The Downside to Transparent Baby Steps:
by Doug Noland
August 1 – Financial Times - Excerpted from Henry Kaufman’s exceptional Op-Ed Piece, “New Fed Chairman Must Tread an Uncertain Path": “When a new chairman of the US Federal Reserve assumes office next year, the transition will be greeted by great fanfare and widespread market apprehension. He or she will succeed a long-serving predecessor and one of the most widely known chairmen in Fed history. The new chairman will also be forced immediately to confront some knotty domestic and international challenges… The new chairman will need to make tough judgments on the housing sector. Unfortunately, the Fed does not yet view this with alarm. It has drawn attention to isolated instances of exuberance while publicly applauding aggregate data on housing activity and the financial strength of households. Nevertheless, household debt has risen sharply, and the grave risks this poses can be minimised only by low interest rates, rising household income or a combination of the two. For the new chairman the question will be: can households continue to serve as a stabilising force in the next recession or have they already been marginalised by the household debt binge? For their part, financial markets will watch closely to see if the new chairman maintains the current tactical monetary approach. Under Alan Greenspan, this has consisted primarily of two tenets – measured responses to economic developments and increasing transparency in monetary policy. Since the inception of this approach several years ago, the central bank has raised its Federal funds rate 25 basis points after each meeting of the [FMOC]. Fed officials have tried to reassure market participants through frequent public utterances. This approach has wrought several unintended consequences. For one, it has contributed to a massive carry trade… This is because investors have been conditioned to expect moderate and steady increases in money rates, which their quantitative analysis shows will pose limited risks, if any, along the yield curve. This, in turn, has led them to conclude that the carry trade can be the source of substantial profits… Although spread compression typically yields smaller profits from carry trades, profits have remained high as investors have enlarged their positions. In short, the Fed’s recent monetary approach, combined with the US Treasury’s practice of confining much of its new borrowing to short- and intermediate-term notes, explains a great deal of what the Fed has dubbed a “conundrum”… The second unintended consequence of the Fed’s measured response policy has been the massive growth of debt. Investors have reacted to the assurance of a measured response by borrowing more. In highly securitised and innovative financial markets, which by themselves encourage entrepreneurial financial behaviour, rapid debt growth is a natural consequence of measured response policies…”
Mr. Kaufman is the master. He may no longer dazzle the markets with his uncanny ability to forecast interest rates as he did years ago, though this is no fault of his. The financial landscape changed profoundly from his heyday as ace market forecaster, an evolution he so brilliantly prognosticated in his 1986 book, “Interest Rates, the Markets, and the New Financial World.”
We do operate these days in a Financial New Age, where limitless Wall Street finance has completely overturned the traditional dynamic whereby market rates were determined through the interplay of the supply of savings with the demand for borrowings. No longer does Kaufman-style diligent analysis of financial flows and Credit demand provide an edge in forecasting bond yields (a contention well supported by the quantities of egg I’ve had to wipe from my face!). The game has changed profoundly to “simply” predicting the Fed’s next move(s). This is not only a one-heck-of-a-lot-less arduous endeavor than analyzing the supply and demand for system finance. It has, as well, been made far too easy by the Greenspan Fed’s “evolution” to Transparent Baby Step Monetary Management.
There is no doubt that Fed policy has nurtured leveraged speculation and incited unprecedented financial leveraging and consumer borrowing, as Mr. Kaufman so adeptly and concisely articulated. And there is little doubt that Transparent Baby Steps was an outgrowth of the fragilities associated with previous excesses. The Fed has been highly cognizant of the speculation and leverage-rife Credit system and an over-indebted economy. I have argued that the resulting Fed timidity and accommodation were absolutely the wrong approach to deal with such a financial and economic backdrop – the Credit Bubble “blow-off” and deeply maladjusted Bubble Economy. It has been a case of policy errors begetting more dangerous mistakes. The predictable consequences include precarious asset Bubbles, greater leveraged speculation, a more debt-laden and vulnerable U.S. economy, acute system fragility and, increasingly, a much more unstable global Credit boom backdrop.
When the Fed nudged rates up 25 basis points a year ago June to 1.25% and made it clear that it was prepared to delicately reduce accommodation over an extended period, Street pundits (along with speculators) were afforded free rein. They relished in theorizing that the Fed had won the long, hard battle against inflation, while forecasting that the spoils of war would include a 2.50% ceiling for short-term borrowing costs. Apparently, savers were no longer deserving of a respectable return, while mortgage borrowers and the leveraged speculating community were to forever delight in financial windfall.
Well, 2.5% came and went, yet the analysis steadfastly stayed the same: Inflation was dead, and the Fed was perpetually almost done. Furthermore, system fragility would hold Fed tightening at bay, while the “disinflationary” economy would forever be at the brink of abrupt slowing. Accordingly, there was every reason to expect that bond yields would remain permanently in the cellar (prices in the penthouse suite). And if anyone was tempted to wager against bond prices, the emboldened bulls were tickled at the opportunity to take their money. One peculiar aspect of Monetary Disorder was an orderly one-way bond market. The historic confluence of unprecedented US household mortgage borrowings, financial sector leveraging and speculation, and foreign central bank balance sheet ballooning assured overly-abundant marketplace liquidity to inflate virtually all asset prices everywhere (and explaining the “conundrum”).
I have (stubbornly) taken the other side of the unavailing inflation “debate,” arguing that inflation is anything but dead and bond prices anything but a sure bet. While intellectually stimulating (at least to me), it has to this point been a waste of time. The bulls have steadfastly fixated on core CPI, low long-term rates, and the flat yield curve, while scoffing at any analysis bearing inflation as a risk factor. There has been no “debate,” but times they are changing.
Market players will likely continue to trumpet quiescent (narrow) CPI inflation and completely disregard (broad) Credit inflation. Yet the bottom line is that the U.S. economy (and globally to a lesser extent) is in the midst of a major inflationary boom. CPI is essentially irrelevant, while the dynamics of broad inflation in Credit and its myriad Inflationary Manifestations are the key issue.
Admittedly, inflation hasn’t mattered to the markets to this point because it hasn’t been a factor with respect to Fed Transparent Baby Step Monetary Management. But I think this may have begun to change this week. The Credit Bubble, the Mortgage Finance Bubble, the Leveraged Speculation Bubble, and the Distorted U.S. Bubble Economy have scoffed at the feeble little Baby Step rate increases. There has been no tightening – none. Mortgage Credit creation is currently at record levels, Credit spreads remain unusually narrow, markets remain over-liquefied, and easy Credit Availability has never been as widespread.
With respect to Credit inflation dynamics, housing inflation has been accommodated and monetized, in the process nurturing inflating household net worth and incomes, along with (largely through the resulting Current Account Deficit) the Commodities Boom and the Energy Boom. Crude, energy and commodity price gains have been accommodated and monetized, adding further impetus to the U.S. Credit and Economic Bubbles, the China/Asia Bubble and emerging market excesses. As inflation dynamics have tended to do throughout the ages, Credit excess begets higher prices that beget only greater Credit excesses. Inflation dynamics and (to this point) limitless Wall Street finance make for a precarious mix. Perhaps the markets are beginning to take notice.
No longer are the issues of Inflation, Disinflation and Deflation merely fodder for intellectual theorizing. If I am correct – that Credit Inflation and Inflationary psychology are now firmly embedded in the U.S. Bubble economy – only significantly higher rates and/or financial crisis will sufficiently rein in Credit excesses. Mortgage Credit creation must be reduced, something made quite challenging by recent housing inflation, financial innovation, and unparalleled Credit Availability. The Fed is certainly hoping to orchestrate a soft-landing for U.S. housing prices. But, as we witnessed with technology and NASDAQ, it is not the nature of powerful booms to quietly succumb. When accommodated, they have an intense propensity to go to wild extremes only to then collapse.
For sometime now the bulls have enjoyed having a copy of the Fed’s playbook. This unusual luxury allowed them to create a fanciful world comprised of a productivity miracle, downward wage pressures, general dis-inflationary pricing pressures, a global savings glut, world-wide manufacturing overcapacity, a stable new “Bretton Woods II” global monetary regime and perpetually low global interest-rates. And, Thinking Soros, market perceptions do have a fascinating way of engendering their own reality – for awhile. The great bond bull market was granted an extended life, right along with an Extraordinarily Dangerous Credit Cycle.
As one would expect, this imaginary nirvana has incited speculation, along with the unwinding of hedges. In the process, we have witnessed the type of wholesale capitulation by bond bears (investors, traders, derivative players, and pundits alike) consistent with a major market top. As such, it would appear that the markets are today unusually susceptible to speculative de-leveraging and derivative-related dynamic trading strategies. And, in regard to “Bretton Woods II,” I will assume that the Chinese today feel Washington has changed the rules mid-game. After accumulating $700 billion of reserves, it’s ok for the Chinese to buy Treasuries and MBS. But we won’t look kindly at our trading “partner” if they use some of those dollars to buy things we really want and need.
Over the past year we have watched (1999-like) end-of-cycle excesses throughout all aspects of mortgage finance – certainly including systemic risky lending and securitizing, leveraged speculation in various mortgage instruments, and the ridiculous mortgage REIT Bubble. The consumer has capitalized on inflated home equity and spent with reckless abandon. The combination of elevated consumption and surplus market liquidity has fostered a huge (end-of-cycle extrapolation) boom in consumer-related investment spending (certainly including housing, retail, and restaurants). Bubble Economy distortions went to unimaginable extremes, only to have maladjustments “double.”
The Downside of the lionized Transparent Baby Step Monetary Policy is that it has significantly postponed necessary monetary tightening and accommodated further late-cycle Bubble excesses. New Age thinking may have it that, since there’s no inflation, the Fed cannot fall behind the curve. But Age-Old Credit Inflation Dynamics dictate that the longer boom-time psychology becomes ingrained in the financial and asset markets; throughout financial institutions; in businesses, governments and households, the greater the monetary tightening inevitably required to goad the system back on a more sustainable course. It is the case that the longer and more robust the inflationary boom, the more spectacular and problematic the unavoidable bust. The dilemma today is that we are long past the point of any possibility for an orderly return to stability. The interest-rate markets are now faced with the prospect of guessing if the Fed will actually attempt a true tightening and, if so, how high will rates have to go?
Things have all the sudden become more challenging for the leveraged player and bullish bond pundit. The inflationary boom has become hard to deny and the fanciful imaginary world increasingly easy to rebut.
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