Terminal Velocity “And Now the End Is Near” observed the onset of the next financial crisis crystallizing around the confusion emanating from the Federal Reserve. The Fed has created the tide of liquidity that has sustained the recovery in financial markets; and the recovery in the US Economy to a significantly lesser extent. Any uncertainty emanating from the Fed therefore ripples through the financial markets and the economy with greater amplitude.
The first ripple effect came with the late replacement of Larry Summers, as the prime candidate for the Fed Chairman position, with Janet Yellen. Having initially backed the wrong horse (i.e. Summers) John Hilsenrath made a dramatic U-turn and began to sing the praises of Yellen[i]; in the hope of rebuilding his bridge of privileged access which he burned with his panegyrics for Summers[ii]. It is clear that Yellen is now the President’s choice. “And Now the End Is Near” opined that Yellen was years behind Summers; in terms of her appraisal of the Credit Crunch and her response by becoming a disciple of Michael Woodford’s Helicopter Money solution[iii]. Yellen was remembered as being asleep at the wheel, with the rest of the FOMC, as the bubble inflated and then imploded. Her current critics opine that she will expand the monetary base even further and create asset bubbles and inflation. Since she will be taking up her Chairmanship at a time when global liquidity is being attracted back to North America, by higher interest rates and the flight to quality motivation, she will inherit the very conditions that are associated with her perceived stock in trade economic policies. She will therefore inherit a domestic liquidity bubble; not of her making but nevertheless attributed to her. The financial markets have thus already begun to discount the negative connotations of her Chairmanship. Faced with this vote of no-confidence, she will therefore have to establish her sound money credentials by being less accommodative. This conservative behaviour will thus affirm the tightening financial conditions already discounted in the markets; which will ultimately lead to weaker economic growth. Yellen will therefore be making the classic mistake associated with Paul Volcker in Terminal Velocity “What Goes Around, Comes Around”. She will try and cure a build-up in domestic liquidity with higher interest rates which exacerbate this liquidity by attracting more liquidity from abroad. These higher interest rates will occur at a time when the economy is already showing signs of slowing down because of the tighter financial conditions associated with the “Taper Talk”. Yellen and her initial austerity will therefore create a self-fulfilling crisis. Having enabled this crisis scenario in financial markets and economic activity, she will then have created the situation in which she is then justified in being more accommodative. The same thing happened to Mario Draghi when he became the head of the ECB. New central bankers are always under institutional and market pressure to be austere; in order to earn the respect that is required in their relationships with the policy makers and investors. There then ensues a period of tightening financial conditions and economic weakness which then allows them to ultimately show their real Keynesian credentials. Mark Carney is currently undergoing a similar trial by fire and water in the United Kingdom. The signs are that Carney has fallen into line and accepted his fate. BOJ Governor Kuroda appears to be the one exception to this rule; however this is because Japan has endured an economic stagnation created by its failure to apply the Woodford thesis for thirty years. Japan is the anachronism that now serves as the example, to the rest of the Developed Markets, of the perils from failure to commit to permanent monetary action.
This sequence of events will confirm that the Fed has lost track of the results of its own guidance. This disorientation can be attributed to a systemic failure to understand the impacts of QE and the “Taper Talk” on global capital flows. In the first instance, QE leaked out of the US Economy for lack of domestic growth opportunities and high yielding assets. In the second instance, this QE is now returning to the US Economy because of the lack of global growth opportunities and attractive yields. By acting unilaterally for the US domestic economy, the Fed is missing the full picture and undermining its own actions.
The disorientation is clearly evident when listening to the chorus of voices from Fed Governors, allegedly all singing from the same sheet, which erupted as soon as the quiet period around the recent FOMC period expired. The audible dissonance corresponds to different voices singing about the different liquidity flows being observed by each singer. Each singer observes a little piece of the whole flow mechanism corresponding to his/her own dogmatic academic position; but taken together each voice is out of sequence and contradicts the other. Diversity and transparency avoid the risk of groupthink but create the risk of chaos, through failure to create practical consensus. Bill Dudley was unapologetic for the failure to “Taper” at the last FOMC; and hinted that more QE is lurking out there awaiting weak data. Lockhart was more balanced and data dependent; suggesting that he could be convinced to “Taper” any time soon. Lacker and George wish to “Taper” immediately. Stein is data dependent; but also mindful of the threat of liquidity bubbles from repatriated QE. He could therefore “Taper” any time soon, just to deflate these bubbles rather than to directly impact the economy. Stein’s “Tapering” however comes with the big caveat that real tightening can only be considered when the unemployment rate falls below 7%. Kocherlakota is at the extreme accommodative end of the audible “Fedspeak” spectrum; and wishes to see more QE now.
Traders are binary decision makers. Confronted with this audible chaos they are uncertain and hence prone to sell. The guru Woodford understands that guidance is chaotic without real commitment. Thus far the Fed has guided with words; and as it turns out many voices. There has however been no action to authenticate the words. All that has been engineered therefore is uncertainty; which will lead to the market volatility which ultimately knocks on to weak economic performance. At this point Woodford’s disciple Yellen will be obliged to authenticate the guidance with a real commitment to expand the money supply permanently. True consensus is then achieved through the external agency of a crisis; which demands the unanimous acceptance of easy money.
Once this permanent expansion is understood by businessmen and individuals, they will go about trying to get their hands on it by engaging in real economic activity; rather than by speculation in financial assets linked to the temporary creation of liquidity through QE and the volatility created through guidance with no action. Right now they are confronted with a pantomime in the Congress accompanied by dissonance from the orchestra pit at the Fed. Little wonder nobody is crying encore!!!