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Paris | Those of us who anticipated a quiet holiday break have been greatly disappointed. It is tempting to blame the electronic flatulence of the POTUS for the market selloff of the past few weeks, but in fact the credit for the great unwind must go to the members of the Federal Open Market Committee.
First, the FOMC embraced unconventional policy after 2008, greatly expanding the liquidity in the US financial markets and thereby boosting valuations for stocks, bonds and real estate to astronomical levels. Second and most important, the FOMC lied to the American public about these policies. Specifically, by adopting a largely conventional policy narrative that ignores the real world impact of unconventional policy, the FOMC has misled the public and confused the markets.
In simple terms, the FOMC refuses to accurately describe its policy for what it is – namely a reckless embrace of asset price inflation. Recall that after the 2008 liquidity crisis, when Fed Chairman Ben Bernanke wanted to call quantitative easing (QE) “large scale asset purchases,” the Fed’s Washington staff instead came up with the absurd and largely inaccurate euphemism of “quantitative easing.” QE, properly understood, was a direct violation of the legal mandate from Congress that instructed the central bank to seek “price stability.”
During the period of radical FOMC policy measures like QE and Operation Twist, the US equity markets rationalized the extraordinary. Economists and Sell Side market analysts told investors that everything was fine, when in fact the FOMC was engaged in a vast and largely speculative experiment that distorted all manner of asset prices in the US and globally. Asset prices rose and investors cheered -- even as Washington's red ink became a torrent of new debt.
From 2014 through the middle of 2018, the S&P 500 and DJIA rose by nearly 60% while the US economy was growing at barely 2%. Say what you want about central bank independence, at some point we need to hold members of the FOMC responsible for their policy actions. If the price of achieving full employment is to set the US economy on a course toward another asset bubble and financial crisis, then it is time for Congress to repeal the Humphrey-Hawkins Full Employment Act of 1978.
Part of the reason why the FOMC finds it impossible to accurately describe its policy actions is that the second part of the mandate, namely “price stability,” has largely been discarded. Humphrey-Hawkins, let us recall, mandated zero inflation given full employment, a goal that was probably never possible. The political pressure from both national parties makes it problematic for any Fed Chairman to repeat the anti-inflation policies of former Chairman Paul Volcker in the 1970s.
The demographic patterns of fifty years ago rightly put the emphasis on wage and consumer prices, this at a time when offshore capital inflows did not figure significantly in the economic equation. Today, however, the vast growth in the global use of the dollar as a means of exchange and store of value has changed the calculus for assessing “inflation” in profound ways. In the 2000s, vast capital inflows financed the US economy with the appearance of low inflation, but now the tide is going out.
Of course, economists point to the heavily adjusted statistical measures of wage and price inflation as evidence that the FOMC is largely fulfilling the dual mandate. But how can any reasonable person watch annual double digit gains in stock market valuations or real estate prices and conclude that inflation is under control? We note in the most recent edition of The IRA Bank Book that inflation in real estate prices finally has skewed the net-loss given default for $2.5 trillion in bank owned 1-4 family mortgages negative in Q3 2018 (see chart below).
Source: FDIC
The same skew in the credit loss characteristics of 1-4 family mortgages is also visible in multi-family and commercial real estate, thus begging the question to the FOMC: Is the same volatility and price deflation now visible in US stocks eventually going to be seen in real estate as quantitative tightening (QT) proceeds with the shrinkage of the Fed’s balance sheet? Real estate markets move far more slowly than stocks, but is the same dynamic that has taken away almost half of the stock market gains since 2014 also pushing property valuations inevitably lower? A: Yes
Our contributor Ralph Delguidice ("Are Leveraged Loans a Problem? Yes, and No. And YES") reminds us that noted economist Zoltan Pozsar has long argued that QE-created bank reserves are not --and have never been --“excess.” In fact, he notes, they remain the ONLY settlement medium that can be used to meet the now binding (intra-day) liquidity requirements and all the other regulatory constraints on bank capital and assets. Pozsar wrote in his paper “A Macro View of Shadow Banking” (2015):
“The swapping of excess reserves for reverse repos and boosting the supply of Treasury bills (whether in a reserve neutral or reserve draining fashion)… would both lead to shrinking bank balance sheets (as reserves are swapped into RRPs deposits flow out of banks to fund RRP counterparties such as money funds) as well as shrinking dealer balance sheets as more Treasury bills and RRPs offer alternatives for money funds that are safer than dealer repos. And on the flipside, reduced matched-book repo volumes mean less funding for levered bond portfolios and fewer opportunities for lending low intrinsic value securities, both of which will reduce opportunities to deliver excess returns via levered betas for pension funds and other real money accounts that struggle with structural asset-liability mismatches.”
The obvious points to take from Pozsar’s work are two: First, the FOMC cannot withdraw the liquidity provided to the US financial system via QE without causing the system to implode. Chairman Jerome Powell needs to publicly state that the Bernanke-Yellen inflation in asset prices will entirely reverse as the FOMC tries to reduce “excess reserves” to pre-crisis levels. Regardless of whether the FOMC raises the Fed funds target rate or not, continuing to shrink bank reserves via QT implies a significant reduction in prices for stocks and real estate.
Second and more important, Powell needs to inform Congress that so long as the Treasury intends to run trillion dollar plus annual deficits, the Fed’s balance sheet must grow rather than shrink. To have the FOMC try to follow a narrative set in place half a century ago when fiscal deficits were minuscule is obviously impossible given the Treasury’s borrowing needs. This implies that the FOMC must embrace an explicit policy of inflation that is at odds with the legal mandate enshrined in Humphrey-Hawkins.
As we’ve noted previously, the POTUS is right to criticize the Fed’s policy actions, but for the wrong reasons. The fixation of markets and the financial media on whether the FOMC raises the target rate for Fed funds or not is misplaced, part of an time worn policy narrative that is completely antiquated. Since 2017, the only important trend in credit markets has been whether the Fed’s balance sheet is shrinking and at what rate. The move in credit spreads that started in August signaled that there is a growing problem with liquidity, yet the FOMC ignored the warning.
Trapped in a policy path that is at odds with actual fiscal and economic realities, the FOMC is now the destabilizing factor in the markets. And remember that credit leads, equities follow. Our prediction for 2019 is that the FOMC will be forced to resume QE and again grow the System Open Market Account (SOMA) portfolio to maintain a ratio (yet to be determined) between the SOMA and the rapidly growing stock of outstanding Treasury debt. This is a pattern familiar to observers of other heavily indebted developing nations. Welcome to Brazil.
