Page 1 of 4 CREDIT BUBBLE BULLETIN The perils of mopping up
Commentary and weekly watch by Doug Noland
October 9 - Reuters (David Milliken): "The US Federal Reserve should try to stop a damaging cycle of booms and busts by breaking investors' expectations that it will mop up after future asset price bubbles, one of the pioneers of inflation-targeting said. Arthur Grimes, who developed inflation-targeting at the Reserve Bank of New Zealand in the late 1980s, said the Fed had inadvertently made bubbles more likely by promising to help the economy after they burst. 'The largest economy in the world is leading policies that lead to asset booms. It makes it incredibly difficult for other central banks to have a credible policy.' ...
"Grimes said investors were still likely to pile into asset price bubbles because they expected that even if they burst, central
bank action to support the economy would soon cause asset prices to return to their previous levels. The US Federal Reserve was particularly at fault after repeatedly supporting markets following brief episodes of financial market turmoil from the 1980s onwards, Grimes said. 'In my view it was a big mistake by the Federal Reserve ... They are stuck between a rock and a hard place, in terms of the Fed officials themselves. You would have to have a big bang to say: 'We are targeting price stability. We are targeting stable asset prices as well as stable goods prices.' ...
"Grimes also had words of caution for central banks adopting forward guidance on their future interest rates, saying it needed to be consistent and should not be a mask for changing inflation goals. 'If you revise based on new information, that is fine. If [the public] think you are going to revise your criteria for where you are going, then you lose your credibility,' he said."
President Barack Obama lavished praise on the soon-retiring Ben Bernanke this week as he announced Janet Yellen as his choice to head the Federal Reserve. Market players absolutely love Bernanke and were cheered by the Yellen selection. Larry Summers? Well, he certainly wasn't wedded to the quantitative easing (QE) experiment and would have likely taken a less than friendly view of the Fed backstopping markets and targeting higher asset prices.
I was critical of the decision to appoint Dr Bernanke Fed chairman back in 2006. From my (and others') perspective, it's difficult to credit him for rescuing the system from near collapse back in 2008/09. After all, his doctrine and policies were fundamental to the preceding bubble.
During the Alan Greenspan era, the Fed strayed dangerously away from sound central banking. Ben Bernanke, the esteemed academic and expert on the causes of the Great Depression, was the last person that would pull the Federal Reserve back from activism, market manipulation and inflationism. And, indeed, he championed the view that central banks should ignore asset bubbles and instead rely on regulation to contain excess. Central to Bernanke's thesis was that bubbles could be ignored with the understanding that central banks (with their electronic "printing press") enjoy the capacity for aggressive post-bubble "mopping up" reflationary measures.
Essentially, the doctrine holds that debt problems can be inflated away through aggressive monetary expansion. The Federal Reserve targeted mortgage credit as the reflationary expedient in the post-tech Bubble reflation - with disastrous consequences. Somehow, the Fed and its flawed doctrine were never held accountable. What began as the Fed employing federal government credit as its post-mortgage finance bubble reflationary expedient has morphed into an experimental use of its own credit to directly inflate asset markets.
As conventional thinking has it, "Thank God for the Bernanke Fed with all the dysfunction from Washington politicians." Yet our central bank should take primary responsibility. After all, Washington and the country are divided by the issues of massive deficits and the government's commanding role throughout the US economy. This is a direct consequence of previous serial bubbles and the Fed's expansive "mopping up" operations. It is also a reminder of how history warns that once monetary inflation takes hold it garners many supporting constituencies.
The Fed has immersed itself in the middle of deeply divided politics. Federal Reserve policies have fomented speculative asset bubbles and attendant wealth redistribution. Those on the political left have justification for distrusting the markets, while pressing forward with policies of redistribution. Fed-induced monetary instability has led to severe structural maladjustment. Fed "mopping up" has monetized an unprecedented peacetime expansion of public spending and deficits.
There is ample support for the view that fiscal and monetary policies have been deeply detrimental to the economy and society. Those on the political right have justification for their view that "money printing" and "big government" risk the downfall of our great nation.
I was struck by comments from Wall Street punditry in the aftermath of the Yellen announcement. "She will touch people in a more feminine way." "Good for our democracy." General market sentiment was captured by Ambrose-Evans Pritchard's headline in the Guardian: "Rejoice: The Yellen Fed Will Print Money Forever to Create Jobs."
For starters, the Fed and our country are in desperate need of a strong and independent leader who would be willing to administer tough love and begin the punchbowl removal process. Unfortunately, the markets today enjoy veto power and would in no way tolerate a Paul Volcker type. The Street prefers someone who is willing to advance this experiment in unprecedented monetary inflation. It was no coincidence that Bernanke was even more experimental than Greenspan and that Yellen is seen as even more the "uber-dove" than "Helicopter Ben". It is no coincidence that academics dominate today's Federal Reserve.
Dr Yellen good for democracy? This is actually a critical issue. So, why don't we just have voters elect the Federal Reserve chairman? Better yet, we could instead just let congress or the president dictate monetary policy. How about we allow them to work together and come to a consensus on rates and a weekly QE quantity?
Monetary stability - stable "money" and credit - are good for democracy. History is unequivocal, unsound finance and resulting booms and busts are bad for society, social stability and democracy. An independent central bank some distance from political influence is fundamental to monetary stability. And, I would argue, it is impossible to have monetary stability in an environment where central bankers are aggressively intervening in the markets, printing money and targeting higher asset prices. I believe Arthur Grimes (see comments above), for years chairman of the respected Reserve Bank of New Zealand, would agree.
During a CNBC interview, Harvard history professor Niall Ferguson spoke of "desperate improvisation" at the Federal Reserve. Ferguson also stated an interesting view of how Yellen might differ from Bernanke: "Theoretically [she is] on the same page as Bernanke, but covertly, she would really like to have a nominal GDP [gross domestic product] target - a new level of policy innovation on the monetary side."
An inflation target; an unemployment rate target; a target for the short-term "Fed funds" rate; a target for market bond yields; and now, perhaps, a GDP target. Lots of policy targets that obfuscate the Fed's true intentions: The Fed is trapped in a desperate monetary inflation and there is apparently no mechanism to rein in our central bank.
The Fed's unstated goal is to inflate credit sufficiently to grow beyond previous debt problems and associated financial and economic fragilities. I have noted that annual non-financial credit growth was about $650 billion in the mid-'90s. A historic credit boom saw annual non-financial growth surge to a peak level $2.55 trillion in 2007.
It is central to my macro credit thesis that protracted credit booms raise various price levels throughout the financial and economic systems. Moreover, credit excesses distort spending and investing patterns in the real economy, leading to progressively problematic structural maladjustment. Importantly, increasingly inflated asset prices and economic maladjustment foster systemic dependency to large and ever-expanding credit expansion.
After the bursting of the mortgage finance bubble, I posited that it would require in the neighborhood of $2 trillion annual credit growth to reflate the structurally maladjusted US economy. Furthermore, I stated this posed a major ongoing dilemma for the Federal Reserve. Massive deficit spending and Federal Reserve monetization were sufficient to initially stabilize asset markets and the economy. At the end of the day, however, it would remain a significant continuing challenge to achieve the requisite $2 trillion annual credit growth bogey.
I believed the Household sector would have little appetite for adding to its huge debt load, while the corporate sector was already sitting on (mortgage finance bubble-enhanced) large cash balances. And I did not believe the $1.5 trillion annual federal deficits from 2009 and 2010 - instrumental in reflating incomes, spending and corporate earnings - were sustainable.
Many speak of the need for the economy to reach "escape velocity". From my analytical perspective, this in a similar vein as my required $2.0 trillion or so of annual credit growth that would fuel asset inflation and sufficient spending to power a self-reinforcing expansion in our services/consumption dominated economy.
With mortgage credit and household debt still contracting, it became increasingly clear to Fed policymakers in 2012 that the credit-dependent recovery was at heightened vulnerability. "Mopping up" wasn't working as the theory and econometric models had forecast. The Fed decided to take a major gamble with aggressive non-crisis QE.
Non-crisis QE should be thought of as a mechanism to short circuit normal (financial and economic) system operations - and a particularly dangerous one at that. Instead of credit expansion and more typical economic processes feeding into higher investment, incomes, corporate earnings and wealth creation, the Fed moved to bypass the economy and inject unprecedented liquidity directly to spur risk-taking and inflated securities markets.
I wrote last week that injecting liquidity into already overheated speculative markets is tantamount to QE as rocket fuel. It both inflates securities prices directly while it also heavily incentivizes risk-taking and speculative leveraging. Couple rocket fuel QE with "transparency", "forward guidance", and a promise to backstop markets in the event of a "tightening of financial conditions", and you've progressed all the way to reckless monetary policy.
Is the Fed really promising the markets that they will remain ultra-accommodative for at least the next couple years in the face of conspicuously speculative securities markets and increasingly overheated asset markets generally?
The Janet Yellen confirmation hearings could be an interesting affair. To what extent could it become a more general hearing on Federal Reserve doctrine and policy? Over the years I've highlighted the central bank "Rules vs Discretion" debate that's been around for generations.
Our great nation's brilliant Founding Fathers clearly appreciated the perils of unsound money. They understood the dangers of excessive power and the necessity for checks and balances. They would have never anticipated an American central bank printing money without restraint.
There was a major flaw in the structure of the Federal Reserve System - and for central bank structures generally. I just don't think anyone ever anticipated that central bankers might someday resort to creating trillions of "money" as they do today - on a whim or academic theory.