Fed Tightening? Not Now
The central bank should pause its double-barreled blitz of higher interest rates and tighter liquidity.
By Stanley F. Druckenmiller and Kevin Warsh
Photo: Phil Foster
Around Oct. 1, global central-bank liquidity reversed and stocks began their descent from peak prices. That is no coincidence. The Federal Reserve should take an important signal from recent developments at its meeting this week.
The Fed created quantitative easing as a novel crisis-response tool a decade ago. It bought assets from the public and stocked them away for safekeeping. Market participants understood the not-so-subtle message: The Fed had investors’ backs. The stock market rallied. The cost of credit fell. And the business and financial cycles charged ahead.
The crisis ended in the U.S. in early 2010, but central-bank asset purchases did not. Other large central banks—the European Central Bank, the Bank of Japan and the Bank of England—followed the Fed’s lead. Together they amassed more than $11 trillion of additional stocks, bonds and other financial assets.
In unheralded news a couple of months ago, quantitative easing gave way to global quantitative tightening as central banks withdrew overall liquidity from the market. True, the Fed had begun to taper its balance-sheet holdings 15 months earlier, but that was more than offset by other central banks’ still-growing asset purchases.
As we head into 2019, quantitative tightening is expected to accelerate. It has been paired with expectations of interest-rate increases from the Fed—and the timing could scarcely be worse.
Economic growth outside the U.S. decelerated over the past three months. Global trade growth also slowed markedly, running about one-third lower than earlier in the year. Growth in some important economies, like China, is significantly weaker. No ocean is large enough to insulate the U.S. economy from slowdowns abroad. And no forecasting model adequately captures the spillovers and spillbacks between the U.S. economy and the rest of the world.
U.S. financial-market indicators also signal caution. Market prices may be showing their true colors for the first time since QE’s expansion. These indicators aren’t foolproof, but they have a better track record than economists. Bank stocks are down about 15% since Oct. 1. Other economically sensitive sectors, like housing, transport and industrials, are down by double digits, underperforming the broader markets. Credit markets are softening, and the decline in major commodity prices is foreboding.
These indicators are at odds with strong U.S. economic growth for 2018, which will come in at around 3.25%. Labor markets also remain strong, although they too are a lagging indicator.
The new Fed leadership team faces the most difficult challenge since Chairman Ben Bernanke and his team confronted shocks to the financial system in 2007-08. They deserve forbearance, not censure. But time is tolling, and the Fed is well-advised to break from the old regime.
The Fed should worry less about fine-tuning its communications strategy and more about getting policy right. In recent months, Chairman Jerome Powell stepped up outreach to Congress and other interested parties. He spoke with refreshing humility about the appropriate policy rate setting. And he prudently scaled back on the kind of pinpoint forecasts his predecessors made. These moves, while welcome, are insufficient.
In response to market tumult, the Fed governors recently hinted at less enthusiasm for rate increases next year. The new forward guidance is different from what they signaled in September. But it is no more reliable. The Fed should stop this option-limiting exercise entirely. And if data dependence is the Fed’s new mantra, it should actually incorporate recent data into its forthcoming policy decision.
The Fed’s balance sheet is where the money is. Yet it has provided little additional clarity on its balance-sheet plans since Chair Janet Yellen’s tenure. At a time of global quantitative tightening and uncertain economic prospects, the Fed’s silence on its asset holdings is contributing to the tumult. We were assured by policy makers that QE provided large benefits to the real economy. If so, won’t its reversal in the form of QT come with a cost? It can’t all be rainbows and unicorns.
In a first-best world, the Fed would have stopped QE in 2010. It might then have mitigated asset-price inflation, a government-debt explosion, a boom in covenant-free corporate debt, and unearned-wealth inequality. It might also have avoided sowing the seeds of future financial distress. Booms and busts take the Fed furthest from its policy objectives of stable prices and maximum sustainable employment.
In a second-best world, on Mr. Powell’s arrival in February 2018, the Fed would have shrunk its balance sheet with speed and determination before raising rates. The economic expansion was still gaining traction at home and abroad. Tax and regulatory reforms were jolting the supply side of the economy from its slumber. Accelerated Fed QT, in the absence of rate rises, would have been much less disruptive to the real economy. Asset prices could then have found a more durable equilibrium and laid a stronger foundation for future growth.
The time to be dovish was when the crisis struck and the economy needed extraordinary monetary accommodation. The time to be more hawkish was earlier in this decade, when the economic cycle had a long runway, the global economy ample momentum, and the future considerably more promise than peril.
This is a time for choosing. We believe the U.S. economy can sustain strong performance next year, but it can ill afford a major policy error, either from the Fed or the rest of the administration. Given recent economic and market developments, the Fed should cease—for now—its double-barreled blitz of higher interest rates and tighter liquidity.
Mr. Druckenmiller is chairman and CEO of Duquesne Family Office LLC. Mr. Warsh, a former member of the Federal Reserve Board, is a distinguished visiting fellow in economics at Stanford University’s Hoover Institution.
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