END OF AN ERA / CREDIT BUBBLE BULLETIN

End of an Era

Doug Nolan


Of the diverse strains of inflation, asset inflation is by far the most dangerous. A bout of consumer price inflation would be generally recognized as problematic and rectified through a tightening of monetary conditions. On the other hand, asset price inflation is both celebrated and venerated. There is simply no constituency calling for a tightening of conditions to ward off the deleterious effects of rising asset prices, Bubbles and attendant economic maladjustment. And as we’ve witnessed, the bigger the Bubble the more powerful the constituencies that rationalize, justify and promote Bubble excess.


About one year ago, I was expecting a securities markets sell-off in the event of a Donald Trump election surprise. A Trump presidency would create disruption, upheaval and major uncertainties – political, geopolitical, economic and social. Instead of a fall, the markets experienced a short squeeze and unwind of hedges. Over-liquefied markets and a powerful inflationary bias throughout global securities markets won the day – and the winning runs unabated.

We’ve come a long way since 1992 and James Carville’s “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” New age central banking has pacified bond markets and eradicated the vigilantes. These days it’s the great equities bull market as all-powerful intimidator.

The President admitted his surprise in winning the election. I suspect he and his team were astounded by the post-election market rally. I’ve always held the view that prolonged bull markets foster a portentous concentration of power – not only in the financial markets but within the financial system more generally.

That was certainly the case in the “Roaring Twenties,” just as it was in the late-nineties and throughout the mortgage finance Bubble period. A big market decline would have provided the new President the opportunity to blame the Bubble while moving forward aggressively with his reformist agenda. Instead, a rally ensured that Team Trump would be held captive by the financial markets. As his administration struggled, President Trump could at least point to record stock prices.

I was hoping for reform-minded Kevin Warsh or John Taylor at the helm of the Federal Reserve. But I’ve somewhat warmed up to establishment-favored Jerome Powell, not so much because he will pursue needed changes in monetary management – but because Mr. Powell is likely about the best we could have hoped for in the current market environment. Apparently, the President was close to reappointing market darling chair Yellen. And if Yellen wasn’t dovish enough for the markets, Bill Gross stated his preference for either Paul McCulley or Neel Kashkari. I have McCulley and Kashkari far down the list - just above Ben Bernanke but below Charles Evans and Mark Zuckerberg.

Powell is viewed as the logical choice for continuity and stability at the Fed. He has a diverse background in law, government, the markets (with Carlyle Group), regulation and monetary policy. Powell will be the first Fed chairman without an economics Ph.D. since Paul Volcker. In many ways, it is a much welcomed End of an Era.

Janet Yellen is a widely respected economist – and by all accounts has been an able administrator of the Federal Reserve system. It has been noted that she will be the first Fed chair whose term ended without the experience of a recession. More importantly, she is surely the first leader of our central bank to have enjoyed a full term of uninterrupted extremely loose policy and financial conditions.

I’ll rain on the parade of accolades: The Yellen Fed failed to tighten policy in the face of increasingly conspicuous Bubble excess. Worse even than unforgivable past episodes, the Fed badly missed its timing. Today’s backdrop ensures an easy start to what will be an extremely challenging job for chairman Powell.

I’ve read numerous articles and listened to various commentaries. Leave it to esteemed former Minneapolis Fed President Gary Stern to offer the keenest insight:

Bloomberg’s Tom Keene: “Ellen Zentner at Morgan Stanley writes a detailed note about what we would expect from chairman Powell. She mentions that there’s a mystery here over chairman Powell and core economics, including NAIRU [non-accelerating inflation rate of unemployment]… Does it matter that chairman Powell maybe has a little fuzzy knowledge of NAIRU like mere mortals like me?”

Former Minneapolis Fed President Gary Stern: “No. And, in fact, I might view that as an advantage. Because that framework is frayed at best, it seems to me given our economic performance over the past “X” years – and “X” is not a small number. So, I think some open-mindedness on that framework is a distinct positive. And I think it would be worthwhile for a fair amount of resources to be devoted to a pretty thorough review of some of the critical macroeconomic issues and frameworks of the day, because they have not all served policymakers well; they have not all served commentators well; they have not all served the Street well. And I think it would be a good idea to open some of that up.”

Bloomberg’s Mike McKee: “Do you think we’ve come to the end, maybe, of the Bernanke era of making policy in terms of setting an inflation target at 2% and aiming for that as sort of the reason – the way you conduct policy. Could we see some sort of change?”

Stern: “I think you certainly could. But I can’t read the new chair’s mind – so I don’t know where he stands on that 2% number. To me, that number’s always been sort of an arbitrary number. My nickel on it is that if you’re running a little below your inflation target that’s hardly a big problem. I would once again urge review and maybe modification of that particular target because it’s not clear to me that there’s great virtue in it. There may be a better way to formulate the inflation objective.”

And from the Wall Street Journal: “‘He is remarkably undogmatic,’ says Jeremy Stein, a Harvard University economics professor, Democrat and former Fed governor whose office was adjacent to Mr. Powell’s. ‘He listens more than he talks.’”

With the suggestion of an End of an Era, I’m thinking of 30 years of ideologies dominating the Federal Reserve system. Alan Greenspan was the free-market ideologue that championed market-based finance, only to morph into “The Maestro” cunningly intervening in and manipulating increasingly unstable financial markets. Dr. Bernanke was summoned to the Federal Reserve in 2002 on the back of his radical theories of post-Bubble reflation. The powers that be later embraced Bernanke as Greenspan’s successor. By 2006, it was clear that reflationary measures had created an only more formidable Bubble for “helicopter Ben” to pilot. Janet Yellen, the pleasantly dovish intellectual of all things employment economics, was to ensure continuity in the implementation of the Bernanke Doctrine of radical monetary inflationism.

As Mr. Stern suggested above, it’s now time for a “pretty thorough review of some of the critical macroeconomic issues and frameworks of the day.” Long Overdue. I don’t envy Mr. Powell. His predecessors have left him, in the words of candidate Trump, “one big, fat, ugly Bubble.” Markets are comfortable that Powell will stick with the program of occasional little, harmless baby-step rate increases. Policies that actually tighten financial conditions remain unacceptable indefinitely. And it goes without saying that markets will be ready to throw a tizzy fit if the new chairman dares to even hint of a departure from market-friendly policymaking.

Powell has been referred to as a “loyal ally” of Janet Yellen, which endears him to the markets. He is by all accounts deferential and hard-working. Yet Powell is not an ideologue. He does not champion a doctrine that would have him wedded to specific econometric models or theoretical constructs.

It’s hard for me to believe he has the mindset to fixate on CPI measures slightly below target, while disregarding the markets. The Fed’s slim notion of “price stability” needs broadened and modernized. And I’m hopeful a Powell Fed’s “risk management approach” will focus more on the risks of promoting excess rather than measures to dampen market volatility and incentivize risk-taking. In such a complex world of extraordinary financial and economic developments, it’s hard to believe Powell will get bogged down in a debate on mythical “neutral” and “natural” interest rates. Ditto NAIRU.

So, trying to be constructive here, it’s a start. He may not be the bold reformer so needed at the Federal Reserve, but I’m hoping he’ll capably begin pulling the Fed away from radical inflationism. If he has been a keen observer and good listener, it would be rational to begin the process of extricating the Fed from such a dominant position in the markets. It’s not as if the Bubble is inconspicuous.

Perhaps Jerome Powell is even the type of individual driven to cultivate a sound analytical framework and philosophy – determined to learn, understand and adapt. That would be such a refreshing change from the Era of ideologues.

As someone with significant market experience, he surely recognizes the risks associated with financial excess. He must appreciate the dangers associated with Bubbles and pandering to speculative markets.

A lot will remain unknown until Powell is tested. How quickly does he come to the markets’ defense? Does he quietly abandon Bernanke’s - “the Fed will push back against a tightening of financial conditions” - over-the-top market inducement?

While he has not dissented on an FOMC vote, from his diverse real world experience does he believe the Fed has been too reluctant in returning to traditional monetary management? Will he be a proponent of QE or instead view it with a healthier skepticism than the ideologues? I have no illusions that the Fed is about to eliminate QE from its toolkit. My view holds that, come the next serious de-risking/de-leveraging episode, central bankers will see few alternatives than creating more “money.”

Yet the key issue is how quickly in a crisis does the Powell Fed come to the markets’ rescue? As a pragmatic non-ideologue, he may appreciate the risks of coming too soon. And I have a crazy thought: maybe he even believes in the value of market discipline. By design or, more likely, by default – it’s the right time to move away from academic economists.

Depending on the President’s other Fed nominations, it could be quite a diverse group at the FOMC. Markets are today worry-free, but could chairman Powell be relegated to herding cats? It’s already a divided group – with divisions going much beyond traditional “hawk” and “dove.” Indeed, there are starkly divergent views as to how the world works. For starters, do economies drive the markets – or is it the securities markets these days that govern economic development? To what extent should central banks be dictating financial market behavior? Under what circumstances should central banks employ aggressive monetary stimulus? To what extent has Fed stimulus fueled deficit spending and big government? Should central bankers have complete discretion to rapidly expand central bank Credit?

Lots of momentous questions that somehow seems to matter so little at this juncture. The focus on interest rate policy and deregulation misses the larger issue: The Federal Reserve is soon under the command of a conventional and non-ideological individual with a distinguished career in the public and private sectors. I so hope Mr. Powell proves to be the distinguished statesman this country desperately needs running our central bank.