Yellen Unveiling, Jackson Hole 2016

Doug Nolan


The Global Financial Crisis and Great Recession posed daunting new challenges for central banks around the world and spurred innovations in the design, implementation, and communication of monetary policy. With the U.S. economy now nearing the Federal Reserve's statutory goals of maximum employment and price stability, this conference provides a timely opportunity to consider how the lessons we learned are likely to influence the conduct of monetary policy in the future. The theme of the conference, ‘Designing Resilient Monetary Policy Frameworks for the Future,’ encompasses many aspects of monetary policy, from the nitty-gritty details of implementing policy in financial markets to broader questions about how policy affects the economy.” The introduction to Janet Yellen’s speech, “The Federal Reserve's Monetary Policy Toolkit: Past, Present, and Future,” Jackson Hole, August 26, 2016

Bloomberg: “Yellen Says Rate-Hike Case ‘Strengthened in Recent Months.’” The FT was almost identical to Bloomberg. It was hardly different at the WSJ: “Fed Chairwoman Janet Yellen Sees Stronger Case for Interest-Rate Increase.” And from CNBC: “Yellen says a rate hike is coming—but markets say not now.” And this from Zerohedge: “Best Reaction Yet: ‘Yellen Speech A Whole Lot Of Nothing.’”


I have a different take: Yellen provided more content for history books. In today’s short-term focused world, analysts and pundits remain fixated on clues to the next policy move. And while Yellen included language unbecoming of ultra-dovishness for the near-term, the Fed chair’s presentation was zany-dovish for the intermediate- and longer-term.

The Yellen Fed has begun methodically laying the analytical foundation for a Federal Reserve (and global central banks) balance sheet of unthinkable dimensions. It’s right there in her writing, as explicit as it is astounding. Before it’s too late, the Fed’s power – and their runaway policy experiment – need to be reined in. Contemporary Central bankers have been operating with blank checkbooks only because it was never contemplated that they would actually exploit their capacity to print “money” with reckless abandon. Who cannot see that these central bankers need clear rules and well-defined restraints? Their judgment is not trustworthy.

The WSJ’s Jon Hilsenrath penned an interesting pre-Jackson Hole piece, “Years of Fed Missteps Fueled Disillusion With the Economy and Washington.” “Once-revered central bank failed to foresee the crisis and has struggled in its aftermath, fostering the rise of populism and distrust of institutions. In the past decade Federal Reserve officials have been flummoxed by a housing bubble that cratered the financial system, a long stretch of slow growth they failed to foresee and inflation persistently undershooting their goal. In response they engineered unpopular financial rescues, launched start-and-stop bond buying and delayed planned interest-rate boosts. ‘There are a lot of things that we thought we knew that haven’t turned out quite as we expected,’ said Eric Rosengren, president of the Federal Reserve Bank of Boston. ‘The economy and financial markets are not as stable as we previously assumed.’”

Yellen’s above speech introduction refers to “lessons we learned.” It is, however, rather obvious that the Federal Reserve has completely failed to recognize how a flawed monetary policy framework was fundamental to a financial Bubble that collapsed into the “worst financial crisis since the Great Depression.”

This year’s Jackson Hole summit is to consider “broader questions about how policy affects the economy.” What’s conspicuously absent from Yellen’s (and others’) analytical framework is the extraordinary impact policy continues to play in the securities and derivatives markets – and over time through the markets into the overall economic structure.

Over the years I’ve detailed how the GSEs, acting as quasi-central banks, in the early nineties began backstopping market liquidity. Having ended 1993 at $1.9 TN, GSE securities (debt and MBS) in just ten years more than tripled to $6.0 TN. Revelations of serious accounting fraud at Fannie and Freddie ended their capacity for “buyer of first and last resort” liquidity support.

I argued at the time that going forward only the Fed would retain the wherewithal to engineer market liquidity backstop operations to counter a serious de-risking/de-leveraging episode, though this would require a major expansion of Fed’s holdings. The mortgage finance Bubble inflated much longer and to far greater excess than I had expected, which ensured that its bursting triggered a historic Trillion plus doubling of Fed holdings. Later, in 2011 the Fed detailed its “exit strategy”, yet proceeded to again double assets to $4.5 TN.

I have posited that the Fed’s balance sheet is likely on course to reach $10 Trillion. This rough guesstimate stems from the view that there is no alternative to the Fed’s balance sheet for future liquidity backstop operations. Moreover, the unprecedented inflation of Bubble excess (securities and asset markets, economic maladjustment) ensures that only another doubling of the Fed’s balance sheet could possibly hold financial collapse at bay.

In the simulations reported by Reifschneider, ‘Gauging the Ability of the FOMC to Respond to Future Recessions,’ in note 8, overcoming the effects of the zero lower bound during a severe recession would require about $4 trillion in asset purchases and pledging to stay low for even longer if the average future level of the federal funds rate is only 2 percent.

The above zinger is footnote #24 embedded in Yellen’s speech. And the Fed chair’s inflationist reasoning culminates with her focus on Fed staffer David Reifschneider’s recent paper (cited above). The gist of the analysis is that if the Fed lacks the typical capacity to slash interest rates, policy can compensate with more aggressive asset purchases and forward rate guidance. Undoubtedly, the Fed will face minimal rate flexibility the next time it employs further monetary stimulus. So get ready. Bonds seem ready.

From Yellen: “
A recent paper takes a different approach to assessing the FOMC's ability to respond to future recessions by using simulations of the FRB/US model. This analysis begins by asking how the economy would respond to a set of highly adverse shocks if policymakers followed a fairly aggressive policy rule, hypothetically assuming that they can cut the federal funds rate without limit. It then imposes the zero lower bound and asks whether some combination of forward guidance and asset purchases would be sufficient to generate economic conditions at least as good as those that occur under the hypothetical unconstrained policy.

Figure 2 in your handout illustrates this point. It shows simulated paths for interest rates, the unemployment rate, and inflation under three different monetary policy responses--the aggressive rule in the absence of the zero lower bound constraint, the constrained aggressive rule, and the constrained aggressive rule combined with $2 trillion in asset purchases and guidance that the federal funds rate will depart from the rule by staying lower for longer…

But despite the lower bound, asset purchases and forward guidance can push long-term interest rates even lower on average than in the unconstrained case (especially when adjusted for inflation) by reducing term premiums and increasing the downward pressure on the expected average value of future short-term interest rates. Thus, the use of such tools could result in even better outcomes for unemployment and inflation on average.

Of course, this analysis could be too optimistic. For one, the FRB/US simulations may overstate the effectiveness of forward guidance and asset purchases, particularly in an environment where long-term interest rates are also likely to be unusually low. In addition, policymakers could have less ability to cut short-term interest rates in the future than the simulations assume. By some calculations, the real neutral rate is currently close to zero, and it could remain at this low level if we were to continue to see slow productivity growth and high global saving. If so, then the average level of the nominal federal funds rate down the road might turn out to be only 2 percent, implying that asset purchases and forward guidance might have to be pushed to extremes to compensate
… (footnote 24)”

If a 2% Fed funds rate equates to $4.0 TN of Fed purchases, what about 1%? How about 50 bps? Using the Fed’s own framework, a $10 TN Federal Reserve balance sheet no longer seems all that “lunatic fringe.”

Of course, chair Yellen is not about to espouse the stunningly audacious without the obligatory tinge of caution: “Moreover, relying too heavily on these nontraditional tools could have unintended consequences. For example, if future policymakers responded to a severe recession by announcing their intention to keep the federal funds rate near zero for a very long time after the economy had substantially recovered and followed through on that guidance, then they might inadvertently encourage excessive risk-taking and so undermine financial stability.”

My comment: “…Future policymakers… might inadvertently encourage excessive risk-taking and so undermine financial stability.” You think?? Might it be worthwhile contemplating the past and current?

Finally, the simulation analysis certainly overstates the FOMC's current ability to respond to a recession, given that there is little scope to cut the federal funds rate at the moment. But that does not mean that the Federal Reserve would be unable to provide appreciable accommodation should the ongoing expansion falter in the near term. In addition to taking the federal funds rate back down to nearly zero, the FOMC could resume asset purchases and announce its intention to keep the federal funds rate at this level until conditions had improved markedly--although with long-term interest rates already quite low, the net stimulus that would result might be somewhat reduced.”

If markets are willing to cooperate, the Fed may bump up rates 25 bps in September. Friday evening from the WSJ’s Heard on the Street column: “Janet Yellen Cries Wolf - Fed chairwoman tries to convince market that a rate rise is coming, but investors aren’t listening.”


Could it be instead that they listened intently and came away even more persuaded? Perhaps the WSJ (and others) is missing the point: it’s not about crying wolf or a lack of credibility with respect to rate hikes. After all, a second little baby-step would be trivial in the context of rising odds of a Fed balance sheet on its way to ballooning to $10 TN. Global bond markets continue to trade as if there’s a very credible threat of monstrous QE/central bank purchases to eternity. 

And the greater the scope of the world’s most spectacular asset Bubble, the higher the odds that central bankers will be forced into even more preposterous desperate measures – aka ever larger QE purchases of a widening variety of securities.

Somehow the Fed completely disregards the prominent role loose monetary policy has played in inflating serial financial and economic Bubbles. It gets worse. Revisionism somehow has Yellen expounding analysis that policy was “tight” heading into the 2008 crisis period. Mortgage debt doubled in less than seven years, for heaven’s sake. Unprecedented leverage, speculative excess and financial shenanigans…

From Yellen: “…The federal funds rate at the start of the past seven recessions was appreciably above the level consistent with the economy operating at potential in the longer run. In most cases, this tighter-than-normal stance of policy before the recession appears to have reflected some combination of initially higher-than-normal labor utilization and elevated inflation pressures. As a result, a large portion of the rate cuts that subsequently occurred during these recessions represented the undoing of the earlier tight stance of monetary policy.”

We’re now eight years into history’s greatest monetary stimulus. Global markets have deteriorated to Desolate Bizarro World. After a respite, some volatility has begun to creep back into the markets. It appeared to be another tough week for the leveraged speculator crowd. 


Some favored shorts significantly outperformed. Periphery Europe was a lovefest. Spanish equities jumped 2.5%. Italian stocks surged 3.3%, led by the banking sector’s almost 10% melt-up. European banks stocks jumped 4.9%. Financials outperformed in the U.S. as well, with the banks up 1.1% and the broker/dealers gaining 1.3%. Utilities and dividend stocks underperformed.

A negative tone is gaining momentum in Asia. Intrigue is returning to China, with policymakers gearing up for yet another shot at curbing Bubbles (bonds, real estate, shadow banking, etc.) and general financial excess. The Shanghai Composite dropped 1.2% this week. 


The Nikkei 225 index dropped 1.1%, with Japanese banks losing 1.7%. Stocks were down 1.0% in India and 1.3% in Turkey. Generally, instability reemerged in EM and commodities. The South African rand was slammed for 6.3%. The Brazilian real and Mexican peso dropped about 2%, while a list of EM currencies declined about 1% (Russia, Turkey, Singapore, Colombia, Chile). Brazil’s equities were slammed 2.5% and Mexico’s stocks dropped 1.9%. In commodities, copper sank 4.3% and silver fell 3.5%. The soft commodities were under heavy selling pressure as well.

The U.S. dollar index rallied 1% this week. It was as if Fed officials were determined to don hawkish-like garb hoping to draw attention away from Yellen’s QE Eternity Unveiling. I’ve expected currency market stability to be a leading (observable) casualty of heightened global monetary disorder. Over recent months a short squeeze in EM currencies morphed into a dysfunctional trend-following and performance-chasing fracas. This type of dynamic tends to reverse abruptly and, often, dramatically.

Meanwhile, developed currencies oscillate sporadically, as perceptions swing between perpetual king dollar and the prospect of permanent Fed-induced dollar devaluation. A similar dynamic is behind the return of wild commodities trading. Natural gas surged 11% this week. 


Everyone’s favorite currency short, the British pound, was the only major currency this week to appreciate versus the dollar. Going forward, it will be interesting to see how Bubble markets attempt to reconcile a short-term Fed rate increase versus the Federal Reserve committing itself to boundless QE.

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