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Jelly Donuts


Ever heard of the jelly donut theory of monetary policy?


Here it is, as explained by David Einhorn from Greenlight Capital:


"The jelly donut theory is that the relationship between monetary policy and the economy is nonlinear. At some point, the sign flips from positive to negative. The analogy to jelly donuts is the first jelly donut tastes great. The second jelly donut is pretty indulgent, but by the 12th jelly donut, you're just making yourself sick, so you really shouldn't do that anymore.


And I think the same is true somewhat with easy monetary policy. If rates are 10%, let's just say, which is pretty high and you lower them to 8%, you're reducing borrowing costs. You're lowering the cost of capital in a material way. It's a 25% reduction in rates, but it's a full 2%, and that's going to cause businesses to build factories that they wouldn't have built when the rates were higher. It's going to cause people to buy houses that they wouldn't have been able to afford when the rates were higher.


But you get to a point where rates are low enough that businesses are going to build whatever factories they're going to do or hold whatever inventory they're going to do and people are going to buy whatever houses and other goods that they want and lowering rates is not any longer going to be the key decision maker to what they're doing. So when you're lowering rates beyond that point and as we approach the zero bound, that's certainly the case, lowering rates from 2% to 1% really doesn't change anybody's decision-making process in the real economy. I don't mean in financial markets, but I mean in just ordinary people and ordinary businesses making decisions.


If the factory doesn't make sense with the 2% rate of interest, it's not going to make sense with a 1% rate of interest because it probably just doesn't make sense. Once you get to the point where rate policy has helped as much as it's going to help, then it begins to hurt. And the reason it begins to hurt is because when you lower rates beyond a certain amount, it becomes a drag on income. The household balance sheet has $17 trillion of interest rate-sensitive assets. Meaning if rates go up a little bit, they get more income; if rates go down, they get less income.


And they only have $5 trillion of interest-sensitive liabilities because the biggest set of liabilities are mortgages, which in the U.S. are 90% fixed. The result is you have a net of $12 trillion of asset sensitivity to short rates on the household balance sheet, which means that if you lower rates 1%, you're taking $120 billion away from households. And if you raise rates 1%, you're adding $120 billion. What's actually happened is, is for a number of years, when they bring rates to really, really low levels, they were actually depressing incomes, and they were actually slowing the economy.


They would think that they were stimulating, but they were actually slowing. And I think what's happened on the other side of that, as we've gone from 1% to 4%, they are very surprised they haven't slowed the economy more. The retail is still good. The consumer is still good. The employment is still high. And I think that's because going from 0% to 4% has basically been a stimulus. It's added probably $0.5 trillion a year to household income and some of that gets spent or invested or whatnot. So I think that the tightening we've had so far hasn't really been effective because it's kind of been like finally getting off the jelly donut diet, and it's actually making the economy probably healthier and stronger."1


Like the sick patient who is trying to wean themselves off painkillers, I'd have thought there would be a rough patch somewhere in the journey from sick, highly medicated economy to healthier economy, as reflected by interest rates moving back to more normal levels; levels where interest rates might actually influence real world decisions and not just financial market decisions. Regional bank problems are indicative of a rough patch - too many banks with long-term assets yielding little as the cost of deposits increases. The UK hit a rough patch last year when UK pension funds liability hedges were turned inside out by rapidly rising interest rates. There's probably still more to come, perhaps an inability to refinance parts of the commercial real estate market; perhaps federal government debt which is rapidly resetting to higher rates and driving up federal interest expense; perhaps corporate borrowers struggling to refinance into higher rates over the next several years.


Remember that monetary policy is generally thought to act with a 12-18 month lag so the worst may be yet to come.


And things may really get interesting if Einhorn's theory holds true and rates move higher from here - into a zone where they might actually begin to influence real world decisions. Maybe that's the next step on the way to the recession we've all been waiting for.


If we get to that point, it would be nice to think the Fed learned something from the last 15 years. More likely, the jelly donuts will be back.


 

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