Part of the reason for my (uncharacteristic) forbearance is that I thought Jay Powell was mostly doing the right things. He’d been dealt a bad hand by Bernanke and Yellen – the Dynamic Magical-Thinking Duo – but he was making the best of it.
To understand the position poor Powell was in, remember that Bernanke foolishly rolled out Quantitative Easing, which no one understood. QE did nothing for the economy, where most people live, and everything for the stock market, where the rich live.
Along the way, Bernanke and Yellen kept interest rates as low as they could keep them – interest rate levels that hadn’t been observed since the Middle Ages.
The result of all this was complete economic gridlock. Free market economies need to set their own interest rate levels via the demand for and supply of credit; to set their own equity prices via the buying and selling activity of millions of investors; to allocate capital efficiently across economic sectors based on expectations for future profits and the discounted cash flow value of those profits today.
But thanks to the Fed, all that went out the window. Instead, we had closeted academics with PhDs making all those decisions – very badly – for the rest of us. Economic actors (companies and individuals) no longer had any idea what the actual cost of money was, and no one had any idea when the Fed would stop pumping up the stock market.
Everyone, however, fully understood how the Fed’s meddling had badly distorted investment decision-making, capital planning, lending and borrowing – in other words, the very activities that make a free economy work. And the Fed can’t understand why GDP growth dawdled along at mere one and a half percent?
When Powell succeeded Yellen, he began raising interest rates in an attempt to get the cost of money back up to its natural level. This would also provide the Fed with some dry powder when the next recession hit.
Powell also began reducing the Fed’s huge balance sheet – a millstone that in and of itself took a good 1 – 2 percent off sustainable economic growth.
But then, very late in the fourth quarter of last year, it all went to hell.
“We cannot remember such a big change of direction by the Fed absent a major shift in the economic backdrop.” –JP Morgan
“It is difficult to read [the Fed’s U-turn] as anything other than the Fed capitulating to recent market volatility.” –Barclays
Exactly. From where I sit, it looks very much like Powell & Co. surrendered under pressure from a wildly tweeting President and a rocky stock market. Trump wants to get reelected, so naturally he wants easy money. Investors in the stock market want prices to go only up.
But so what? You can read through the Fed’s enabling legislation until you’re blue in the face, and you won’t see anything about sucking up to a President or pumping up the stock market.
The Fed’s mandate is (12 USC 225a): “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The Fed’s Open Market Committee – the one that sets interest rates – is to operate (12 USC 263c) “with a view to accommodating commerce and business and with regard to their bearing upon the general credit situation of the country.”
What does a tweeting President and a falling stock market have to do with any of this? The answer is “almost nothing.” It’s true that a complete collapse in equity prices, a la 1929 or 2008, can indirectly affect the broader economy if risk-taking behavior atrophies.
But (are you listening Powell & Co.?) ordinary corrections and bear markets are a normal and necessary characteristic of healthy equity markets. What is unhealthy for equity markets is for the Fed to convince investors that those markets will never go down (or if they do, that the Fed will promptly pump them back up, they did in late December).
And that’s what we’ve gotten for three decades: the Greenspan put, the Bernanke put, the Yellen put, and now the Powell put. And, not incidentally, we also got the Tech Bust and the Global Financial Crisis.
What future horrors are in store for us?
For more than a year Powell had maintained a steady stance: interest rates would be raised slowly and the Fed’s balance sheet would be systematically reduced. In the fourth quarter of 2018 nothing had changed in the global economy or the domestic economy and nothing had changed in employment or inflation numbers.
And that should have given the Fed a strong backbone to continue with the hard work of getting monetary conditions back into the real world. Instead, the Fed panicked.
The Fed had no idea what the implications of imposing QE on the U.S. economy were likely to be, and now it turns out, unsurprisingly, that the Fed has no idea how to stop imposing QE on the economy.
Every time the Fed gets serious about pushing rates back to a neutral level or reducing its bloated balance sheet (Quantitative Tightening), three things happen. The first is that the Fed becomes the object of a Twitter storm by the President. The second is that the market pukes – that’s a technical term. The third is that the Fed panics and makes a U-turn. So, apparently, we’re in QE Forever.
For a central banker, credibility is everything. If the markets and economic actors don’t believe that the Fed can do its job, that it won’t collapse in the face of annoyance from a President or volatility from the stock market, then the Fed is dead in the water. The Open Market Committee might as well be disbanded.
In short, the stock market, and probably the President, appear to have veto power over sensible Fed policies. Fed cred, I’m afraid, has taken a huge hit. So have we.
Next up: Back to Cold War II, Part 5