The Fed Is Playing A Dangerous Game
In an ideal world, we wouldn’t have to read the Federal Reserve’s rabbit entrails to discern the economy. But Since the Fed exists in the real world, and its decisions matter, we have to pay attention.
Just so new and perhaps even old readers know my views on the Fed: I believe we need it to handle the practical matters of the banking system plus interact with other international central banks (we live in a complicated world) and, in the midst of crisis, act as a lender of last resort and liquidity provider. I agree with Walter Bagehot’s (pronounced badget) very important pronouncement (often called "Bagehot's Dictum") that “in times of financial crisis central banks should lend freely to solvent depository institutions, yet only against sound collateral and at interest rates high enough to dissuade those borrowers that are not genuinely in need.” That rule or dictum remains wise.
I would prefer that the market set rates at the lower end as opposed to the Federal Reserve, again, except in times of crisis. I don’t believe 12 people sitting around a desk, no matter how brilliant and educated they are, can arrive at a proper market-clearing rate better than the market itself. Seriously, LIBOR was set for decades without government intervention. Yes, in times of crisis it got a little funky, but that is when you want the central bank to step in (and then get out as soon as possible).
Infested with Crawdads
Following Fed policy has been whiplash-inducing over the last year. It was just two months ago that Jerome Powell set off a market panic by suggesting the FOMC would do what it thinks is right and let asset prices go where they may. They were promising at least two if not three more rate hikes in 2019. The stock market fell out of bed.
Fast-forward to now and it seems the market won and got the “Powell Put” it wanted. The Fed has given up its tightening dreams and might even loosen policy. It is even (gasp!) losing its fear of inflation.
Nassim Taleb in his book Antifragile argues that preventing small “crises” from happening on a regular basis eventually causes a very large crisis. It’s analogous to not allowing small forest fires to clear out undergrowth. Eventually you get one very large fire which is far more destructive. The Fed assuming a “third mandate” to protect asset prices is similarly dangerous.
To understand what’s going on, we need to review some ancient history, and by “ancient” I mean December 2018. That’s several eons ago in today’s news cycle.
Recall what had just happened. The US stock benchmarks had peaked in September before weakening to create a rough fourth quarter. The Fed was continuing to raise rates even as President Trump grumbled they were hurting the economy. In early December he had called a temporary delay on higher Chinese import tariffs. That helped a little but Wall Street was still worried. The Fed seemed tone deaf.
On December 19, following a regular FOMC meeting, Powell held the usual news conference which was, not to put too fine a point on it, a disaster. The more he talked, the more markets plunged as he seemed to dismiss concerns the Fed was affecting asset prices.
I said two days later in Powell, the Third Mandate, the New Fed and Crawdads that I thought this was exactly the right move. Powell’s predecessors had given the Fed an unofficial third mandate: defend stock prices as well as maintain low inflation and full employment. His comments that day seemed to reveal Powell had no interest in continuing that practice.
As I said in that letter,
I went on to explain how we would know if Powell were serious, metaphorically using the little creatures we call “crawdads” in Texas.
Unfortunately, I am not applauding in that way. Powell is crawdadding as fast as one can without actually changing species. I now wonder if he was serious in the first place.
Steadily More Dovish
Recall how FOMC meetings go. They have two days of meetings, issuing a policy statement mid-day on the second one, followed by a news conference with the chair.
On December 19, Powell told the media,
But the minutes of the meeting he had just emerged from, which were released on January 9, said,
Now, Fed statements are so dense you can probably argue these are consistent. But it sure looks to me like the FOMC observed market volatility and decided they should be “patient about further policy firming.”
That is not at all the impression Powell gave in public that day. Markets would not have fallen had he talked about patience. They would have more likely rallied.
So what was going on? I wish I knew. The minutes don’t identify who said what, so possibly this reflects some disagreement on the committee. Maybe Powell wasn’t among the “many participants” who thought patience was in order. I doubt that, however, because other speeches and statements since then show the FOMC getting steadily more dovish.
In December, I said that raising the benchmark rate while they were also reducing the balance sheet was a mistake, and they should do one or the other. Now they seem intent on stopping both soon, with Powell’s full assent. That was nowhere on the radar screen just three months ago.
In theory, central bankers are supposed to worry about inflation. The Fed and its peers in other countries exist partly because their governments tired of dealing with out-of-control inflation. Not that they are against inflation completely; they just want it to happen on their terms.
For the Fed, acceptable inflation is 2%, as measured by PCE (not the better-known CPI). It ran below that level for most of this growth cycle and is only now catching up. So they should be happy. They are not.
Last week Richard Clarida, the newly-installed Federal Reserve vice chair, told a monetary policy conference at (where else) the University of Chicago that the Fed might give itself a little do-over. Without changing the 2% target, they would consider allowing a period of above-2% inflation to compensate for the years it was below the target.
We’ve heard this before. Fed officials talk sometimes about letting the economy “run hot” since it was lukewarm for so long. They haven’t done so because the economy hasn’t wanted to run hot. It has not been an option recently. What would be “hot” in this context is unclear. Maybe 4% real GDP growth? If that’s what they now consider unusually strong, we have bigger problems. 2018 appears to have been the best year since 2005 at roughly 3% growth.
In any case, this is a dangerous game, mainly because the Fed has little control over how such inflation would be distributed. If it shows up mostly in asset prices, it will reward the wealthy and punish the lower 80%, who will face higher costs for housing, health care, and other essentials. That is a political problem, as we’ll discuss below.
Then this week, Powell went to Capitol Hill for his semiannual congressional testimony. He specifically noted the Fed is watching the markets: “Financial markets became more volatile toward year end, and financial conditions are now less supportive of growth than they were earlier last year.”
Powell went on to say the Fed remains “data dependent” and that it could adjust the balance sheet based on “financial and economic developments.” My friend Peter Boockvar noted in one of his multiple (and highly valuable) daily letters that Powell really meant “S&P 500 dependent.”
That, my friends, is what I meant by crawdadding. Powell has turned the other direction and is now bent on pleasing investors, the exact opposite of the impression he so carefully gave in December.
Why the change? Did the economic data change significantly? I don’t think so. My best guess is Powell simply got cold feet. He is worried about recession on his watch and wants to prevent it if he can, or at least make the Fed look less responsible for it.
Michael Lebowitz summed it up:
Remember, the “Bernanke Put” didn’t end the Great Recession or the bear markets that accompanied it. The Powell Put is no more powerful. Can it have short-term, market-friendly results? Absolutely. For longer than we might think? Assuredly. Can corporations continue to build up high-yield debt to unsustainable levels? They’re trying. As long as the music keeps playing, they will continue to dance.
I think Powell is probably changing course too late, but he might buy another year or so. And given where we are in the electoral cycle, that could make a difference. A recession starting in early 2020 would certainly make Trump’s reelection path more difficult. Further, merely postponing recession won’t make everyone fat and happy.
Specifically, it is quite possible and even likely that a Fed decision to keep policy soft and let the economy run hot will raise middle-class living expenses faster than it raises middle-class wages. That will make it easier for Democrats to argue the Trump policies aren’t delivering the promised results. Then in January 2021 we could see a hard-left Democratic president with solid majorities in both House and Senate. Taxes will rise sharply soon after, as will the deficit when those who argue for more federal spending and even MMT proponents start getting their way.
There is no free lunch. Large deficits will have a cost. Yes, more QE of $3 trillion or $6 trillion or more is possible. As I will demonstrate in a future letter, the cost will be slower economic growth and greater wealth and income disparity. It may not be a crisis, but more of a slow grind that requires a different investing mindset.
I don’t want to be pounding the SIC at you, as like I said we are going to sell out, but that is one of the questions that I have brought this specific group of speakers together to answer. I want to dig a lot deeper and broaden my own understanding. This is going to be one of the most important topics that we face in the coming years. Hope is not a strategy.
Right now, investors seem happy to have the Fed back on their side. I think we may regret having that wish granted.
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