New York | In his new book, “Keeping At It: The Quest for Sound Money and Good Government,” by Paul Volcker (1979-1987) with Christine Harper, the former Fed Chairman delivers a sound rebuke to Chairmen Ben Bernanke (2006-2014) and Janet Yellen (2014-2018), and other Fed governors and economists, for fretting overmuch about deflation. He argues that the true danger is that loose monetary policy leads to inflation and market contagion caused by the manipulation of risk preferences.
Volcker specifically chides Bernanke and Yellen for their fixation on a two percent inflation target, one of the main ornaments on the data dependent Fed Christmas Tree. “How did central bankers fall into the trap of assigning such weight to tiny changes in a single statistic, with all of its inherent weakness?” he asks. Good question. Volcker writes in Bloomberg:
“Deflation is a threat posed by a critical breakdown of the financial system. Slow growth and recurrent recessions without systemic financial disturbances, even the big recessions of 1975 and 1982, have not posed such a risk. The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the ‘easy money,’ striving for a ‘little inflation’ as a means of forestalling deflation, could, in the end, be what brings it about. That is the basic lesson for monetary policy. It demands emphasis on price stability and prudent oversight of the financial system. Both of those requirements inexorably lead to the responsibilities of a central bank.”
Of course, Volcker is cut from different cloth than his successors. Janet Yellen was only chairman of the Federal Reserve Board for four years and with good reason. She was arguably the most dovish Fed Chairmen in the history of the central bank, with a strong tendency to do too much rather than too little. Yellen confessed to the Financial Times last week that “I really thought we needed to pull every rabbit out of the hat.” And she did.
An adherent of the state-intervention school championed by her Yale mentor James Tobin, Yellen has always followed the tendency of the left to support greater ease and tolerate higher levels of inflation. During her tenure as a Fed governor and then chairman, the Fed engaged in the purchase of trillions of dollars in government debt and mortgage securities through “quantitative easing” – a free loan to the Treasury that was couched as “stimulus.”
The Federal Open Market Committee (FOMC) under Bernanke and Yellen also engaged in a deliberate manipulation of the term structure of interest rates via “Operation Twist,” a terrible mistake that has yet to be reversed. Operation twist caused untold damage to the financial markets and the US economy – damage that is still in process.
In that interview with the FT, Yellen worries that the rhetorical attacks on the central bank by President Donald Trump is “whittling away the legitimacy and stature of institutions the public has traditionally had some confidence in. I feel it ultimately undermines social and economic stability.” She then goes on to say that “Trump has the potential to undermine confidence in the Fed.”
Former Chairman Alan Greenspan, the most politically astute Fed chief in half a century, puts such worries in perspective: "I don't know a single President, and I worked for a lot of them, who don't want lower interest rates. Now, obviously that's not possible. You keep lowering them down to zero, where do you go from there?"
Like Yellen, many observers worry that criticism of the Fed will make it difficult for the central bank to act when necessary. The dual, conflicted political mandate of full employment and price stability created by the Humphrey Hawkins law is not possible to achieve in practice, thus the FOMC lurches from one extreme to the other, causing enormous collateral damage.
Consider the effects of QE and Operation Twist on housing. Think about the thousands of people in the mortgage industry, for example, that have lost their livelihoods because the boom and bust policies followed by the Fed since 2008 and even before. Think about the millions of American families today that cannot afford to buy a home because asset prices have skyrocketed over the past five years.
By pulling tomorrow’s home sales and other economic activity forward via various policy manipulations, tomorrow is now light in terms of growth. Tomorrow also carries hidden market and credit risks caused by the Fed’s past actions. As we watch mortgage lending and home building volumes fall next year and thereafter thanks to the property price inflation created by the FOMC under Bernanke and Yellen, remember that Fed policy was explicitly meant to “help” the housing sector.
When people talk about “Fed independence,” our response is independence from what? Presidents going back to FDR have tried, unsuccessfully, to bend the central bank to the political circumstances of the day. In the book Inflated: How Money and Debt Built the American Dream, we wrote about how Chairman Thomas McCabe (1948-1951) and his colleagues on the FOMC starred down President Harry Truman on the eve of the Korean War. He won back the Fed’s independence from the Treasury. But the Fed and Treasury, like all federal agencies, are notional institutions, merely alter egos for the United States.
The greatest threat to the central bank’s existence is the tendency of Fed governors and economists to pursue abstract economic theories that make no sense in real world terms and often do more harm than good. We have written at length about how the radical policies followed by the FOMC, first under Bernanke and then Yellen, have distorted asset allocations, and the term structure of interest rates and credit spreads.
For example, our best guess is that the 10-year Treasury bond, in the absence of QE2-3 and Operation Twist, should be yielding well-over 4 percent today. Instead this important benchmark of risk is barely over three percent. Indeed, the entire Treasury yield curve still shows a strong tendency to fall thanks to debt purchases by the Fed and other central banks. And corporate credit spreads remain compressed, with high-yield spreads up 25bps in the past month but really unchanged from a year ago, as shown in the chart below.
Traditionally, Fed chairmen have disappeared into the world of academia, speaking or consulting after leaving office. Bernanke has followed this rule, but Yellen seems unconstrained by such conventions. During her discussion with the FT, Yellen worries about lending to heavily indebted, less creditworthy corporate borrowers, which she sees as a source of potential “systemic risk.” She also talks about the need for more regulation, to counter the potential for systemic risk caused by this accumulation of risk.
Is it really possible that Chair Yellen fails to understand that the Fed’s deliberate manipulation of the credit markets since 2008 made this worrisome accumulation of corporate junk debt possible? Does she understand why most corporate debt issuers are clustered around the “lower bound” of investment grade ("BBB")? As we noted this past week, liquidity in the credit sector is the next risk on the merry-go-round of financial markets, a cycle of asset and market risk that the Fed largely controls.
Today the FOMC under Chairman Jay Powell is working to “normalize” policy, but without unwinding QE2-3 and Operation twist. Last week, at a talk at the Peterson Institute for International Economics, newly confirmed Fed Vice Chairman Richard Clarida discussed monetary policy normalization, but significantly made no mention of ending other legacies of "unconventional" policy such as QE 2-3 and Operation Twist, or paying above-market interest rates on excess bank reserves.
In the language of the FOMC, QE and Operation Twist were a form of stimulus. In the language of the financial markets, they represented a back door loan to the Treasury and the manipulation of credit markets. Even in the supposedly conventional world of Fed monetary policy, the concepts and indicators used to formulate public policy are often vague – a point that has already drawn the critical notice of Chairman Powell.
Chairman Volcker is not the first member of the Federal Reserve System to criticize the dangerous policy drift inside the US central bank, but his comments are entirely on point. By substituting nonsensical concepts like “neutral” interest rates for hard data, and by manipulating the financial markets so that they are no longer reliable measures of risk or inflation, the FOMC under Bernanke and Yellen has been deliberately flying blind.
Former Cleveland Fed President Lee Hoskins and his former colleague Walker Todd note in a important research paper, “Twenty Years after the Fall of the Berlin Wall: Rethinking the Role of Money and Markets in the Global Economy,” that the Fed is now a source of systemic risk. They write:
“Today we bear the fruits of state-managed intervention and seat-of-the-pants monetary policy. Many of the interventions from the 1930s are still with us—the Federal Housing Administration, Fannie Mae, and Freddie Mac, to name just a few—and they all played a major role in the housing bubble and its collapse in 2008… Meanwhile, government guarantees and insurance programs for financial assets, along with bank bailouts, have produced, arguably, the largest increase in moral hazard in the history of financial markets. The Fed’s zero interest rate policy lasted so long (2008–15) that it encouraged excessive risk-taking, certainly riding the yield curve for banks (funding short and lending long). Unless reversed, these policies will plant the seeds for the next bubble.”
So far, Chairman Powell and his colleagues on the FOMC have refused to speak publicly about unwinding QE 2-3 and Operation Twist. Meanwhile, former Fed Chairs Bernanke and Yellen travel the globe, congratulating themselves for saving the world from the threat of deflation even while encouraging the accumulation of the biggest pile of debt in modern history. But the full aftermath of the 2008 crisis is still incomplete.
As and when the wheels come off the proverbial cart in the credit markets around 12-18 months out, it will not be due to a lack of regulation but rather because of reckless polices of the FOMC under the past two Fed chairmen. As Jim Grant noted recently, Chairman Powell truly is a prisoner of history.
Click here to listen to the interview with Jim Grant of Grant's Interest Rate Observer.