The Fed Threw In the Towel On the 'Boom,' Doesn't Know Why

The Fed Threw In the Towel On the 'Boom,' Doesn't Know Why
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And so, just like that, the policy cycle is now over. In terms of time, it took far longer than the last one. Alan Greenspan’s Fed, finished up under Ben Bernanke, packed 17 successive 25 bps “rate hikes” into 501 trading sessions. Those begun under Janet Yellen in December 2015 have now been closed by Jay Powell in March 2019 (the final one conducted in December 2018). First to last, 753 trading sessions, more than one half longer.

Whereas Greenspan would push the federal funds target from 1% to as much as 5.25% in two years, Yellen would start at 0% and three years later Powell would finish at just 2.25%. There is no federal funds target anymore.

Throughout this last cycle we kept constantly hearing about an epic bond rout that was surely looming on the horizon. It was going to be like 1994 all over again, the economy so good the FOMC would have to become so aggressive bond investors would get pummeled by the heat of the Fed. After all, the unemployment rate has remained substantially less than what Economists predict is “full employment.”

There was a bond massacre in 1994, one that still lingers in the collective market imagination a quarter century later. It was always a stupid comparison, however, especially by consideration of just federal funds. In this earlier cycle, Alan Greenspan began with his policy target at 3% and less than a year later it was 6%. 

Something is very different these days.

Absolutely so, says the current federal government. The economy is booming. Skillful fiscal policies, a mix of deregulation and tax reform have unleashed the American system after, oh, about eight years of dangerously languishing without growth. Below is taken from the 2019 Economic Report of the President (summary), released a few days ago:

“Collectively, the 10 chapters that constitute this Report demonstrate that the strong economic performance in 2017 and 2018 constituted a sharp break from the previous pace of economic and employment growth since the start of the present expansion, reflecting the Administration’s reprioritization of economic efficiency and growth over alternative policy aspirations that subordinated growth.”

The new guy fixed the last guy’s mess, they are saying. The funny thing is, the last guy said exactly the same thing about the previous guy; under the same exact circumstances. In February 2015, the Economic Report of the President claimed:

“As I send you this Economic Report of the President, the United States has just concluded a breakthrough year. In 2014, our economy added jobs at the fastest pace since the 1990s. The unemployment rate plunged to its lowest point in over 6 years, far faster than economists predicted…These achievements took place against a backdrop of longer‑term economic strength.”

What has happened instead is incredibly simple and absurd. Every small economic improvement is blown up into the greatest thing ever. That’s just the nature of politics, and this includes, obviously, the Federal Reserve. But what happens in between those few years when things look a little better, that’s what actually matters but is always met with official silence; apart from blaming the previous administration.

The 2012 Economic Report of the President actually lays out perfectly what is at stake:

“This is a make-or-break moment for the middle class, and for all those who are working to get into the middle class. It is a moment when we can go back to the ways of the past—to growing deficits, stagnant incomes and job growth, declining opportunity, and rising inequality—or we can make a break from the past.”

Since those words were transmitted to Congress, twice now successive administrations have claimed to break from the (recent) past. Both have failed, the unemployment rate still missing those who, as noted all the way back seven painful years ago, remain on the outside.

In February 2012 when the President’s report was issued, the 10-year US Treasury bond was yielding around 2%. Interest rates had fallen, sharply, in the second half of the year before. In February 2011, 10-year yields were surging getting as high as 3.75% with all the same economists predicting another escape back to normal levels befitting an economy on the mend. Never happened.

In February 2015, the 10s were right around 2% again. The benchmark had briefly touched above 3% at the end of 2013, but then spent 2014 falling in clear disagreement with President Obama’s, and Janet Yellen’s, economic breakout scenario.

Here we are all over again. Ten-year UST rates touched 3.25% last year, and are now downward once more, getting to 2.50% this past Wednesday when the FOMC finally came back down to reality.

The problem isn’t Republicans or Democrats, it’s that both Republicans and Democrats continue to rely on Economists. Those like Jay Powell, Janet Yellen, or Ben Bernanke.

In 2016, Bernanke was writing about the Fed’s balance sheet. Having undertaken four QE’s on his watch, huge, massive stimulus by all accounts, by consequence of large-scale asset purchases (LSAP) the central bank’s asset list had grown to several trillion. Central bank accounting being what it is, what doesn’t get offset on the liability side is a remainder called bank reserves. Thus, as assets were purchased the level of bank reserves increased.

To the outside, this was money printing or liquidity or something. In 2014, believing in that second false dawn due primarily to people thinking this way about reserves, Federal Reserve officials began to consider what should happen to the level during the recovery they were sure the QE’s had engineered. Reserves should decline, but by how much?

This was, in the orthodox view, a complex issue as the former Fed Chairman wrote in September 2016. Things were different mechanically:

“Today, the Fed influences it [the federal funds rate] and other short-term rates primarily by varying the interest rate it pays banks on their reserves (known as IOER, or interest on excess reserves). This approach relies on the presumption that banks are unlikely to want to borrow or lend in private markets at an interest rate much different from what they can earn on the reserves they hold at the Fed.”

The federal funds target was scrapped in December 2008 because, among other things, it no longer applied. Not by choice.  The federal funds market had as early as August 2007 taken to just ignoring the target entirely. In response, the Federal Reserve under Bernanke adopted several new tools to keep money markets and liquidity in line with policy goals.

I’ve recounted the sordid tale of IOER many times before, so I’ll but briefly summarize here: it never worked. Never. In October 2008, the FOMC voted to use it as a floor. No good, federal funds remained belowtarget (during the worst of the world’s biggest monetary panic in four generations) for the duration.

In June 2018, the Fed performed a “technical adjustment” in its updated corridor scheme using IOER set 5 bps below the upper boundary for federal funds. It had previously been equal to the upper boundary ever since December 2008, US central bankers thinking that if IOER wasn’t actually a floor it must then be a ceiling of sorts. A second technical adjustment was undertaken last December.

Bernanke wrote in 2016 that he, as current officials, presumed how IOER is effective because “banks are unlikely to want to borrow or lend in private markets at an interest rate much different from what they can earn on the reserves they hold at the Fed.” The bigger question is why anyone would continue to think this way eight years after this theory was so methodically, thoroughly disproved in practice.

It is a more fundamental sticking point.

In June 2003, the FOMC was discussing this very topic. It was in consideration of a monetary policy environment they considered “ultra-low.” Policymakers at that time had just voted to bring the federal funds target down to 1%, and therefore they began to wonder about a Japan-type scenario with the zero lower bound in sight.

Chairman Greenspan said:

“It’s really quite important to make a judgment as to whether, in fact, yield spreads off riskless instruments—which is what we have essentially been talking about—are independent of the level of the riskless rates themselves. The answer, I’m certain, is that they are not independent.”

In other words, central banks are central and the rest of the financial world works off what policy instruments are offered and more so where they are offered. The FOMC moves something and the rest of the system merely obeys, within very small, immaterial tolerances.

Former Chairman Bernanke in 2016 was still talking like 2003 Chairman Greenspan; the Fed sets the number on a dial and then watches as the marionettes dance in perfect synchronization with the declared tune. From short-term money rates to credit decisions and therefore economic consequences, it was all supposed to be so predictable based on this one presumption.

Again, why do Economists still believe this?

If anything, the last ten years have conclusively shown that rates, therefore markets, therefore the economy, are, in fact, independent. It works both on the macro level as well as micro in money.

You name it, repo, LIBOR, even federal funds (effective) the last ten years have been more disobedience than not; never more so than during those particular years when politicians have the hardest time claiming the economy has finally broken free. The 2020 Economic Report of the President will almost certainly be very different than the current one, a wager we can safely make based on something like repo.

As it stands right now, an entire section of the yield curve is trading underneath effective federal funds and IOER. Yesterday, during the trading session, the 7-year bond became the latest maturity (bucket) to drop below both. The 5-year note made it all the way to 2.30%, a galling 10 bps less than those.

If Bernanke was right about his and Greenspan’s presumption, how can this be? Why would anyone in their right mind lend to the federal government for 5 years at 230 bps when they can get 240 bps on free excess reserves by “lending” them to the Federal Reserve instead?

The answer is complexity. Only depository institutions are eligible for IOER, and only dealers are holding excess reserves. There are, obviously, far more pertinent considerations among the vast global network of money market participants than just what Ben Bernanke or Jay Powell thinks about IOER as a ceiling and its twin the RRP “floor.” There is a lotmore going on here.

Very quietly, the New York branch (FRBNY) recently sent out a survey to primary dealers asking them about a new prospective tool the Fed might offer to help keep money market rates in line. Policymakers, it appears, are getting nervous. Subsequent media reports have confirmed the possibility of a standing repo facility which would, almost certainly, circumvent IOER.

It is a more complicated topic but in summation monetary officials are starting to get the sense that they don’t control money markets like they thought they did. The nuts and bolts of it, the specific details of any repo facility deserve a more complete discussion (and I’ve already done that elsewhere; this would amount to a QE5 using bank reserves, of course).

The broader issue is perhaps the more important one: if the Fed cannot get the small things right, the stuff it had the world believing it is most technically capable and competent about, then there is the non-trivial risk they don’t get anything right. Like an economic boom.

It’s not specifically a central bank problem, rather this is for all Economics. The latter merely assumes that the central bank takes care of money and finance at will. Before August 9, 2007, the entire discipline had believed it was just as simple as Alan Greenspan said; nothing was independent of the Fed (or ECB, any central bank).

Therefore, if the FOMC declared a monetary target as “accommodative” they merely expected that it was. The economy should be supported as a result. There would never be any question otherwise, especially if the economy was given years upon years of highly accommodative policies (according to the federal funds settings, or their QE enhancements).

How, then, can an economy be so weak that it can no longer handle nine 25 bps rate hikes spread out over a three-year period? This is now the official position, after this week’s FOMC meeting where the “rate hike” cycle has been called off. Not only that, balance sheet normalization, or what has been called quantitative tightening (QT), will be halted in the near future. The economic downside has materially advanced, so much so that the most optimistic of optimists aren’t really optimistic any longer.

Not sure who or what to blame, they’ve opted to halt everything.

If the central bank isn’t central in setting money rates, then how would we know if monetary policy is accommodative, tight, or anything in between? It would tend to suggest, instead, that monetary policies are irrelevant entirely. Money markets, this complex global network, do what money markets do and pay little or no attention to the FOMC and ECB circuses. Independence, as it turns out, is a very big deal.

While the mainstream was filled with this economic boom stuff especially during 2017, flattening curves pegged at historically low nominal levels declared a far greater chance it was going to end badly; sour, not soar. Powell as Yellen was going yell loudly for his case, but bonds were right – he wasn’t ever going to get very far. He didn’t.

The reason a curve will flatten like it did, or what the FOMC last summer laughably tried to dismiss as “strong worldwide demand for safe assets”, is that money markets and liquidity aren’t what officials say they are. Bank reserves don’t really matter.

This is exactly what has pushed several UST maturities underneath IOER and federal funds, further distorting already highly inverted US$ curves. Officials, as Bernanke in 2016 demonstrated, still operate on Greenspan’s doctrine that liquidity is whatever they say it is. Liquidity risks remain paramount because that’s just not the way it works. As incomprehensibly complex as the eurodollar system can be at times, it really is that simple.

If you don’t actually know if monetary conditions are tight or loose, if policy is accommodative, strict, or just irrelevant, you aren’t going to have a very good grasp of the economy. When things appear to be going well, you pat yourself on the back for a job well done; only to be shocked and dismayed when it doesn’t go all the way. Again.

The FOMC just threw in the towel on that whole boom thing. It’s a start, I suppose. If they ever figure out why they did, that’ll really be something. And only then will it be a truly awful day in the bond market, far worse than 1994. 

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

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