Monday, February 25, 2019

Why The Fed's Doom-Loop Will Take The US Economy Down, Part 1

By David Stockman

When you boil it down to the bare essence, the reality is that Wall Street traders and speculators are now---and have been for quite some time--- running the Federal Reserve. And, apparently, the stock market averages are the new policy transmission channel through which the monetary politburo FOMC seeks to manage the main street economy.

Yesterday's meeting minutes made that crystal clear:

Participants agree that it was important to continue to monitor financial market developments and assess the implications of these developments for the economic outlook. 
Needless to say, this kind of rubbish has been issuing from the Eccles Building for so long that neither the "participants" nor Wall Street even get the joke. That is to say, 30- years ago no one--not even the most rabid Keynesian interventionists----would have said that the stock market should have any bearing on monetary policy at all.

That's because the very last thing that monetary policy should be based upon is the momentary spasms of headline-reading, chart-driven algos and day traders. Yet between December 19 when Powell said the Fed's long overdue balance sheet shrinkage was on "automatic pilot" at a $600 billion annual drainage rate and two weeks latter when he slammed the Pause Button, absolutely nothing changed about Money or Economy.

Well, actually one thing did change. We have been arguing for some time that Jay Powell is just Janet Yellen in tie and jacket. But now its also pretty clear that he's been depantsed, too.

In any event, with respect to Money, what we are saying is that it's supposed to be a standard of value, a store of wealth and a medium of transaction. Surely a server farm full of robo-machines trading DMAs, trend lines, Elliot Waves and Fibonacci points while pretending that virtually profitless companies like Netflix are worth 195X earnings has nothing to do with money at all.

Likewise, what could Powell and his merry band have learned about Economy during those two weeks that would justify an abrupt and radical pivot at this late stage of the cycle---especially after years and years of delaying, dithering, dodging and ducking the need to normalize policy?

And the shift was radical, indeed. After two months of elaborations and exegesis, the Powell Pivot has now been interpreted by Wall Street to mean no rate increases at all in 2019; an end to QT by September 30 by the very writ of Goldman Sachs itself; and the sharply elevated probability that the next policy move is toward a new round of easing and stimulus.

In regard to the latter, in fact, one of the very worst of the Fed money-wreckers, James Bullard, was on bubblevision this AM arguing exactly that. By Bullard's lights, the Federal funds rate at 2.4% is already too high, meaning the Fed should sit on its hands or even ease until the inflation rate is at or above its 2.00% target.

In other words, the post-inflation and post-tax return on liquid savings should be zero or below forever; and that if you should actually want to "save" for a raining day or retirement you must buy corporates, junk bonds, the SPX or the FAANGs.

Likewise with respect to the balance sheet. It took 94 years to build the Fed's balance sheet from zero to $900 billion, but only 94 days to get it to $2.2 trillion, and then another 55 months to reach $3.6 trillion.

Yet, as articulated by the Fed heads when the QE phases were being launched, this was all being done on an emergency basis; it was ostensibly a desperate resort to "extraordinary" policy measures that were to be reversed as soon as the crisis passed and economic and financial stability was restored.

So after the longest bull market in history, the second longest economic expansion ever and the Fed heads and the Donald alike taking bows for the lowest unemployment rates in 50 years, you could be forgiven for thinking that the financial crisis was far back in the rearview mirror and that stability had been regained.

But no matter. It's now patently obvious that the balance sheet of the Fed will go no lower than $3.6 trillion, and that the power-hungry monetary central planners who run the Fed were flat-out lying when they said the balance sheet explosion shown below was not monetization of the public debt, but only a temporary "emergency" loan designed to quell the panic and liquefy the parched balance sheets of the Wall Street dealing houses and hedge fund gamblers.

A perspective on the magnitude of this Big Lie can be gained by repairing to Uncle Milton Friedman's rule of money growth at @3% per annum. If you lay that on a straight ruler from the pre-crisis $900 billion, you would have a Friedman approved balance sheet of about $1.2 trillion today.

Accordingly, the monetary politburo apparently intends to permanetly monetize about $2.4 trillion of excess balance sheet in the form of its "emergency" holdings of Treasury and GSE debt, and for exactly what purpose other than to pleasure the stock market?

It certainly couldn't be on account of need to bolster its statutory mandate. After all, it's hard to say that current conditions do not actually imply full satification of those targets.

According to the January meeting minutes themselves, the unemployment rate at 4.0% is under the Fed's long-term goal of 4.3%; the core CPE deflator at 1.9% is nigh on to the magic 2.00% inflation target; and it would be nearly impossible to deny that the 10-year treasury note at 2.68% isn't "moderate" and then some.

The Federal Open Market Committee (FOMC) is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. 
Actually, the magnitude of the real monetization gambit here is actually far greater than indicated above. That's because for the 19 years prior to Bernanke's printing spree in the fall of 2008, Alan Greenspan had already gone to town big time.

As it happened, the Fed's balance sheet was only $200 billion when the Maestro arrived in the Eccles Building in August 1987, and would have been about $380 billion when he left in January 2006 under Friedman's rule.

So the contrafactual math of the matter is this: Under a Friedmanite growth rule the Fed's balance sheet today would be under $600 billion. In the interim, $3.0 trillion of public debt will have been monetized even if the Fed succeeds in cranking its balance sheet back from $4.0 billion today to the newly muted target of $3.6 trillion.

Needless to say, monetizing $3 trillion of public debt is financial fraud on an epic scale. Every dollar of those bonds and GSE securities funded real claims on labor, capital and materials, but they were all purchased with fiat credits plucked from thin air by the FOMC.

So what we actually have is a horrible mutation of what money and central banking are supposed to be about.

Way back in 1914, the Fed started as a "bankers' bank" to provide back-up liquidity to the commercial banking system on a decentralized basis (hence the 12 regional banks).

It was not authorized to buy a single dime of government debt, could only make discount loans against current business assets such as receivables and finished inventory, and at a penalty rate above the market rate of interest.
It therefore had no mandate for Economy---unemployment, inflation, GDP growth, housing starts etc.----as opposed to Money. Nor was it authorized to peg the money market rate like today in pursuit of Economy. And most certainly it had no remit to finagle against an imaginary thing called r-star, which is allegedly the "neutral rate" of interest, because the free market was sovereign.
Then during the two wars it became a war finance arm of the Federal government; and thereafter during the William McChesney Martin era at the Fed (1951-1970) a custodian of the banking system with a light touch view to the general drift of Economy---sans the spurious precision of Humphrey-Hawkins' employment, inflation and GDP targeting.

At length, Arthur Burns and William Miller destroyed the tenuous balance of Martin- style central banking in the roaring stagflation of the 1970s; and it took the heroic efforts of Paul Volcker to undue the damage and purge the rampant inflation that overcame the system.

But Tall Paul was fired by the pols in the Reagan White House before he could re- establish a Money-based model of central banking, which viewed the GDP and all its components as the business of capitalism, not the FOMC.

That's perhaps because the White House pols knew that the rubber was about to meet the road with Reagan's giant deficits in the context of near full employment in 1987, and that surging interest rates would crowd out private investment and spending, and end the Gipper's borrowing spree in a renewed bout of recession.

As it happened, the 10-year treasury rate surged from 7.0% to more than 10.0%
during the first 9 months of 1987, thereby triggering the devastating 22% meltdown in the stock market on Black Monday of October 1987.

Then and there, of course, Alan Greenspan crossed the Rubicon. By injected massive liquidity into Wall Street, commanding dealing houses to trade with each other whether than wanted to or not and dragooning the nation's top CEO into a stock buyback spree, Greenspan overrode the stock market and started the nation down the treacherous road of Bubble Finance and monetary central planning.

As we will develop further in Part 2, the entire Greenspan central banking model was based on the notion that Money didn't matter anymore, and that Economy could be managed through the transmission channel of the capital markets for equities and other risk assets.

That was a monumental error. It ended up transforming the stock market into a raging speculative casino that actually functions as a financial pathogen on the main street Economy. It causes speculators in the trading pits and the C-suite managers of corporate America to consume the cash flows and debt capacity of the main street Economy in financial engineering, while starving investment in productive assets and the rudiments of capitalist growth.

As Sven Henrich of Northman Trader observed this AM:
It’s as straight up talk as you will get from the Fed. What this all means is what critics like myself has been saying for a long time: The Fed needs rising markets for a growing economy. Market performance and economic performance have become so intertwined that the Fed’s primary mandate, admitted or not, involves preventing or minimizing market drops. A crash would bring about a recession and hence Bernanke stepped in again in 2011 and 2012 following the initial QE1 program, hence why Janet Yellen paused rate hikes in February 2016, hence why Powell stopped rate hikes now. All for the same reason, all at the same time: Coinciding with dropping markets. And hence we’ve morphed into a financial system that is never allowed to price in the reality of its underlying fundamentals so afraid are they of the consequences of the baseline, and this is why ever more debt is needed to sustain it. And while we have some big companies who are winning in this game the vast majority look increasingly exposed to a future shock. 

David Stockman was Director of the Office of Management and Budget under President Ronald Reagan. After leaving the White House, Stockman had a 20-year career on Wall Street.

The above originally appeared at David Stockman's Contra Corner.

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