Another Coin in the Fuse Box

Doug Nolan

It’s not as if we’re lacking history as to how this works. Some two decades ago the Greenspan Fed’s “asymmetrical” (baby-step “tightening” measures versus aggressive rate slashing and market support) policy approach emboldened speculation and nurtured precarious Bubble Dynamics. “Asymmetrical” then took on a whole new meaning during the post “tech” Bubble backdrop, as the Greenspan/Bernanke Fed held rates at 1% in the face of double-digit mortgage Credit and house price inflation. Confidence that the Fed (and Washington) would never tolerate a housing bust proved integral to prolonged excesses that ensured a historic Bubble.

Credit is inherently unstable. Market-based Credit is potentially highly destabilizing. And I would strongly argue that the proliferation of market-based Credit within a global backdrop of unfettered “money” and Credit is a recipe for catastrophe. This is the heart of the problem that officials refuse to acknowledge. 



The profound financial innovation that gathered momentum during the nineties beckoned for a major rethink in monetary management. Special precautions were needed to ensure that monetary management was not allowed to compromise market discipline. In short, increasingly speculative and leveraged markets required a shorter leash; the Federal Reserved needed to “lean against the wind.”

The Fed responded to market changes, although it took the opposite approach: Monetary policy shifted to providing an increasingly unstable marketplace more certainty, liquidity and market backstops. Moreover, the Fed looked the other way as the GSEs evolved into powerful liquidity backstops for the leveraged speculating community. The Fed repeatedly accommodated market speculation, as the game became rigged in favor of sophisticated market operators. Indeed, the activist Federal Reserve turned progressively assertive in using market manipulation as a stimulus mechanism. 

   
Back in 2011, when the Fed was formalizing its “exit strategy,” I titled a CBB “No Exit.” At the time the Fed publically detailed its plans for normalizing interest rates and, importantly, its balance sheet that had inflated to $2.1 TN. I was confident that our central bank was much too optimistic in the markets’ capacity to absorb the selling associated with the Fed shrinking its securities holdings. I had no idea that rather than “normalizing” the Federal Reserve’s balance sheet a few years later would approach $4.5 TN.

I have in the past posited that the individual QEs exerted quite divergent effects. QE1 essentially accommodated marketplace deleveraging. If not for QE1, the hedge fund and derivative complexes would be a fraction of their current size. QE2 unleased massive liquidity that fueled “Terminal Phase” excess throughout EM and commodities Bubbles. Then, with EM Bubbles faltering and bond markets floundering, the QE3 liquidity onslaught set it sights on the asset class with the strongest upward momentum at the time: equities. Liquidity will seek out assets with the strongest inflationary biases.

Yet the Fed remained disinterested in the actual consequences of its “money”-printing operations. Theory claimed that injecting huge amounts of liquidity into the securities markets would raise the general price level and spur spending, investing and economic development more generally. If results demonstrated less than effectiveness, it was only because monetary stimulus had been employed in insufficient quantities.

When the Bernanke Fed scrapped its “exit strategy” it was imperative to avoid conveying an “asymmetrical” approach to its balance sheet – that it would be very hesitant to reduce holdings (extract liquidity from the marketplace) while quick to aggressively expand its securities portfolio (create liquidity). The Fed needed to state emphatically that the nuclear option was now off the table. Our central bank did the opposite and the predictable materialized: the Fed (and global central bankers) became hostage to runaway securities market Bubbles.

Bernanke committed yet another huge blunder back in 2013 – one that went largely unnoticed. When an intense “risk on” market backdrop began to waver, he commented that the Fed was ready to “push back against a tightening of financial conditions.” By this time, booming securities markets had become even more essential to the functioning of the broader economy – through both the financing channel (debt and equity) and wealth effects. That the Fed years after the crisis was so sensitive to any indication of fledgling market risk aversion, along with the Fed repeatedly delaying even a little 25 bps start to rate “normalization,” essentially signaled to the marketplace that the Fed had little tolerance for a bout of “risk off,” let alone a bursting Bubble or bear market.

The Fed should have from the get-go (2009) – back when the scheme was developed to induce “money” into the risk markets; back when the securities markets and associated wealth effects were the centerpiece of extraordinary post-Bubble reflationary measures – they should have formulated a strategy to ensure it did not become locked into sustaining market Bubbles of its own making. Somehow, the overarching central bank “financial stability” mandate has morphed into ensuring Bubbles don’t burst.

Back in the 1960s, Alan Greenspan was said to have explained to a group of ideological compatriots that the Great Depression was caused by the Fed repeatedly putting “coins in the fuse box” during the Roaring Twenties Bubble period. About the same time, Milton Friedman came with a revisionist view: the twenties were the “Golden Age of Capitalism,” while responsibility for the Great Depression rested primarily with the derelict Federal Reserve that failed to both administer aggressive monetary stimulus after the stock market crash and recapitalize the banking system.

(Friedmanite) Dr. Bernanke professes that a senseless shortage of money was the root cause of economic depression. If only helicopters had been available to drop money on families to buy shoes and automobiles; on corporations to invests and hire; on governments to spend; and on banks to recapitalize and lend – the despair and destruction of the Great Depression could have been avoided.

I side with the Roaring Twenties “coins in the fuse box.” Repeatedly, the inexperienced Fed backstopped the boom. The perception that the Fed could abrogate financial and economic crises became paramount. Confidence was certainly bolstered by momentous technological advancement coupled with unmatched gains in national wealth. And throughout the decade, securities speculation and leveraging proliferated. After awhile it seemed normal.

Securities leveraging had surreptitiously evolved into the prevailing source of system Credit and leveraging that was fueling a highly imbalanced “Bubble Economy.” By the late-twenties, “Wall Street” had essentially become a massive financial scheme, reliant on ever increasing amounts of securities Credit and speculative excess. Intense speculation, liquidity abundance and booming securities markets had financed scores of enterprises that were viable only so long as the Bubble continued to inflate. The financial scheme collapsed with the 1929 stock market crash, ushering in a period of acute instability for both the financial system and real economy. 
 
The Great Depression was fundamentally the system’s response to the deep systemic structural impairment that had compounded throughout the Bubble period.

Long ago it was well understood that central banks should not be in the Credit allocation business. There needed to be an intense debate when the Greenspan Fed bailed out the stock market in 1987, slashed rates and manipulated the yield curve in the early-nineties, and then became intensely involved in various bailouts throughout the nineties. There needed to be an intense debate about the role of the GSEs. There needed to be an intense debate about the radical notions of Dr. Bernanke. There needed to be an intense debate about the Fed’s ploy to use mortgage Credit to reflate. There needed to be an intense debate about the Fed targeting securities market inflation and all the QEs. Policies were accepted without serious discussion in 1987 because of the fear of another Great Depression; in the early-nineties because of fear of deflation, ditto the nineties as well as the new Millennium.

Chair Yellen’s Tuesday (The Economic Club of New York) speech is worthy of serious discussion. A Bloomberg headline: “Yellen Takes Control of Fed Message to Stress Gradual Approach.” It was already clear to everyone that the Fed would take an extremely gradual approach to “normalization.” The chair’s assertiveness gives the appearance of global monetary policy being dictated by team Draghi, Yellen, Carney, Kuroda and Zhou. It’s remarkable that Yellen deems it necessary to assure the markets that the Fed is prepared to employ additional “money” printing (QE):

Yellen: “Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long-term interest rates and so support the economy--specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities. While these tools may entail some risks and costs that do not apply to the federal funds rate, we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed.

Yellen: “In December, the Federal Open Market Committee (FOMC) raised the target range for the federal funds rate, the Federal Reserve's main policy rate, by 1/4 percentage point. This small step marked the end of an extraordinary seven-year period…”

Noland: Moving short-term rates slightly above zero surely does not mark the end of years of extraordinary policy accommodation.

Yellen: “As has been widely discussed, the level of inflation-adjusted or real interest rates needed to keep the economy near full employment appears to have fallen to a low level in recent years. Although estimates vary both quantitatively and conceptually, the evidence on balance indicates that the economy's ‘neutral’ real rate--that is, the level of the real federal funds rate that would be neither expansionary nor contractionary if the economy was operating near its potential--is likely now close to zero.

Noland: The concept of a so-called ‘neutral’ Fed funds rate is deeply flawed. The securities markets now dictate whether the backdrop is “expansionary” or “contractionary” – and powerful “risk on” or “risk off” dynamics can these days take hold at any level of short-term interest rates.

Yellen: “In my remarks today, I will explain why the Committee anticipates that only gradual increases in the federal funds rate are likely to be warranted in coming years…”

Noland: The acutely unstable Bubble backdrop will for the duration provide convenient justification for gradualism. More importantly, maintaining extraordinary accommodation and prolonging Bubble excess only exacerbates structural impairment and systemic risks more generally.

Yellen: “More generally, the economy will inevitably be buffeted by shocks that cannot be foreseen. What is certain, however, is that the Committee will respond to changes in the outlook as needed to achieve its dual mandate.”

Noland: With the fragile global (faltering Bubble) backdrop in mind, such comments signal to market participants that another round of QE is virtually inevitable.

Yellen: “Financial market participants appear to recognize the FOMC's data-dependent approach because incoming data surprises typically induce changes in market expectations about the likely future path of policy, resulting in movements in bond yields that act to buffer the economy from shocks. This mechanism serves as an important ‘automatic stabilizer’ for the economy… In addition, the public's expectation that the Fed will respond to economic disturbances in a predictable manner to reduce or offset their potential harmful effects means that the public is apt to react less adversely to such shocks--a response which serves to stabilize the expectations underpinning hiring and spending decisions.

Noland: Market participants are all too confident that the Fed subscribes to the “whatever it takes” monetary management school of ensuring that Bubbles don’t burst. When de-risking/de-leveraging starts to gain momentum, bond yields collapse in anticipation of safe haven demand and crisis management policy measures. Chair Yellen may see this as an “automatic stabilizer,” while I view it as yet “Another Coin in the Fuse Box.” Bear markets and recessions are Capitalism’s indispensable circuit breakers.

Yellen: “Such a stabilizing effect is one consequence of effective communication by the FOMC about its outlook for the economy and how, based on that outlook, policy is expected to evolve to achieve our economic objectives. I continue to strongly believe that monetary policy is most effective when the FOMC is forthcoming in addressing economic and financial developments such as those I have discussed in these remarks, and when we speak clearly about how such developments may affect the outlook and the expected path of policy.

Noland: “The Fed has learned frustratingly little from previous fiascos. Extended periods of ultra-low interest rates in conjunction with public assurances of liquidity support and market backstops promote leveraged speculation along with associated financial and economic imbalances. Central bank “transparency” is pro-Bubble and thus counter-productive to financial stability.

Yellen: “The FOMC left the target range for the federal funds rate unchanged in January and March, in large part reflecting the changes in baseline conditions that I noted earlier. In particular, developments abroad imply that meeting our objectives for employment and inflation will likely require a somewhat lower path for the federal funds rate than was anticipated in December. Given the risks to the outlook, I consider it appropriate for the Committee to proceed cautiously in adjusting policy. This caution is especially warranted because, with the federal funds rate so low, the FOMC's ability to use conventional monetary policy to respond to economic disturbances is asymmetric.”

Noland: More importantly, global Bubble and policy backdrops ensure the FOMC's (and global central banks’) proclivity to use unconventional monetary policy (i.e. QE) in response to market disturbances. At this stage of heightened monetary disorder, prospects for more “whatever it takes” central bank stimulus is highly destabilizing for global markets.

It was another highly unsettled week in the currencies. The dollar index dropped 1.6%, with prevailing dollar weakness versus EM and developed currencies. The South African rand jumped 4.9% and the Brazilian real gained 3.4%. The commodity currencies – Australia, Canada and New Zealand – all gained at least 2%. The euro traded near a six-month low. The Malaysian ringgit gained 3.6% and the Turkish lira rose 2.0%.

With the Japanese yen trading near 17-month highs, Japan’s Nikkei equities index sank 4.9% (down 15.1% y-t-d). Global equities were erratic. Italian equities dropped 2.1%, as the Italian bank index sank 5.8% (down 33.4% y-t-d). European banks had another rough week, with the STOXX Europe 600 Bank Index down 2.7% (down 21.9% y-t-d). Spanish stocks declined 2.1%, and French stocks posted a small loss for the week. Germany’s DAX index declined 0.6%.

U.S. stocks responded strongly to Yellen, although there were notable divergences. The more speculative sectors enjoyed a big week. The biotechs surged 5.7%, the Nasdaq100 gained 2.9% and the small cap Russell 2000 surged 3.5%. At the same time, the banks (BKX) slipped 0.2% and the Transports declined 0.5%. It was as if the markets were admitting that the ultra-dovish policy stance would do little to boost real economy fundamentals - but perhaps a lot to spur speculation and market mayhem. Global bond markets love it.

March 21 – Financial Times (Ed Crooks): “About 600 people packed on to the Machinery Auctioneers lot on the outskirts of San Antonio, Texas, last week to pick up some of the pieces shaken loose by the oil crash. Trucks, trailers, earth movers and other machines used in the nearby Eagle Ford shale formation were sold at rock-bottom prices. One lucky bargain hunter was able to pick up a flatbed truck for moving drilling rigs — worth about $400,000 new — for just $65,000… The fire sale in Texas is just a small part of the worldwide value destruction caused by the oil decline. From Calgary to Queensland, oil and gas businesses are scrambling to sell assets, often at greatly reduced prices, to pay back the debts incurred to buy them… It is a reflection, some say, of worries about the destabilising effects of the industry’s mountain of debt. From 2006 to 2014, the global oil and gas industry’s debts almost tripled, from about $1.1tn to $3tn…"

The inflationists will surely continue to lament insufficient “aggregate demand,” while espousing the virtues of Trillions more of “money”. But let’s not lose sight of the fact that “From 2006 to 2014, the global oil and gas industry’s debts almost tripled, from about $1.1tn to $3tn.” The problem was clearly too much “money” and Credit stoking boom-time excess. 
 
Aggressive rate and QE policy measures played an integral roll in the funding free-for-all that has come home to roost for the global oil patch.

And, today, monetary accommodation will do little to ameliorate the energy bust, not with liquidity and speculation preferring ongoing Bubble Dynamics throughout “Silicon Valley”, commercial (and residential) real estate and anything providing a yield. Our central bankers, by fixating on fragility while ignoring segments of intense excess, are ensuring even more precarious Monetary Disorder.

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