Fed fears unfounded, fortunately


A November 28 headline in the New York Times gushed, “Two Words From Fed Chairman Jerome Powell Sent Markets Soaring”.

Jay Powell – who likes being called Jerome about as much as Jerome Seinfeld does – noted, according to the Times, “the Fed’s benchmark interest rate was ‘just below’ the neutral level, meaning the central bank was close to the point where it would not be tapping on the brakes or pressing on the gas.”

Investors liked that news but didn’t love it. U.S. stock prices rose between 0.3% and 0.4% depending on your index of preference, but it was really just another decent day at the office for the markets.

Contrast that with what happened December 24. In a holiday-shortened session, stocks plunged more than 2% in four hours, which went a long way toward establishing that month’s distinction as the worst December for the U.S. stock market since the Great Depression. Many TV newscasters read that off their teleprompters and incorrectly corrected themselves by saying “Great Recession.” (You were right the first time, Judy Woodruff.)

The proximate cause was a pair of unrelated but simultaneous messaging mistakes from the White House. Treasury Secretary Steven Mnuchin made a statement that America’s money-center banks had adequate reserves (did anyone believe otherwise?) and, just to be sure, he informed the listening audience that he had personally called the CEOs of each major bank to confirm. If his goal was to start a panic, he couldn’t have picked a better way to do it.

But the bigger news was President Donald Trump’s tweet storm expressing regret over his selection of Powell as Fed chair, critiquing his appointee’s performance and hinting that he could fire America’s central banker at his pleasure.

It’s doubtful that the president can fire the Fed chair at will. No other president has tried, but this is the kind of thing that could get caught up in both the courts and the Congress for longer than it would be worth. For his part, Powell indicated he wouldn’t hand in his resignation just because President Trump asked for it.

Gauging interest

The Fed has two jobs: keeping employment high and inflation low. But it has to be careful. If inflation is too low or even turns negative, that’s a disincentive to invest and bad for the economy. If employment growth is too rapid then employers have to increase the speed with which they give raises, leading us back to inflation. It also crowds out such non-economic activities as raising children.

So, what the Fed does to control the temperature of the economy is adjust the money supply, and it has a couple ways of doing this.

Federal Reserve Board Chairman: The Hon. Jerome Hayden Powell, J.D.

The first is tinkering with interest rates. When it lowers the rate it charges big banks, the big banks then lower the rates they charge smaller banks and large corporations. The ripple extends out to small business loans and revolving credit lines. This is called “expansionary” policy because it tends to expand economic investment. Stock investors love it because it also tends to raise share prices.

This is all well and good when the nation is enmeshed in a recession or is nursing a fragile recovery. But when we’re already at full employment – as we are now – there’s a danger inherent in lowering interest rates further. Companies build more capacity than they can staff, prospective employees demand more money than companies can afford to pay and, next thing you know, we’re heading back to hard times.

So, the smart thing to do – and the Fed has been doing it – is to hike interest rates. The question is, at what pace? In 2018, the central bank announced four interest rate increases interspersed through the year, a quarter percent at a time. Considering that economists are still calling for slowing but continued economic growth through 2019, this “contractionary” policy seems to be appropriate. Powell’s body language seems to imply that he might feel the need to add only one or two more rate hikes over that time.

Getting tight

Which brings us to the other tool the Fed can use: its balance sheet.

There’s a point at which you just can’t lower interest rates any further – 0%. (There are exceptions, but let’s just go with this.)

So, what do you do if your economy is still spiraling deeper into recession?

This isn’t a rhetorical question. It was exactly the issue in 2009 facing newly sworn-in President Barack Obama and Fed Chair Ben Bernanke, who had been appointed by President George W. Bush.

The answer they came up with is quantitative easing (QE), through which the central bank made wholesale purchases of government bonds and troubled financial assets. This has the effect of adding liquidity to the market, just like lowering interest rates, so it’s another lever to support an expansionary policy. And the U.S. economy desperately needed it at the time.

But there’s such a thing as too much of a good thing. At the start of the Great Recession, the Fed held around $750 billion in Treasury notes. By June 2010, QE had expanded the Fed’s holdings to $2.1 trillion in Treasuries, bank debt and sketchy mortgage-backed securities. After two more rounds of QE the Fed’s balance sheet had ballooned to $4.5 trillion in assets.

So now the Fed is reversing course, a process which started in the fall of 2017. As it unwinds that position, the result will be a contractionary strategy called quantitative tightening (QT), which will have the effect of both removing liquidity from the marketplace and increasing yields for longer-dated bonds.

As long as it’s done at a pace that neither swamps the economy with non-performing debts in exchange for perfectly good cash, there’s no problem. It’s like a controlled burn – a small, artificial forest fire that prevents a bigger, hotter, uncontainable one.

Looking forward

The good news is that it appears that the Fed will continue to work toward normalizing interest rates and reducing the size of its balance sheet, which will give the Fed ammunition to combat the next recession. Earlier this month, Powell proclaimed that “there is no preset path for policy,” suggesting that he’s not ignorant to worries of slowing economic growth nor the increase in market volatility. “We will be patient as we watch to see how the economy evolves,” Powell said.

That said, with all the capacity for quantitative tightening at his disposal, rate hikes might just be the second-best tool for the job.

The bad news is that QT—which is going to continue to remove billions in liquidity on a monthly basis—has only scratched the surface. With this analysis in mind, the Fed has already reduced its balance sheet from roughly $4.5 trillion to about $4.1 trillion. And while the Fed manages the controlled burn as best it can, we witnessed various spikes in volatility which show that the flames can flash. These flashes are the unintended consequences of QE that we’ve alluded to in the past few years in our blog.