Page 1 of 4 CREDIT BUBBLE BULLETIN The Fed goes too far
Commentary and weekly watch by Doug Noland
The Federal Reserve shocked the markets Wednesday with its decision to furlough QE "tapering". The Ben Bernanke Fed, having for years prioritized a clear communications strategy, threw unsettled global markets for a loop.
Much has been written the past few days addressing the Fed's change of heart. I'll provide my own take, noting first and foremost my belief that Wednesday's decision likely marks a critical inflection point. A marketplace that had been willing to ignore shortcomings and give the Federal Reserve the benefit of the doubt must now reevaluate. After all the fun and games, the markets will have to come to terms with a divided and confused
Fed that has lost its bearings. As much as the Bernanke Fed was committed to the notion of market-pleasing transparency, it had kind of come to the end of the rope and was forced to just throw up its hands.
I'll make an attempt to place the Fed and markets' predicament in some context - at least in the context of my analytical framework. This requires some background rehash.
Credit is inherently unstable. When credit is expanding briskly, the underlying expansion of credit works to validate the optimistic view (spurring borrowing, spending, investing, speculating and rising asset prices) - which tends to stimulate added self-reinforcing credit expansion. When credit contracts, asset prices and economic output tend to retreat, which works against confidence in system credit and the financial institutions exposed to deteriorating credit, asset prices and economic conditions. One can say credit is "recursive".
And with credit and asset markets feeding upon each another, I'll paraphrase George Soros' Theory of Reflexivity: perceptions tend to create their own reality. Credit cycles have been around for a very, very long time. We're in the midst of a historic one.
Credit fundamentally changed in the nineties, with the proliferation of market-based credit (securitizations, the government-sponsored enterprises, derivatives, "repos", hedge funds and "Wall Street finance"). Unbeknownst at the time - perhaps to this day - marketable securities-based credit created additional layers of instability compared to traditional (bank loan-centric) credit.
These new instabilities and attendant fragilities should have been recognized with the bursting of a speculative Bubble in bonds/mortgage-backed securities/derivatives (along with the Mexican collapse) back in 1994/5. Fatefully, policy measures moved in the direction of bailouts, market interventions and backstops. Credit and speculative excesses were accommodated, ensuring a protracted period of serial booms, busts and policy reflations.
Monetary policy fundamentally changed to meet the demands of this New Age marketable securities-based, highly-leveraged and speculation-rife credit apparatus. The Greenspan Fed adopted its "asymmetric" policy approach, ensuring the most timid "tightening" measures in the face of excess and the most aggressive market interventions when speculative Bubbles inevitably faltered.
Greenspan adopted a strategy of "pegging" short-term rates and telegraphing the future course of policymaking. This was apparently to help stabilize the markets. In reality, these measures were instrumental in a historic expansion of credit, financial leveraging and speculation. The Fed has been fighting ever bigger battles - with increasingly experimental measures - to sustain this inflating monster ever since.
I am a strong proponent of "free market capitalism". I just don't believe financial market pricing mechanisms function effectively within a backdrop of unconstrained credit, unlimited liquidity and government backstops. I believe this ongoing period of unconstrained global credit is unique in history.
Indeed, this is an open-ended experiment in electronic/digitalized "money" and credit. This experiment has necessitated an experiment in "activist" monetary management and inflationism. At the same time, these experiments have accommodated an experimental global economic structure. The US economy is an experiment in a services and consumption-based structure with perpetual trade and current account deficits. The global economy is an experiment in unmatched - and persistent - financial and economic imbalances.
US and global economies are at this point dependent upon ongoing rampant credit expansion. Highly interrelated global financial markets have grown dependent upon the rapid expansion of credit and marketplace liquidity. The Fed and global central banks have for some time now been desperately trying about everything to spur ongoing credit expansion (to inflate credit). Curiously, they avoid discussing the topic and frame the issues much differently.
The Fed pushed short-term rates down to 3% to spur credit inflation during the early-'90s. Rates were forced all the way down to 1% - and the Fed resorted to talk of the "government printing press" and "helicopter money" in desperate measures to spur sufficient reflationary credit growth after the bursting of the "technology" bubble. Even zero rates were insufficient to incite private credit expansion after the collapse of the mortgage finance bubble.
With this New Age (experimental) marketable credit infrastructure crumbling, the Bernanke Fed resorted to a massive inflation of the Fed's balance sheet - an unprecedented monetization of government debt and mortgage-backed securities. What unfolded was a historic reflation of global securities prices, along with further massive issuance of marketable debt securities.
In spite of all the "deleveraging" talk, the growth of outstanding global debt securities went parabolic. Central bank holdings of these securities grew exponentially. Instrumental to the credit boom, Fed policy spurred trillions to leave the safety of "money" for long-term US fixed income, international securities and the emerging markets (EM).
It is unknown how many trillions of leveraged speculative positions were incentivized by global central bankers. The combination of an unprecedented policy-induced inflation of prices across securities markets and a low tolerance for investor/speculator losses creates a very serious and ongoing dilemma for the Fed and its global central bank cohorts.
Over the years, I've chronicled monetary management descending down the proverbial slippery slope. Actually, monetary history is rather clear on the matter: loose money and monetary inflations just don't bring out the best in people, policymakers or markets. I definitely don't believe a massive bubble in marketable debt and equity securities is conducive to policymaker veracity. I don't believe a multi-trillion dollar pool of leveraged speculative finance - that can position bullishly leveraged long or abruptly sell and go short - promotes policy candor. Actually, let me suggest that a global credit and speculative Bubble naturally promotes obfuscation and malfeasance. Invariably, it regresses into a grand confidence game with all the inherent compromises such an endeavor implies.
I titled a February 2011 Credit Bubble Bulletin "No Exits". This was in response to the details of the Fed's plan for normalizing its balance sheet after it had bloated to $2.4 trillion (from $875 billion in June of '08). There was simply no way the Fed was going to be able to sell hundreds of billions of securities into the marketplace without inciting risk aversion and de-leveraging. I assumed the Fed's balance sheet would continue to inflate, though never did I contemplate the Fed resorting to $85 billion monthly QE in a non-crisis environment.
I speculated a year ago that the Fed had told "a little white lie". The Fed was responding to rapidly escalating global risks - right along with the Mario Draghi European Central Bank, the Bank of Japan, the Chinese and others. Open-ended QE was, I believe, wrapped in a veil of an American unemployment problem for political expediency.
Meanwhile, the Fed has pushed forward with "transparency" believing it gave them only more control over market prices. And, at the end of the day, the $85 billion monthly QE, the unemployment rate target, and long-term (zero rate) "forward guidance" provided a securities market pricing transmission mechanism that must have made former Fed chairman Alan Greenspan envious.
The bottom line is that the $160 billion (Fed and Bank of Japan) experiment in ongoing monthly QE (along with Draghi's backstop) only worked to exacerbate global fragilities that were surfacing last summer. I believe increasingly conspicuous signs of excess had the Fed wanting to begin pulling back. Yet just the mention of a most timid reduction of QE had global markets in a tizzy. After backing away from an exit strategy, the Fed has for now backtracked on tapering. It seems I am on an almost weekly basis now restating how once aggressive monetary inflation is commenced it becomes almost impossible to stop.