A Fed Without Power Assaults All Conventional Sense

A Fed Without Power Assaults All Conventional Sense
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In the common perception, the Federal Reserve is all that matters in terms of dollar money.  So when the central bank’s executive policy board, the Federal Open Market Committee, decides to change stance it is largely assumed a matter long ago decided.  They command; the market does.  Even the name of that body plays into this assumption. All the textbooks say that the money supply is controlled through open market operations.

It has never been asked, or quite rarely pondered, how that is supposed to work via federal funds.  If the FOMC votes to raise rates, as they have three times over the past six months, then it is believed to be tightening.  But the world does not run on a tautology, where simply saying the Fed is tightening means the Fed is tightening. What goes on underneath does matter. 

It is, in fact, right now contradictory. In the minutes of its last policy meeting, one where last the federal funds “corridor” was raised 25 bps both top and bottom, there was some unknown level of discussion about this opposite state of markets.

“They also noted that, according to some measures, financial conditions had eased even as the Committee reduced policy accommodation and market participants continued to expect further steps to tighten monetary policy. Participants discussed possible reasons why financial conditions had not tightened.”

This is, of course, not the first time the Fed has done one thing and the money markets its opposite.  Practically all of the 21st century has been operated under this condition, or “conundrum” as Alan Greenspan once called it.  He was referring specifically to the bond market, but even that was a symptom of this same problem.  The global market for dollars doesn’t seem to ever respond “correctly” to monetary policy.

That was certainly true over the past three years of this “rising dollar.”  Janet Yellen, Greenspan’s successor’s successor and intellectual descendant, claimed often in 2014 that QE had made financial markets resilient. She was only to be proven wrong globally by what happened in 2015 and especially early 2016.  It was in many ways started by, of all things, a buying panic in US Treasuries on October 15, 2014; an event to this day that officially remains a result of computer trading.

It wasn’t really a buying panic so much as a desperate collateral call, one of the derivative money elements that continue on in the real world but are still completely absent from the official policy canon.  The last ten years have been a series of damning examples of this kind of intellectual disparity, where the Fed says and does what it thinks achieves especially “accommodation” but instead there isn’t in private operation anything like it. 

The events of 2011 really recall this disparity, where despite already two QE’s and the $1.6 trillion in bank reserves conjured as a result of them, the FOMC in early August that year sat befuddled contemplating how they might have to bail out the repo market despite all that open market operations had supposedly accomplished. 

The big one, of course, was 2008.  The Fed had done a considerable amount throughout that year and the year before – to no avail.  It was one failure after another, where no matter what huge policy action was taken the reverse condition followed anyway.  In the most basic terms, the FOMC voted the federal funds target rate down from 5.25% to just 1% in a little over a year, mirroring exactly Alan Greenspan’s conundrum that starting in 2004 had brought the federal funds rate up from 1% to 5.25%.  The conundrum clearly applied to more than just long-term UST yields in the middle 2000’s.

The reason nobody bothered to investigate how things really worked was simple.  Alan Greenspan was the “maestro”, who throughout especially the 1990’s changed the way central banks worked and achieved the Great “Moderation.”  In many cases, people didn’t want to know or care how Greenspan’s Fed accomplished the feat; they simply removed to faith that power could be just that effective if wielded by the right hands.

Writing for National Review in August 2003, just a month or so after the FOMC voted the federal funds target down to 1% for the first time, Victor Canto defended Greenspan’s record, but in doing so gives away the ending.

“But the concern with the maestro is that he never fully disclosed how he did it; there’s really no way of ascertaining when he is behaving correctly or not, other than judging the results produced by his actions.”

It is in every way a violation of good science.  This was instead mere alchemy, or better yet snake oil.  Science demands an explanation, provable and testable.  Results must be predictable and replicable.  Alan Greenspan raised and lowered the federal funds rate a little bit here and there and because what resulted looked like stable economic conditions people attributed one to the other. What else could it have been?

Canto’s lacking defense was spurred on by criticism of the Fed lobbied by none other than Milton Friedman. The father of modern monetarism had written in the Wall Street Journal at that time that other central banks around the world had achieved what Greenspan had.  But, they did things often quite differently.  Friedman wrote:

“I am a great admirer of Alan Greenspan and he deserves much credit for the improvement in performance, yet this simple explanation is not tenable. It is contradicted by the simultaneous improvement in the control of inflation by many central banks at about the same time, including the central banks of New Zealand, the United Kingdom, Canada, Sweden, Australia, and still others. Many of these central banks adopted a policy known as inflation targeting, under which they specified a narrow target range for inflation — 1% to 3%, for example. But inflation targeting and non-inflation targeting central banks did about equally well in controlling inflation, so explicit inflation targeting is not the answer.”

We have to understand, and there is no overstating this point, that monetary policy after the 1970’s and the Great Inflation evolved into a discretionary format by necessity. The way the FOMC set the federal funds rate was no longer tied to money supply, nor was it by the 1990’s much directly related to money demand.  Instead, the Fed quite blindly took a holistic approach, meaning tracking all sorts of economic and financial variables and trying desperately to make linkages between them and what it did – only threaten open market operations to maintain a singular money rate target.

If Alan Greenspan never publicized how he did what he did, it was because he really didn’t know. It was in some ways the inverse of the old Lincoln quote: better to remain silent and be thought a genius than to speak and prove all doubt. 

If you actually listen to and hear what Alan Greenspan said in the 1990’s, it was essentially this.  It was in reality a fingers crossed strategy where policymakers hoped they were acting with aplomb but really didn’t know how that might be.  So they never outright stated just how it all worked. I go back again and again to his “irrational exuberance” speech in spite of those words, because what really mattered was how he was forced philosophically in their direction.

“Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy. Thus, to keep the Congress informed on what we are doing, we have been required to explain the full complexity of the substance of our deliberations, and how we see economic relationships and evolving trends.

“There are some indications that the money demand relationships to interest rates and income may be coming back on track. It is too soon to tell, and in any event we can not in the future expect to rely a great deal on money supply in making monetary policy. Still, if money growth is better behaved, it would be helpful in the conduct of policy and in our communications with the Congress and the public.”

Money demand forecasting never did come “back on track”, but you’d be forgiven if you thought that it did; the Fed nor anyone else never clarified one way or the other.  The ECB in the middle 2000’s, right at the time of Greenspan’s fuller “conundrum”, kept unpublished a significant report that blew apart the idea of using money demand as a policy setting.  German newspaper Handelsblatt reported at the time in a little noticed article that the central bank had “downgraded the role of money demand functions in its analysis.”

If monetary policy was set by neither money supply nor money demand, how do we know there was money in it at all? 

Friedman’s argument against the “maestro” was under these conditions an inflation-driven one.  Inflation is, after all, a monetary effect.  Even to the Fed and these other central banks that principle remains a bedrock association.  Whatever they did, if it was effective, would have an effect on inflation – if what they did was monetary! But the Fed, of course, is not the only possible monetary source. 

It was the basis for this mainstream assumption about federal funds.  Throughout the Great “Moderation”, inflation came to be not only low and not only stable, but both of those close to and around the then-implicit range the Fed defined for its mandate.  FOMC officials had no idea how minor adjustments in the federal funds rate got into the real economy to achieve that, they merely and often meekly inferred causation from what was a rough correlation. Surveying the narrow monetary world that they knew, why not federal funds?

It matters a great deal that Greenspan could never explain how he believed it worked (to be fair, as verified by just these few of his quotes I have included here, he more than Ben Bernanke was slightly more open to the possibility that it was all just blind, dumb luck; Janet Yellen in at least one speech last year finally appeared to be somewhat less intellectually rigid due to exasperation in that same way).  Friedman’s critique was that other central banks could, if they chose, infer the same causation even if they acted differently.  Thus, the matter of central bank money causation was not at all established, only what was then a global correlation.  And there lies the big clue as to what has really happened. 

If the Fed and the rest of the central banks had little idea what was taking place with money demand, they had no idea what was going on for money supply.  In fact, they really didn’t want to know, preferring instead to focus on what Ben Bernanke would later specify as the “aggregates”; things like income, GDP, and most especially inflation rates. If those aggregates were well-behaved, particularly inflation, then, once again, it was simply assumed monetary policy was the reason.

You can already see the conundrum for what it really was.  If inflation or whatever other monetary characteristic was not well-behaved, where would the Fed even begin?  That has been the history of the last ten years in particular, where once things started to go wrong none of the central banks had a real idea what it was that was wrong, let alone any further idea what to do about it.  That they chose a 1960’s view of the 1930’s isn’t all that surprising. 

It was around that time, and under Milton Friedman no less, that economics veered away from real scientific investigation toward more pure mathematics and statistics (econometrics that prizes correlations above knowledge of why they exist). Like reinstalling a computer program to its last good condition, the Fed, the ECB, and others tried starting in 2007 to reboot back to their monetary roots, finding instead that they really had in the 21st century no idea how to do that.  The very fact that there was a second QE (in the US) establishes this point, for if you have to repeat it then it doesn’t work. Doing it two more times simply shows they had no other ideas on how to proceed (which included this possible repo bailout in early August 2011).

To find legitimate answers we need only explore the monetary spaces that central bankers refuse to examine.  When Princeton economist Stephen Goldfeld wrote his Missing Money paper in 1976, he left off without an answer but still a start

“The results of this paper are difficult to characterize. Insofar as the objective was an improved specification of the demand function for M1, capable of explaining the current shortfall in money demand, the paper is rather a failure. Specifications that seem most reasonable on the basis of earlier data are not the ones that make a substantial dent in explaining the recent data.”

What he meant was for us later incredibly easy to see, if only you move past blind faith in Alan Greenspan’s enigmatic results.  In the 1970’s, forecasts for money demand kept coming up short; meaning that they believed given economic conditions demand for M1 should have been x, but was consistently (always) less and often considerably less than x.  In other words, something else was meeting clear demand for money that didn’t fall into the definition of M1.  As we know from Greenspan’s speeches, M2 would later run into the same difficulty; meaning that something else then beyond M2 was meeting now global demand for money.  From a 1997 speech at Stanford:

“Nonetheless, we recognize that inflation is fundamentally a monetary phenomenon, and ultimately determined by the growth of the stock of money, not by nominal or real interest rates. In current circumstances, however, determining which financial data should be aggregated to provide an appropriate empirical proxy for the money stock that tracks income and spending represents a severe challenge for monetary analysts.”

The Great “Moderation” was not blind luck, as economists Stock and Watson suggested in giving us that label, therefore it couldn’t have been due to monetary policy.  Money supply across the world was being met by something else.  Policymakers presumed it didn’t matter that they didn’t know what it was, their discretion with federal funds would for them always into the future suffice – an arrogant and deeply troubling state of basic economic operation.  It should have been clear that this was a false and dangerous assumption by virtue of the dot-com bubble, the very thing, monetarily, Greenspan was concerned about in that “irrational exuberance” speech. 

In some ways, we might sympathize with how reluctant economists were to investigate this something.  The eurodollar system is not one strictly of dollars nor even much of eurodollars anymore. It is incredibly complex and in ways that are even today for me difficult to fully understand let alone describe. For someone starting with that 1960’s view of money, it might really be utterly incomprehensible. 

On the other hand, that was the very essence of Alan Greenspan’s job.  He had at his disposal more information on the subject (banking) than any other person, and also the power to compel information, but he preferred instead to keep to the indefinable magic of the federal funds rate that throughout the new millennium kept producing less and less genius.  Since no one could really explain why the federal funds policy appeared to work in the 1990’s, they were similarly at a loss as to why it didn’t in the 2000’s – right on through to the QE’s and today. If inflation is a monetary phenomenon, as it surely is, we see now how all central banks are in trouble. 

Janet Yellen has now run into the conundrum, though in truth it was there all along unrecognized by mainstream. Like Greenspan, it is not for her a mystery of the bond market alone.  If the “rising dollar” was tightening because of the true nature of modern, global money, then its end last year necessarily produced this year less of tightness.  It would not matter that the Fed was raising or even lowering the federal funds rate.  The private money system quite far apart from federal funds and central bank policies has been charting its own course for decades now independent of open market operations. 

Our current circumstances are in the second part of it but the mirror image of the first.  In that initial eurodollar build up, this “something”, it made Alan Greenspan a genius, the maestro through nothing more than being in the right place at the right time and taking credit for what had nothing to do with quarter point federal funds maneuvers (or good luck).  As it now only falls apart (but not all at once), it proves unequivocally why he could never reveal the substance of his magic. 

Global oil prices this year realized in the US as well as Europe that which no amount of QE could – an inflation rate that for the first time in several years conformed to each target. And then oil promptly and embarrassingly took it away. There is no money in monetary policy, and since there is only unstable money (“dollar” shortage or “rising dollar” being a symptom) in the world today we remain at a global economic impasse.

One or the other will have to give.  We either forget federal funds altogether in favor of a monetary view of the world as it actually is, or the prolonged stretch of insufficient global growth will eventually achieve its breaking point. For most people it just doesn’t seem possible that central banks hold no money nor monetary power.  It assaults all conventional sense, not to mention common history of the last half century.

Despite that, laid out quite intentionally I might add, even a short examination of what really went on during that time easily establishes not just that it is and was the case, but also that even contemporarily officials had no idea what was going on in the shadows.  They knew it was something, and then bet our shared future that in the long run it would just work out somehow; the transferable magic of the Fed Chair.  Pace Keynes, it’s now the long run and it does matter. Correlations were never enough, and now we really need recognition of cause.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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