Doug Noland: Fed Guessing

“I’m not sure why they think they know that it’s transitory. How do they know that when there’s plenty of money printing that’s been going on and we’ve seen commodity prices going up really massively? There’s plenty of indicators that suggest that inflation is going to go higher, and not just on a transitory basis, for a couple of months. So we’ll see how the Fed is trying to paint the picture, but they’re guessing.“ Jeffrey Gundlach, DoubleLine Capital

“Guessing” is giving the Fed the benefit of the doubt. It’s more of a declaration: inflation is not and will not be an issue. And I doubt there’s anything that would shift their approach. Our central bank has its heels firmly dug in. Monetary policy will remain ultra-loose, while their communications strategy at this point is little more than rationalization and justification. I can only assume they are fearful of the consequences of puncturing Bubbles. It’s been only 13 months since a near financial meltdown.

The deflating stock market Bubble was surely troubling for the Fed; money market fund liquidity issues concerning. The run on corporate bond and equities ETFs must have been scary – illiquidity and dislocation in the Treasury market darn right horrifying. After all, an unwind of Treasury market (and fixed-income) leverage would surely bring this entire historic party to an unceremonious conclusion. Policy must kick that can down the road as far as possible.

We’ve witnessed a historic experiment in monetary management go completely off the rails. Future historians will surely be confounded. They will see recklessness and policy negligence. Where was the oversight? Were there no checks and balances? How could a small group of unelected officials just create Trillions out of thin air – Trillions of dollars that fueled history’s greatest speculative manias?

With the potential momentous impact of monetary policies, central banking by its nature must be a conservatively managed institution. No big experiments. No big mistakes. Err on the side of prudence and caution. Never take your eye off money and Credit.

There is no basis for believing that massive “money printing” is a reasonable solution to any problem. History, meanwhile, is replete with inflationary catastrophe. Inflationism has a long list of spectacular failures. Monetary stability is fundamental to stable prices, markets, economies, societies and governments. Bubbles are dangerous phenomena that must be contained early – before risks become so great as to make them untouchable.

It’s stunning what doesn’t matter these days – what is downplayed, disregarded and obfuscated. We’re left with this “dual mandate” BS that essentially disregards every critical issue relevant to monetary and price stability.

For posterity, excerpts from Chairman Powell’s Wednesday press conference:

Question from the Wall Street Journal’s Paul Kiernan: “Is it time to start talking about tapering yet? Have you and your colleagues had any conversations to this effect?”

Chairman Powell: “So, no, it is not time yet. We’ve said that we would let the public know when it is time to have that conversation. And we said we’d do that well in advance of any actual decision to taper our asset purchases, and we will do so. In the meantime, we’ll be monitoring progress toward our goals. We first articulated this substantial further progress test at our December meeting. Economic activity and hiring have just recently picked up after slowing over the winter. And it will take some time before we see substantial further progress.”

New York Times’ Jeanna Smialek: “You’ve obviously made it very clear that you want to see improvements in the real economy and the real data and not in just sort of expectations data before making that move, but I guess I wonder what happens if inflation expectations were to move up before you see some sort of return to full employment. It seems like a lot of the stability in inflation has been tied to the fact that those have been so low and stable, and I guess I wonder how your reaction would be—your reaction to that and how you’re thinking about that.

Powell: “So it seems unlikely, frankly, that we would see inflation moving up in a persistent way that would actually move inflation expectations up while there was still significant slack in the labor market. I won’t say that it’s impossible, but it seems unlikely… So that’s not to say inflation won’t—might not move up, but for inflation to move up in a persistent way that really starts to move inflation expectations up, that would take some time and you would think it would be quite likely that we’d be in very strong labor markets for that to be happening.”

Noland Comment: CPI surpassed 4% in 2008 with the unemployment rate at 6%. Year-over-year CPI reached 3.9% in September 2011 while the unemployment rate languished at a post-crisis 11.0%. And CPI reached a secular peak 14.8% in March 1980, with an unemployment rate of 6.3% – above last month’s 6.0%. To state that inflation persistently above the Fed’s 2% target would require “very strong labor markets” defies history.

The Washington Post’s Rachel Siegel: “The housing market in many American cities has seen booming prices, bidding wars, and all-cash offers well above asking price. And this is happening at the same time that housing is becoming much more expensive for lower-income Americans and people who are still struggling from the pandemic. Do you have concerns that there are localized housing bubbles, or that there’s the potential for that? And what is the Fed doing to monitor or address this?”

Powell: “So, we do monitor the housing market very carefully, of course. And I would say that before the pandemic—it’s a very different housing market than it was before the global financial crisis. And one of the main differences was that households were in very good shape financially compared to where they were. In addition, most people who got mortgages were people with pretty high credit scores. There wasn’t the subprime—low doc/no doc lending practices were not there. So, we don’t have that kind of thing, where we have a housing bubble where people are over-levered and owning a lot of houses. There is no question, though, that housing prices are going up. And, so, we’re watching that carefully… it’s part of a strong economy with people having money to spend and wanting to invest in housing. So, in that sense, it’s good. It’s clearly the strongest housing market that we’ve seen since the global financial crisis.

So, it’s not an unalloyed good to have prices go up this much. And we’re watching it very carefully. I don’t see the kind of financial stability concerns, though, that really do reside around the housing sector. So many of the financial crackups in all countries—all Western countries—that have happened around the last 30 years have been around housing. We really don’t see that here. We don’t see bad loans, and unsustainable prices, and that kind of thing.”

AFP’s Heather Scott: “Can you tell us what is different this time versus previous periods, like in the ’60s, when inflation got out of control? Why are you confident, with the lags in monetary policy, that the Fed can get ahead of inflation and make sure it doesn’t go too far above the 2% target?”

Powell: “So let me start with just saying that we’re very strongly committed to achieving our objectives of maximum employment and price stability. Our price stability goal is 2% inflation over the longer run. And we believe that having inflation average 2% over time will help anchor long-term inflation expectations at 2%. With inflation having run persistently below 2% for some time, the committee seeks inflation moderately above 2% for some time…

During this time of reopening, we are likely to see some upward pressure on prices, and I’ll discuss why, but those pressures are likely to be temporary as they are associated with the reopening process. And an episode of one-time price increases as the economy reopens is not the same thing as, and is not likely to lead to, persistently higher year over year inflation into the future – inflation at levels that are not consistent with our goal of 2% inflation over time. Indeed, it is the Fed’s job to make sure that that does not happen. If, contrary to expectations, inflation were to move persistently and materially above 2% in a matter that threatened to move longer-term inflation expectations materially above 2%, we would use our tools to bring inflation expectations down to mandated, consistent levels…

We think of bottlenecks as things that, in their nature, will be resolved as workers and businesses adapt. And we think of them as not calling for a change in monetary policy, since they’re temporary and expected to resolve themselves. We know that the base effects will disappear in a few months. It’s much harder to predict with confidence the amount of time it will take to resolve the bottlenecks or, for that matter, the temporary effects that they will have on prices in the meantime… If we see inflation moving materially above 2% in a persistent way that risks inflation expectations drifting up, then we will use our tools to guide inflation and expectations back down to 2%. No one should doubt that we will do that. This is not what we expect, but no one should doubt that in the event we would be prepared to use our tools.”

Noland comment: We should absolutely doubt the Fed would use its “tools” to quell above-target inflation. The markets have become the Fed’s top priority. Any circumstance where the Fed is preparing to actually tighten policy will be a major problem for Bubble markets. And everyone knows the Fed would reverse a fledgling tightening course on the first indication of market disruption. I don’t believe the Fed today has credibility on the issue of containing an upward surge in inflationary pressures. Markets are instead confident the Fed will maintain loose financial conditions in almost every situation. And, importantly, this perception precludes markets from responding effectively to mounting inflationary pressures, while the absence of a functioning market adjustment mechanism only increases the likelihood that the current inflationary upcycle becomes more firmly entrenched.

Question: “Over the past decade, the Fed has invested significant resources in large-scale bank supervision, has completely overhauled that approach, and it’s even created a special committee that looks horizontally across the largest banks to find common risks. Did the Fed not see that multiple banks have large exposures to Archegos? If not, why not? And then what regulatory changes would you like to see implemented to change that going forward?”

Powell: “We supervise banks to make sure that they have risk management systems in place so that they can spot these things. We don’t manage their companies for them or try to manage individual risks. In the grand scheme of these large institutions, the Archegos risks were not systemically important or were not of the size that they would have really created trouble for any of those institutions. What was troubling, though, was that this could happen in a business for a number of firms that is thought to carry relatively well-understood risks. The prime brokerage business is a well-understood business, and so it was surprising that a number of them would have had this. And it was essentially, I believe, the fact that they had the same big risk position with a number of firms and they weren’t—some of the firms were not aware that there were other firms that had those things. I wouldn’t say it’s in any way an indictment of our supervision of these firms. In some cases it seems as though there were risk management breakdowns at some of the firms, not all of them, and that’s what we’re looking into.”

Noland comment: There have been innumerable derivative accidents going back to the role “portfolio insurance” played in the 1987 stock market crash. Derivatives have repeatedly proven themselves instruments that distort, exacerbate and redistribute risk. In the past, a multitude of derivative strategies have been used for highly levered speculation across the markets. And there is every reason to believe the Fed’s extreme monetary accommodation has further incentivized leveraged speculation. Archegos’ egregious leverage – financed by many of the leading global prime brokerages – is confirmation of this thesis. How can a central bank run such momentous monetary stimulus and not be completely on top of developments at the prime brokerages and derivatives markets?

Yahoo Finance’s Brian Cheung: “I wanted to ask about financial stability, which is a part of the Fed’s reaction function here. It seems like to people on the outside who might not follow finance daily they’re paying attention to things like GameStop, now Dogecoin, and it seems like there’s interesting reach for yield in this market, to some extent also Archegos. So, does the Fed see a relationship between low rates and easy policy to those things? And is there a financial stability concern from the Fed’s perspective at this time?”

Powell: “So we look at—financial stability for us is really—we have a broad framework, so we don’t just jump from one thing to another. I know many people just look at asset prices and they look at some of the things that are going on in the equity markets, which I think do reflect froth in the equity markets. But really, we try to stick to a framework for financial stability so we can talk about it the same way each time and so we can be held accountable for it.

So one of the areas is asset prices, and I would say some of the asset prices are high. You are seeing things in the capital markets that are a bit frothy. That’s a fact. I won’t say it has nothing to do with monetary policy. But it also has a tremendous amount to do with vaccination and reopening of the economy. That’s really what has been moving markets a lot in the last few months – is this turn away from what was a pretty dark winter to now a much faster vaccination process and a faster reopening. So that’s part of what’s going on. The other things, though, you know, leverage in the financial system is not a problem. That’s one of the four pillars. Asset prices were one. Leverage in the financial system is not an issue. We have very well-capitalized large banks. We have funding risks for our largest financial institutions are also very low. We do have some funding risk issues around money-market funds, but I would say they’re not systemic right now. And the household sector is actually in pretty good shape. It was in very good shape as a relative matter before the pandemic crisis hit…

So, the overall financial stability picture is mixed. But on balance it’s manageable, I would say. And, by the way, I think it’s appropriate and important for financial conditions to remain accommodative to support economic activity. Again, 8 ½ million people who had jobs in February don’t have them now, and there’s a long way to go till we reach our goal.”

Noland comment: Leverage in the system is very much an issue. The financial stability “picture” is not “mixed” – it’s calamitous. Ever since the Bernanke Fed coerced savers into the risk markets, the latent instability associated with the “Moneyness of Risk Assets” (the misperception of safety and liquidity) has festered. The Fed’s (and global central banks’) repeated market bailouts, and now perpetual massive monetary stimulus, have spurred unprecedented speculation and speculative leverage. Bank capital is not a pressing issue for this cycle; a traditional run on the banking system is not a prevailing risk. Yet there is monumental risk of a run on the risk markets – stocks, fixed-income, Treasuries. The Trillions that have flowed freely into the ETF industry, in particular, pose a clear and present danger to financial stability. Global leveraged speculation poses a clear and present danger to financial stability. Derivatives – a clear and present danger.

MNI’s Jean Yung: “We are seeing elevated market valuations and some economists are concerned that the economy might overheat, at least for a period of time. So, should the Fed and other regulators be thinking about tightening capital requirements or extending oversight to the nonbank sector so that financial stability risks stay as low as they have been?

Powell: “Capital requirements for banks went up tremendously, really, over the course of the 10 years between the financial crisis and the arrival of the pandemic… But to your point, …so what kind of happened during the pandemic crisis that requires attention: number one is money-market funds and corporate bond funds where we saw run dynamics, again, and we need to—we’re looking at that. So, we’re looking at ways and people around the world are looking at ways to make those vehicles resilient so that they don’t have to be, you know, supported by the government whenever there’s severely stressed market conditions. It’s a private business. They need to have the wherewithal to stay in business and not just count on the Fed and others around the world to come in. So that was that.

The other one is Treasury market structure. Dealers are committing less capital to that activity now than they were 10 or 15 years ago, and the need for capital is higher because there is so much more supply of Treasurys. And, so, there are some questions about Treasury market structure and there’s a lot of careful work going on to understand whether there’s something we can do about this, because… the U.S. Treasury market is probably the most single important market in the economy in the world. It needs to be liquid. It needs to function well for the good of our economy and the good of our citizens… As you know, at the very beginning of this recent crisis, there was such a demand for selling Treasurys, including by foreign central banks, that really the dealers couldn’t handle the volume. And so what was happening was the market was really starting to lose function, and that was a really serious problem which we had to solve through really massive asset purchases. So, we’d like to see if there isn’t something we can do to—do we need to build against that kind of an extreme tail risk, and if so what would that look like.

MarketWatch’s Greg Robb: “It’s just kind of confusing, the question and your answer, you know, the housing market is strong, prices are up. And yet, the Fed is buying $40 billion per month in mortgage-related assets. Why is that? And are those purchases playing a role at all in pushing up prices?”

Powell: “We started buying MBS because the mortgage-backed security market was really experiencing severe dysfunction. And we sort of articulated what our exit path is from that. It’s not meant to provide direct assistance to the housing market. That was never the intent. It was really just to keep that very close relation to the treasury market and a very important market on its own. And so that’s why we bought, as we did during the global financial market, we bought MBS too. Again, not an intention to send help to the housing market, which was really not a problem this time at all. So, it’s a situation where we will taper asset purchases when the time comes to do that. And those purchases will come to zero over time. And that time is not yet.

Bloomberg’s Mike McKee: “Since I am last, let me go back to… the first question, and ask… whether you’re thinking about thinking of tapering, but why you’re not… The markets seem to be operating well. Are you afraid of a taper tantrum? Or is it, as one money manager put it, if you get out of the markets there aren’t enough buyers for the treasury debt and so rates would have to go way up? The bottom-line question is: What do we get for $120 billion a month that we couldn’t get for less?

Powell: “So, it’s not more complicated than this: We articulated the substantial further progress test at our December meeting. And really for the next couple of months we made relatively little progress toward our goals… We got a nice job report for March. It doesn’t constitute substantial further progress. It’s not close to substantial further progress. We’re hopeful we will see along this path a way to that goal. And we believe we will, it just is a question of when. And so when the time comes for us to talk about talking about it, we’ll do that. But that time is not now. It’s—we’re just that far. We’ve had one great jobs report. It’s not enough. We’re going to act on actual data, not on our forecast. And we’re just going to see more data. It’s no more complicated than that.

McKee: “If you leave rates where they are, doesn’t change anything. But does it change anything if you actually tapered a bit? If you spent less would you still get the same effect on the economy?

Powell: “No, no. I think the effect is proportional to the amount we buy. It’s really part of overall accommodative financial conditions. We have tried to create accommodative financial conditions to support activity, and we did that. And we articulated the tests for withdrawing that accommodation… And the only thing that will guide us is, are the tests met? That’s what we focus on, is have the macroeconomic conditions that we’ve articulated, have they been realized? That will be the test for tapering asset purchases and for raising interest rates.”

Noland Comment: The Fed asymmetric policy approach has been a rather slippery slope going back to Alan Greenspan’s nascent venture into market manipulation (and, as such, financial conditions management) with terse comments and little “baby step” rate moves. At this point, the Powell Fed’s version of asymmetric policies makes Greenspan’s asymmetry appear as virtual mirror images.

It was only about two weeks from record stock prices to the Fed’s March 2020’s emergency meeting, with the Fed slashing rates and immediately beginning a program that would inject Trillions of liquidity directly into the securities markets. There is zero doubt when it comes to the Fed’s stimulus reaction function: market instability. This had already been made clear the previous September, when the Fed adopted “insurance” policy stimulus in response to repo market instability – this despite stocks near record highs and unemployment at multi-decade lows. When Bubble markets then began to falter in the face of pandemic risks, the Fed responded rapidly and with overwhelming force.

Despite Chair Powell’s repeated explanations, the Fed’s reaction function for reversing stimulus measures is nebulous and clearly asymmetric (when compared to employing stimulus). Strangely, market function – even so much as gross excess – plays no role. It might well be several years from the point of robust market recovery to even the first little “baby step” off zero rates. That the economy is in the process of rapid recovery has to this point played no role in the Fed even discussing the tapering of its historic QE program. Forecasts call for April job growth of just under a million, following March’s almost one million jobs created. It may not be many months before the unemployment rate is back below 5%.

The Fed focuses on financial conditions when initiating QE. Markets have become so integral to system Credit, liquidity, perceived wealth, spending, investment, and economic activity generally, that our central bank responds immediately – and now with overwhelming force – in the event of market disruption. Yet no matter how “frothy” the markets and how incredibly loose financial conditions have become – these are not considerations for removing stimulus.

Simplifying the Fed’s reaction function: Move with overwhelming force at the first sign of market trouble – then stick with unprecedented stimulus until data is on a trajectory to soon return to full employment. This policy framework is a godsend to speculative Bubbles.

It’s a huge mistake to disregard a year of extremely loose financial conditions when contemplating stimulus reduction. The unemployment rate is a lagging indicator. Is it coincidence that the Fed’s key metric for commencing stimulus tapering is the lagging jobs market? Global asset markets and inflationary pressures are clearly signaling that monetary policies are dangerously loose. And it’s becoming so obvious that some are breaking rank.

April 30 – Bloomberg (Catarina Saraiva): “Signs of excess risk taking in financial markets show it’s time for the U.S. central bank to start debating a reduction in its massive bond purchases, said the president of the Dallas Federal Reserve, breaking ranks with Chair Jerome Powell. ‘We’re now at a point where I’m observing excesses and imbalances in financial markets,’ said Robert Kaplan… ‘I’m very attentive to that, and that’s why I do think at the earliest opportunity I think will be appropriate for us to start talking about adjusting those purchases.’”

April 30 – Bloomberg (Alexander Weber): “European Central Bank policy maker Jens Weidmann said officials must be prepared to tighten monetary policy when needed to curb inflation, even if that increases the strain on heavily indebted governments. ‘We central bankers must clearly say that we will rein in monetary policy again when the price outlook demands it,’ the Bundesbank president said… ‘And irrespective of whether the financing costs for governments rise.’ Weidman said the institution risks becoming too entangled with fiscal policy through its massive bond purchases, which have been deployed repeatedly to calm markets and to boost inflation, and which were ramped up during the pandemic. ‘When the Eurosystem started its first purchase program 10 years ago, some were hoping that it would be temporary. This hasn’t become true,’ he said. ‘My worry at the time that fiscal policy would increasingly smother monetary policy is still on my mind.’”

Original Post 30 April 2021


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Categories: Perspectives