In Terminal Velocity 1, it was suggested that Exter's Inverted Pyramid provides the best model to understand Federal Reserve Policy. We observed that:
Even though he [Bernanke] says that he is targeting growth, it can be seen that the real economy is far less in size than the capital markets and doesn't need all his QE. It is the debt pyramid that has been created since 1980, that needs all this credit. He is not however printing money as his critics opine. He is holding down the term structure of interest rates, so that all the debt can be carried at a low rate of interest through refinancing. The new low rate of interest will thus be closer to the rate of normal GDP growth of the real economy; so that debts will be able to be paid out of the proceeds of economic activity. His real intended purpose is to keep the size of the capital markets higher than the real economy.
Looking at Exter's Pyramid, if he [Bernanke] allowed the capital markets to shrink in size, then all the layers above Gold would vanish and we would be back to primitive times. There would be no credit, no growth, no assets, no savings and we would all be fighting each other to accumulate Gold. Worse still, once holders of paper assets saw that the Fed had abandoned them, they would take their money out and drive up the price of real assets in a period hyperinflation. The Fed and QE are a necessity to avoid both depression and hyperinflation in a modern civilization. Exter's Pyramid is built to create economic growth without hyperinflation; its functioning is its own Dual Mandate.
On February 7th, a speech by Fed Governor Jeremy Stein provided further insight into how to apply this model. Governor Stein is ostensibly the "go-to" man at the Fed, with the unenviable task of deciding which asset classes and sectors of the economy are experiencing sub-optimal or excessive liquidity. Based on his analysis and pre-emptive and remedial policy action, the monetary transmission mechanism will be guided back to normal. An analysis of Stein's speech has become more important, because recent signals from the FOMC have become equivocal on the subject of Quantitative Easing and the Exit. Markets have become confused by the conflicting signals and signs of debate within the Fed. The situation has become so absurd, that some commentators have begun to seriously consider the end of QE. The Treasury Bond market began to discount this event; and the back up in yields has had a knock on effect on interest rate sensitive sectors, such as housing; so that an economic headwind from the end of QE is already blowing before it has happened.
Chairman Bernanke was at pains to acknowledge the appearance of bubbles in some sectors, where lending standards have become lax. His Humphrey Hawkins testimony on February 26th, made it clear that he would like to see these bubbles deflated, at the same time that QE is ongoing. He made it very clear that he wishes the great refinancing, at low yields, to continue; and for lending to be advanced to new business simultaneously. It must therefore fall to Jeremy Stein and his team to create a tool kit for the surgical removal of bubbles, whilst at the same time allowing QE to liquefy the economy.
If we read Stein correctly, he sees bubble risks coming from three sources:
- Financial Innovation
- Financial Regulation (related closely to 1 above)
- Policy incentives to take excessive financial risk (related closely to 1 and 2 above)
Currently, he does not see dangerous bubbles developing; even in High Yield. He sees three ways to deal with them, when they occur.
The first is regulation, but this often lets things slip through the cracks; especially when clever investment bankers and dumb regulators meet head on. This problem is compounded by the myriad of regulatory agencies, which often are not joined up and fight turf wars with each other. They can be divided and conquered. Currently, the Fed is making its play to be the Uber-Systemic Regulator; but one can see that Stein is realistic about the Fed's ability to interface with this chaotic regulatory landscape.
The second is the blunt tool of interest rate policy, which indiscriminately affects all assets; and often punishes some sectors of the economy and asset markets unfairly. Interest rate policy is the nuclear option, that is invoked when all else fails; and the Fed judges that the collateral damage is worth it.
The third option is a synthesis of his observations to date. Following his thesis and this synthesis, it seems that he is proposing a mix of regulation and microeconomic interest rate policy management tools, to allow the growth in credit without the creation of bubbles. The final paragraphs and conclusion, suggests that the Fed is at an advanced stage of creating a tool box of regulations and subtle market operations, to allow for micro-monetary policy before the nuclear option is triggered.
We note from his speech that:
"in response to concerns about numbers of instruments, we have seen in recent years that the monetary policy toolkit consists of more than just a single instrument. We can do more than adjust the federal funds rate. By changing the composition of our asset holdings, as in our recently completed maturity extension program (MEP), we can influence not just the expected path of short rates, but also term premiums and the shape of the yield curve. Once we move away from the zero lower bound, this second instrument might continue to be helpful, not simply in providing accommodation, but also as a complement to other efforts on the financial stability front.
To see why, recall the central role that maturity transformation-the funding of long-term assets with short-term, run-prone liabilities-can play in propagating systemic instabilities. Moreover, as illustrated by the mortgage REIT sector that I described earlier, the economic appeal of maturity transformation hinges on the shape of the yield curve-in that particular case, on the spread between the yield on agency MBS and the so-called general collateral (GC) repo rate at which these securities can be funded on a short-term basis. And it would appear that our policies have at times put pressure on this spread from both sides. Our purchases of long-term Treasury securities and agency MBS have clearly helped reduce long-term yields, and a number of observers have suggested that an unintended byproduct of our MEP-and the associated sales of short-term Treasury securities-was to exert an upward influence on GC repo rates.
This sort of compression of term spreads is the twist in Operation Twist. And you can see the financial stability angle as well as a possible response to concerns over numbers of instruments. Suppose that, at some point in the future, once we are away from the zero lower bound, our dual mandate objectives call for an easing in policy. Also suppose that, at the same time, there is a general concern about excessive maturity transformation in various parts of the financial system, and that we are having a hard time reining in this activity with conventional regulatory tools. It might be that the right combination of policies would be to lower the path of the federal funds rate-thereby effectuating the needed easing-while at the same time engaging in MEP-like asset swaps to flatten the yield curve and reduce the appeal of maturity transformation.
Conclusion: I hope you will take this last example in the spirit in which it was intended-not as a currently actionable policy proposal, but as an extended hypothetical meant to give some tangible substance to a broader theme. That broader theme is as follows: One of the most difficult jobs that central banks face is in dealing with episodes of credit market overheating that pose a potential threat to financial stability. As compared with inflation or unemployment, measurement is much harder, so even recognizing the extent of the problem in real time is a major challenge. Moreover, the supervisory and regulatory tools that we have, while helpful, are far from perfect.
These observations suggest two principles. First, decisions will inevitably have to be made in an environment of significant uncertainty, and standards of evidence should be calibrated accordingly. Waiting for decisive proof of market overheating may amount to an implicit policy of inaction on this dimension. And, second, we ought to be open-minded in thinking about how to best use the full array of instruments at our disposal. Indeed, in some cases, it may be that the only way to achieve a meaningfully macro-prudential approach to financial stability is by allowing for some greater overlap in the goals of monetary policy and regulation."
Reading between the lines, it is clear that the Fed intends to maintain a large balance sheet of assets for some time; even after interest rates have begun to normalize. The Fed will then use a rolling form of Operation Twist, across the Yield Curve and across asset classes, in order to target particular areas that it believes need influencing. The overall size of the balance sheet and its composition will then be managed, to achieve a background of benchmark interest rates for specific capital market sectors and the economy in general. This balance sheet management will involve increases and decreases in overall size, in addition to substitution of different assets and maturities. In this way, the Fed intends to anticipate and prevent bubbles or excessive tightness in liquidity from occurring.
It therefore looks as though the Fed will allow QE to roll off via expiry; and that it is quite prepared to provide specific monetary support to specific credit instruments, even as interest rates are rising in general. The intention and capability are to make the economic recovery sustainable during the rising rate environment.
Are we worried?
We are not worried by the Fed. If it did not have a Jeremy Stein, we would be worried. It has a clear strategy and tactical tools in place to deal with the exit of QE; and to adhere to its Dual Mandate in a rising interest rate environment. What worries us is that the Sheep and the Bears in the markets do not understand this "New Fed", nor are they aware of it. They are still trading headlines and economic numbers. Based on our analysis of Stein and the Sheep and Bears, the only thing to do is to keep buying dips in the equity markets when the Bears create them and the Sheep follow them over the cliff.
Perhaps the biggest reasons to worry are the Sheep in Washington; who will start grandstanding about the Fed controlling the economy, once they pick up on this theme. As Montaigne observed:
"Nothing is so firmly believed as that which least is known."
Boston Fed Governor Rosengren recently provided a very clear signal that this "New Fed" policy tool box was open for business. In his latest speech on February 27th, he gave clear signals of how the Fed perceives the prices of asset classes in relation to bubbles. By his yardstick Equities, Housing and High Yield are not in bubble territory. Agency REITs however are in a bubble. One can therefore expect the heavy hand of Fed regulatory oversight to be felt in the Agency REIT markets. Tied to this oversight will also be aggressive intervention in the collateral markets, to make these securities and also the underlying home loans from which they are derived more expensive to finance.
Rosengren seems to support Stein's analysis that High Yield is not in a bubble. Based on our view that Bernanke is engineering the great refinancing, by holding down interest rates, we would assume that much of this refinancing is going to occur in the High Yield end of the credit universe. This would fit an economy, where indebted borrowers are trying to refinance; which is growing too slowly for them to have the kind of income that gives them high credit scores.
We have recently heard about "templates" for dealing with the liquidation and bailout of the European banking sector. Compared and contrasted with the "New Fed" template for Central Banking, it is going to be interesting to observe global capital flows in the near future. The "New Fed's" macro-prudential attractiveness for capitalism, stands in stark contrast to the Austrian School template being enforced in Europe. It is hard not see the US Dollar reasserting itself as the Global Reserve Currency; and the American economy benefiting from the vote of confidence in its macro-prudential status. Perhaps this "New Fed" model will serve as the template for global central banking.... in some nations. We will watch Jackson Hole closely this year, to see if this template becomes official global central banking dogma.
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The performance of US Equities versus Global Equities has formed a base pattern, which signals long-term capital flows back into the US. This pattern is now moving from capital outflow reversal to capital inflow; and the emergence of a new secular trend. There has been genuine concern about the absolute level of US Equities; which has mainly been attributed to QE.
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The high level of liquidity in the economy, thanks to QE, has created a situation in which companies are returning cash to shareholders in the form of buybacks and dividends, because there are no growth opportunities for this cash.
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The high level of M&A is also a symptom of this situation. This situation can be described as Monetary Stagflation; in which the inflation component is Monetary Inflation rather than Price Inflation. The level of shareholder fund returns and M&A are now back at pre-Crisis of 2008 levels, causing concerns that Equities are in bubble territory. Fortunately, Governor Rosengren's analysis of Equity Valuations, has provided some comfort that the Fed is not about to drive the Equity Market lower.
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The second mixed signal from the Fed has come in relation to inflation. There are those at the Fed, like Lacker, Fisher and George, who are fixated with the idea that the latent Monetary Inflation in the capital markets will lose faith; and desert this sector for hard assets in the real economy. So far, their prescience has been poorly timed. The PCE Deflator, which is an index that tracks exactly what US Consumers are buying more closely than the archaic formula of the CPI, so far has signaled that Deflation remains the greatest risk. In terms of the Exit from QE, under the conditions set by the Evans Rule, there is no pressure on the Fed to consider ending QE prematurely or to reverse it. In fact, should global economic conditions create the kind of headwinds that threaten the US recovery, the Fed may be obliged to announce a new round of QE.
Read also Terminal Velocity (2) for a discussion about the UK..