Home › Perspectives › Doug Noland: Revisiting “Coin in the Fuse Box”

Doug Noland: Revisiting “Coin in the Fuse Box”

By Doug Noland on September 19, 2020

Excerpts: I see the entire inflation-targeting doctrine as little more than a sham. This is not about CPI and inflation expectations. The Fed is trying to convince the marketplace it retains the power to sustain market and speculative Bubbles…

Moreover, when the Fed Chairman downplays financial stability risks, he does sow some market doubt he fully appreciates the degree of underlying market fragility. Will he be ready with another immediate multi-Trillion stimulus package in the event of a non-pandemic, non-economic free-fall financial market dislocation? And this gets to the Core Issue: Fed reflationary measures at this point stoke massive late-cycle speculative excess and leverage. This significantly exacerbates market fragility, ensuring the next major de-risking/deleveraging episode will require even greater Fed liquidity injections (central bank Credit inflation) and market support.

It’s reasonable to ask, “Where does it all end?” – with an equally reasonable answer, “with market dislocation and a crash”. All those Coins in the Fuse Box in 1929 contributed directly to the house collapsing in flames.

Michael Bond comment: To be specific, the Federal Reserve stepping in to buy corporate bonds was not only another penny in the free market circuit breaker, but made market participates think the Fed is insuring that all financial markets will be backstopped and the juice will continue to flow. And the juice will flow until the whole house burns down.

September 17 – Wall Street Journal (Greg Ip): “Can words take the place of actions? The Federal Reserve hopes so. On Wednesday it issued a policy statement promising to get inflation above 2%. In their accompanying projections, officials indicated that would mean keeping interest rates near zero at least until 2024 and until unemployment falls to 4%. ‘This very strong forward guidance, very powerful forward guidance that we have announced today will provide strong support for the economy,’ Chairman Jerome Powell told reporters. To drive the point home, he used the word ‘powerful’ 10 times in the press conference.”

Powell’s hammering home “powerful” had me recalling ECB President Jean-Claude Trichet’s “never precommit.” “The European Central Bank never pre-commits on interest rate moves.” “We are never precommitted as regards the future level or path of policy.” “We are never precommitted and we can increase rates whenever we judge appropriate to do that.”

Powell is struggling to reinforce flagging Federal Reserve credibility. Trichet was focused on establishing credibility for the unproven European Central Bank. The Chairman is directly signaling to the markets the Fed’s resolute commitment to maintain (for years to come) the most extreme monetary stimulus. Trichet was essentially signaling to market participants not to bet on a particular policy course. The FOMC is saying wager freely on an extended period of ultra-loose policies.

With zero rates and $120 billion monthly Treasury and MBS purchases, along with other measures, the Fed has completely succumbed to inflationism. In contrast, pre-Draghi ECB doctrine was founded on well-tested traditional central banking and sound money principles.

It’s as if the CBB has a weekly mandate to remind readers of the abnormality of so much that these days passes for normal. Why was Trichet so adamant against markets betting on the course of monetary policy? Because such activities would add an element of instability and risk compromising ECB credibility. It would increase leveraged speculation, in the process spurring an unstable monetary backdrop. Over time this would bolster asset price inflation and propagate Bubbles. And, importantly, speculative Bubble dynamics would pose increasing risks to system stability and monetary policy flexibility. Maintaining financial stability and central bank credibility were dependent on the central bank’s powerful commitment to sound money.

“Sound money” and “inflationism” are such critical fundamental concepts that are these days little more than archaic terminology from a bygone era. Over the years, rising securities prices evolved into the Federal Reserve’s primary mechanism for system stimulus and reflation. The Fed has reduced the cost of borrowing for leveraged speculation to about zero. It has committed to indefinitely injecting $120 billion monthly into highly speculative markets, while essentially promising to boost these purchases as necessary to support financial asset prices and marketplace liquidity. Importantly, the Fed continues to aggressively promote speculation and financial leveraging.

Bloomberg’s Mike Mckee: “…In terms of the balance sheet, are you concerned that your actions are more likely to produce asset price inflation than goods and services inflation? In other words, are you risking a bubble on Wall Street?

Chairman Powell: “Yeah, so of course we monitor financial conditions very carefully. These are not new questions. These were questions that were very much in the air a decade ago and more when the Fed first started doing QE. And I would say if you look at the long experience of… the ten-year, eight-month expansion, the longest in our recorded history, it included an awful lot of quantitative easing and low rates for seven years. And I would say it was notable for the lack of the emergence of some sort of a financial bubble, a housing bubble or some kind of a bubble – the popping of which could threaten the expansion. That didn’t happen. And frankly, it hasn’t really happened around the world since then. That doesn’t mean that it won’t happen, and so of course it’s something that we monitor carefully. After the financial crisis, we started a whole division of the Fed to focus on financial stability. We look at it through every perspective. The FOMC gets briefed on a quarterly basis. At the Board here we talk about it more or less on an ongoing basis. So, it is something we monitor. But I don’t know that the connection between asset purchases and financial stability is a particularly tight one. But again, we won’t be just assuming that. We’ll be checking carefully as we go. And by the way, the kinds of tools that we would use to address those sorts of things are not really monetary policy. It would be more tools that strengthen the financial system.”

What about the connection between asset purchases and market speculation? In the 1960s Alan Greenspan was said to have commented the Great Depression was a consequence of the Fed having repeatedly placed “Coins in the Fuse Box”.

There are contrasting points of view. According to Powell, we have experienced a period of over a decade of QE (new Fed policy doctrine) “notable for the lack of the emergence of some sort of a financial bubble.” “The connection between asset purchases and financial stability” is not “a particularly tight one.”

A counter argument holds that the Fed (along with the ECB, BOJ, PBOC, BOE and others) has for over a decade been inserting “Coins in the Fuse Box” to ensure the juice continues to flow freely into Credit, market and asset Bubbles. Excesses have been allowed to mount unchecked. System correction and adjustment mechanisms have been impeded. Financial and economic structural impairment has run long and deep. In short, it’s a backdrop with parallels to that which culminated in the 1929 Crash and Great Depression.

It’s been a slippery slope, accordant with the history of inflationism. Powell now resorts to double-digit wielding of “powerful” as the Fed attempts to communicate the essence of its new inflation-spurring regime.

My own view holds Fed credibility has already been irreparably diminished. When it comes to the Federal Reserve’s commitment to tighten monetary policy in the event of an upside inflation surprise, credibility has been lost. There is minimal credibility the Fed will ever respond to asset Bubble risks to financial stability. The Fed’s stated strategy of employing macro-prudential policies as first line defense against financial excess is unconvincing. And for now, these credibility voids have minimal impact. Markets see little inflation risk on the horizon, while speculative markets are more than fine with the Fed’s neglect of its financial stability mandate.

From day one, this new inflation framework lacks credibility. Markets don’t believe central banks have much control over some nebulous consumer price aggregate. There is little confidence that the Federal Reserve will miraculously orchestrate a price level just nicely above its 2% target.

So-called Fed “credibility” today rests instead on faith that the Fed (and global central bankers) will sustain elevated securities prices and market Bubbles. “Whatever it takes” central banking with open-ended balance sheets ensures abundant and uninterrupted marketplace liquidity. In this regard, a huge Coin was jammed in the Fuse Box in March and April.

I’m the first to admit the Fed/market nexus appears virtually miraculous. The Fed’s early and aggressive “insurance” stimulus spurred surging securities prices in the face of deep economic contraction and a spike in unemployment. And no reason to fret the old dynamic whereby rising loan losses and resulting tighter bank lending standards usher in an economic down-cycle. Not these days – not with markets having evolved to become the primary source of finance throughout the economy. With the Fed’s powerful market-based stimulus and attendant dramatic loosening of financial conditions ensuring a rapid “V” recovery, there’s no fear of the type of festering Credit problems that would have traditionally incited a problematic tightening of system Credit.

I have a few issues with this miracle. As noted above, this policy process promotes asset inflation, speculation and Bubbles, while forestalling important system correction and adjustment. In short, this deviant financial and policy apparatus abrogates crucial facets of Capitalism.

Bloomberg this week featured an article, “Why Liquidity Is a Simple Idea But Hard to Nail Down.” The always insightful Mohamed El-Erian penned an op-ed, “Are Stocks Losing Some Liquidity Momentum?”

In the latest weekly data, M2 “money” supply surged another $112 billion to a record $18.577 TN. M2 was up $3.069 TN in 28 weeks, or about 37% annualized. Not a mention of this data as the Fed agonizes over consumer price inflation slightly below target. Can marketplace liquidity be an issue when the system is in the throes of runaway M2 growth?

What is driving this historic monetary inflation? Clearly, Fed balance sheet growth is a primary factor. But I believe there’s another key component: speculative leveraging. The expansion of securities Credit creates new financial claims (“liquidity”) that circulate through the financial system and into the real economy.
September 18 – Reuters (Kate Duguid): “Investors are gearing up for the year’s record-breaking pace of corporate bond issuance to continue in the coming week… The past week has seen roughly $42 billion of high-grade debt come to market in 39 deals… The breakneck pace of fresh issuance illustrates how the Fed’s late March pledge to backstop credit markets and its policy of holding interest rates near zero have spurred borrowing… Companies had already issued $1.7 trillion in debt through the end of August…, compared with $944 billion in the same period last year.”

In the wake of the Fed’s March move to backstop corporate bonds, how much of this year’s record issuance has been purchased by speculators employing leverage? How much corporate Credit is these days being funneled into Wall Street structured finance (i.e. CDOs, CLOs and such), again incorporating leverage? How much leverage is being used to purchase shares in corporate bond ETFs? For that matter, how much new leverage is finding its way into mortgage securities – as the Fed backstops this key marketplace with $40 billion of monthly buying?

Finance evolves over time – and Federal Reserve policymaking has clearly had a profound impact on financial innovation and evolution. I argued the Fed, GSEs and Treasury momentously altered market risk perceptions for mortgage-related finance – the “Moneyness of Credit” – that was fundamental to mortgage finance Bubble inflation. A decade ago, I warned Bernanke’s move to use the securities markets for system reflation had unleashed the “Moneyness of Risk Assets” – the perception that Fed backing elevated stocks and corporate Credit to the status of perceived safe and liquid instruments.

Post-mortgage finance Bubble policy measures were instrumental in the phenomenal expansion of the ETF complex. It was no surprise then that ETF illiquidity was a key aspect of March’s market dislocation – or that the Fed would be compelled to provide a liquidity backstop for this illiquidity flash point.

The Fed’s move to bolster the markets and ETFs this past spring spurred a tsunami of ETF flows, especially into corporate Credit. Moreover, the Fed’s aggressive measures (“Coins”) in December 2018, September 2019 and March/April 2020 profoundly altered the perception of risk versus reward opportunity in trading options and other derivatives. In short, after creating an enticing market environment for using derivatives to speculate on the market’s upside, the Fed’s dramatic pandemic crisis response made buying call options a can’t lose proposition.

I suspect options trading over recent months has had a profound effect on market prices, trading dynamics and overall liquidity – and I suspect derivatives-related leverage has become a key source of monetary fuel throughout the system – the financial markets and in the real economy.

My view is the disregard for speculative leverage and resulting liquidity effects is the most dangerous flaw in contemporary central bank doctrine. When the Greenspan Fed moved to accommodate – and then underpinned – market-based finance, he unleashed a process that saw leveraged speculation take an increasingly prominent role in system liquidity creation. The LTCM crisis in 1998 foreshadowed the collapse of speculative leverage and financial crisis in 2008.

And for over a decade now the Fed has been putting “Coins in the Fuse Box” – adopting increasingly extreme measures specifically to quash de-risking/deleveraging dynamics. And with each new act of desperation – 2018, 2019 and 2020 – the Fed only stoked greater excess and speculative leverage.

I see the entire inflation-targeting doctrine as little more than a sham. This is not about CPI and inflation expectations. The Fed is trying to convince the marketplace it retains the power to sustain market and speculative Bubbles. And why not a more constructive market response to Wednesday’s statement and Powell press conference? Because markets at this point recognize Bubbles will be sustained only through an ongoing massive expansion of the Fed’s balance sheet – and Powell was somewhat timid with balance sheet details.

It’s reasonable to ask, “Where does it all end?” – with an equally reasonable answer, “with market dislocation and a crash”. All those Coins in the Fuse Box in 1929 contributed directly to the house collapsing in flames.

For now, Fed policies worsen inequality and social tension. The Fed is clearly cognizant of these issues. Powell hopes to get back to a 3.5% unemployment rate and strong job gains for blacks, Hispanics, other minorities, and the less fortunate more generally. But what a challenge it is to explain this new inflation-spurring regime in the context of how it will assist the common citizen.

Yahoo Finance’s Brian Cheung: “So it seems like a lot of the new inflation framework is about shaping inflation expectations. But the average American who might be watching this might be confused as to why the Fed is overshooting inflation. So what’s your explanation to Main Street, to average people what the Fed is trying to do here? And what the outcome would be for those on Main Street?”

Powell: “That’s a very important question, and I actually spoke about that in my Jackson Hole remarks… It’s not intuitive to people. It is intuitive that high inflation is a bad thing. It’s less intuitive that inflation can be too low. And the way I would explain it is that inflation that’s too low will mean that interest rates are lower. There’s an expectation of future inflation that’s built into every interest rate, right? And to the extent inflation gets lower and lower and lower, interest rates get lower and lower. And then the Fed will have less room to cut rates to support the economy. And this isn’t some idle…, academic theory. This is what’s happening all over the world. If you look at many, many large jurisdictions around the world, you are seeing that phenomenon. So, we want inflation to be — we want it to be 2%. And we want it to average 2%. So, if inflation averages 2%, the public will expect that and that’ll be what’s built into interest rates. And that’s all we want. So we’re not looking to have high inflation. We just want inflation to average 2%. And that means that you know, in a downturn, these days what happens is inflation, as has happened now, it moves down well below 2%. And that means, as we’ve said before, that we would like to see and we will conduct policies so that inflation moves for some time moderately above 2%. So, these won’t be large overshoots and they won’t be permanent. But to help anchor inflation expectations at 2%. So yes, it’s a challenging concept for a lot of people, but nonetheless, the economic importance of it is large. And you know, those are the people we’re serving. And you know, we serve them best if we can actually achieve average 2% inflation we believe. And that’s why we changed our framework.”

What a tangled web they’ve woven. Year-over-year headline CPI inflation has averaged 1.7% over the past five years (1.9% during the past four). Year-over-year CPI was up 2.3% in February, before pandemic forces pushed it as low as 0.1% in May. It was already back up to 1.3% in August. Is all the Hullabaloo really about consumer inflation fractionally below target? And will this be viewed as reasonable by the average American?

TSP Smart & Vanguard Smart Investor serve serious and reluctant investors