downturn, let alone every crisis?
If the Federal Reserve and Congress can bring an economy back to life, that would imply they can create wealth.
Politicians and central bankers can create wealth? Really?
Friedrich von Hayek and Ludwig von Mises might have a word on that.
Our hunch is that, for those who wield it, “the Fed will save the economy” is an argument of convenience — like the high back of a sturdy chair, reached out for in a moment of instability, by a man who has lost his balance.
The Federal Reserve does, in fact, play an important role, especially in times of crisis. Central bankers are like firefighters. When you need emergency liquidity, you call them to put the fire out.
Then, too, when central bank fire fighters sound the alarm and swing into action, it does not mean times are good. It means times are very, very bad.
When the Federal Reserve decided to commit to “unlimited” bond buying, backstop the credit markets with a blank check, and partner up with the Treasury and Congress for trillions’ worth of aid, this was not a “break out the party hats” type of moment.
It was more of a “we have to keep the patient from dying” moment.
Think of a car accident victim who has lost a lot of blood. An emergency room nurse rolls up with a blood transfusion cart. If the cart has gallons of blood available, is that a bullish sign?
And which factor matters most: The volume of blood available on the cart, or how much blood is successfully transfused into the patient’s circulatory system?
The following statements seem straightforward:
- A central bank can buy debt, but it can’t enable profits.
- It can juice corporate lending, but not consumer spending.
- It can create liquidity, but not productivity.
- It can print currency, but not prosperity.
This is why the Federal Reserve’s actions in the pandemic can be seen as a necessary rescue element — to keep the house from burning down, or the patient from dying on the table, or both — but not the thing to enable a recovery.
As we have said before, a financial crisis and a crisis in the real economy are not the same thing.
Various forms of financial crisis have occurred, repeatedly, over the past 30 years.
But the current real-economy crisis has no comparison in the modern era, and adding a global pandemic on top means that, to find a historical parallel, we have to look back 90 to 100 years.
What this means is that, while the Federal Reserve can help keep companies from going under, it cannot play a real role in helping them, or the U.S. consumer, bounce back.
It doesn’t matter how cheaply a company can borrow, for example, if a major chunk of revenues and profits are gone. Nor will emergency stimulus make up for 20.5 million lost jobs or consumer savings rates at 39-year-highs.
At the same time, there is the not-so-small matter of the pandemic, which is still ongoing.
The data and the science strongly suggest that, not only is the pandemic far from over, we are still in the early stages. This reality will continue to impact revenues and profits, even if the great reopening is successful (and brutally so if not).
This matters because the U.S. consumer has received a serious psychological shock, as well as a shock to the wallet, and the post-pandemic landscape will feature lower spending levels and a higher savings rate that could well be permanent.
Very few companies will get away from this, and the Federal Reserve can’t help. Some portion of revenues and profits are not just temporarily gone, but permanently gone. They won’t all come back.
Take Coca-Cola, for example, which saw worldwide sales volume fall 25% as a result of canceled or lost sales to fast-food chains, movie theaters, concert venues, sporting-event stadiums, theme parks, large outdoor events, and so on.
Some of that revenue will come back. But how much, and how quickly?
Or take Disney, one of the bluest of all blue chips, which took a $1.4 billion hit to earnings due to a loss of revenues via Disney parks, resorts, cruise ships, movie ticket sales, and merchandise sales across mall stores and other venues.
A fair chunk of that business will come back — though we don’t know when. But again, how much?
Or take Starbucks, which saw same-store sales shrink 60 to 70% in the final week of March.
When Starbucks reopens fully, its stores will have to reconfigure for social distancing rules. More space will mean less foot traffic and reduced turnover.
But the mandated extra space might not be a problem because, with unemployment nearing Great Depression levels, tens of millions of Americans who once thought nothing of a $4 latte have now crossed that off their list.
How will Starbucks recover old glories in a newly frugal world?
Or what about Exxon Mobil, which has to deal with a market cap on par with Netflix and a crude oil forward curve that is sub-$40 a barrel all the way out to July 2023?
The list could go on and on.
These blue-chip companies aren’t going anywhere — though 12 million small businesses could be lost — and the Federal Reserve can assure their corporate bond offerings will be safely buyable.
But the Fed can’t magically bring consumer spending back. And the Fed can’t overcome lost revenues and profits via reduced traffic borne of stepped-up social distancing rules. Nor can the Fed reassure psychologically battered consumers, or fix severe real-economy breakage, or somehow beat the virus.
We’ll have to do that stuff ourselves. And it is going to take a while. Not to mention that, if the U.S. consumer sees a permanent psychological shift toward a higher savings rate, which can logically be expected, the total level of consumer spending that existed pre-2020 (which powered roughly 70% of the U.S. economy) could be out of reach not just for months, but years.