We are witness to momentous secular change unfolding in real time. The Federal Reserve desperately needs to regain control of inflation in order to maintain trust, but that requires jettisoning policy doctrine that evolved over the past three decades, undoing years of error while convincing everyone none of it was in error, lest they look like they are simply undoing themselves, which is exactly what they are doing….
We’re striving for context and perspective. In this incredible environment, feelings of insecurity and apprehension are inescapable. But we can work hard to minimize confusion.
A Bubble: “A self-reinforcing but inevitably unsustainable inflation.” An Experiment: “A test; trial; a tentative procedure or policy; an operation or procedure carried out under controlled conditions in order to discover an unknown effect or law.” The former definition is Noland’s and the latter Webster’s.
We are witness to momentous secular change unfolding in real time. The FOMC hiked rates 75 bps Wednesday, the largest rate boost since Greenspan’s lone 75 bps move more than 27 years ago (November 1994). For anything bigger, it’s back to the Volcker era.
The 1994 tightening cycle and attendant acute bond/derivatives market upheaval fundamentally altered Federal Reserve doctrine. It’s been gradualism ever since. All policy moves had to be well telegraphed to the markets. In effect, rates would be cautiously raised to ensure little market impact, hence no actual tightening of financial conditions.
The previous fateful cycle has run its course. Gradualism is out. Importantly, the Fed’s current objective is to meaningfully tighten financial conditions specifically to control runaway inflation. While the Fed remains as committed as ever to transparency, this comes with a major caveat: the FOMC can now be forced into changing its mind in a blink of an eye. Powell and the committee’s recently telegraphed 50 bps June hike was abruptly scrapped for 75. Fed guidance, the bedrock of bond market expectations and pricing in recent decades, has been turned to sand.
June 15 – Bloomberg (Mohamed A. El-Erian): “For its sake and that of both the domestic and global economy, the central bank desperately needs to regain control of the inflation narrative. The persistent failure to do so in the past 12 months is turning the perception of the Fed from the world’s most powerful central bank — long respected for its ability to anchor global financial stability — to an institution that too closely resembles an emerging-market bank that lacks credibility and inadvertently contributes to undue financial volatility. Regaining control of the inflation narrative is critical to the Fed’s policy effectiveness, its reputation and its political independence.”
It’s easy to agree with Mr. El-Erian: go out and regain the inflation narrative! But for the Fed to accomplish such a feat would basically require jettisoning policy doctrine that has evolved over the past three decades – the very doctrine underpinning the great Experiment in unfettered contemporary market-based finance.
Former ECB President Jean-Claude Trichet (2003-2011) was fond of saying “we never pre-commit.” The critical role of a central bank is to resolutely promote stable money and Credit. Committing to a set course only incentivizes market operators to exploit a predictable path of policy measures. Examples would include leveraged speculation to profit from future rate moves, the structure of the yield curve, currency devaluation and asset inflation more generally. In its most dangerous form, market participants push risk and speculative leverage envelopes in response to foolproof central bank liquidity and market backstops. I’m reminded of the Hyman Minsky insight, “stability is de-stabilizing.” Manipulating a false sense of stability in financial markets is ensuring trouble.
A cycle that commenced in the early nineties has run its course, and the Fed has no alternative than to adapt to new inflation realities. Tinkering with the markets proved a most slippery slope, from Greenspan to Bernanke to Yellen and Powell. Somehow, manipulating market expectations evolved to become a centerpiece of contemporary monetary management. The entire doctrine was developed with bolstering financial markets the focal point.
Trillions of liquidity were injected into the markets as the primary mechanism for inflating securities prices, loosening system finance and stimulating wealth-effect household and business spending. When resulting highly speculative markets wavered, Bernanke was there to “push back against a tightening of financial conditions.” A market downdraft early in his term had Powell executing a dizzying pivot. When cracks emerged in the summer of 2019, the Fed restarted QE. In response to collapsing Bubbles, the Fed desperately unleashed $5 TN (as global CBs added Trillions more).
The Fed is wishful thinking if it actually believes it will stabilize inflation back down near its 2% target. For a few decades, the Fed has had the luxury of directing its policy focus to the financial markets. Consumer price inflation was relatively contained and stable. It was also aberrational.
The inflating global Bubble backdrop created the perception of an expanding economic pie. The forces of cooperation and integration were powerful. Importantly, China, benefiting from a confluence of unlimited cheap finance and globalization, unleashed a historic investment boom. The resulting massive increase in the supply of low-cost manufactured goods (from China and EM more generally) was fundamental to subdued consumer price inflation in the face of historic Credit excess.
This anomalous inflationary dynamic, with asset prices rising more forcefully than consumer prices, proved powerfully self-reinforcing. Global liquidity excess fueled the ongoing investment boom, stoking both growth dynamics and insistent asset inflation. Downward pressures on goods prices, a key inflationary dynamic, were misinterpreted as manifestations of deep-seated disinflationary forces. Then, as asset Bubbles inevitably faltered, the battle cry quickly turned to a whatever it takes fight against the scourge of deflation. Increasingly fanatical monetary inflation repeatedly revived Credit, asset and economic Bubbles.
A historic cycle has, finally, come to its conclusion. Multiple Interconnected Historic Experiments are failing concurrently – unfettered global finance, inflationist central bank doctrine, market and economic structure.
History – distant and recent – teaches that Credit is Inherently Unstable. Market-based Credit, within a backdrop of central bank inflationism and resulting speculative excess, is acutely unstable. A retrograde multi-decade Experiment in central bank market manipulation and egregious monetary excess fed the misperception of financial stability and soundness – for Credit, Credit markets, stocks, derivatives and “structured finance.”
Over time, the entire global financial structure was underpinned by new paradigm central bank policy doctrine. How could governments endlessly create Trillions of new liabilities (i.e. bonds), while prices of these (increasingly unsound) securities only inflated higher? Central bank policies. Defaults – or even market illiquidity – would never be tolerated. In a world of such great uncertainty, how could the perception take hold that stocks were a sure bet to always increase in price? Central banks and their “whatever it takes” liquidity backdrop. Why is there such little concern for booms in about every type of risky lending, leveraged speculation and crazy manias? Central Banks. Better yet, how could derivatives markets willfully disregard past debacles and expand to hundreds of Trillions on the specious assumption of liquid and continuous markets?
The life of a central banker has turned incredibly more complicated. A new cycle of significantly higher and unstable inflation has taken hold. It’s the downside of global Bubble Dynamics – a shrinking pie, insecurity, angst, and disintegrating relationships and alliances – along with conflict. The Ukrainian war, tit for tat sanctions, and the new Iron Curtain. Meanwhile, cost structures over the years have inflated tremendously in previously low-cost economies China and EM more generally. And with new Inflation Dynamics now favoring energy, commodities and hard assets over suspect financial assets, central bank liquidity injections will increasingly gravitate to real things and away from securities (reinforcing consumer price inflation and imperiling the central bank market liquidity backstop).
The week’s good news – that should not be easily dismissed – was that markets made it through quarterly options/derivatives expiration without a serious accident. It was anything but a sure thing. Things were looking dicey.
Still, Crisis Dynamics have attained important momentum.
Renowned economist issues startling prediction for America’s future:
According to former Goldman Sachs executive, Nomi Prins, Americans who are hoping for a ‘return to normal’ are going to be shocked when they see what happens next in America. She says, “If you’re betting your job, savings, or retirement accounts on a return to ‘normal’ you’re about to be left behind by a brand-new crisis few see coming.”