“A drunk walking through a field can create a random walk, despite the fact that no one would call his choice of direction rational. Still, if asset prices depended on the path the drunk adopted, it would be a good idea to study how drunks navigate.” ~ Professor Richard Thaler, “The End of Behavioral Finance”
Recently, in what has become known as his “Tapering speech”, Ben Bernanke, Chairman of the US Federal Reserve, upset investors when he implied that quantitative easing (QE), the buying of bonds by the Fed to suppress yields, was likely to be scaled down or ‘tapered’. The subsequent turmoil in capital markets triggered a barrage of speeches by his Fed colleagues as well as Mario Draghi (ECB chairman) and Mark Carney (recently appointed governor of the BOE). The aim of the speeches was to calm markets by clarifying the intended message, namely that actual tightening of monetary policy, e.g. by raising interest rates, was a long way off. Moreover, they emphasized that any change in policy would not be “date” but rather “data” dependent. In the case of the Fed, changes in monetary policy are dependent, for example, on the unemployment rate. A drop of the latter to below 7%, accompanied by economic growth (e.g. payrolls) and well-behaved inflation, would likely lead the Fed to start tapering.
Dependence can be a dangerous condition because the sequence of cause and effect becomes blurry. An entity suffering from it loses free will and exhibits compulsive behavior often fueling the factors that cause the dependence. Its general meaning varies from subordination to addiction. For example, a “dependency” can be a territory subject to a state on which it does not border. In Europe this seems to describe the current relationship Greece and Portugal have with Germany. Physical dependence is another example and involves addiction to substances. They can include medicines or, worse, drugs and these can inflict varying levels of harm:[1]
Source: Economist
For our purposes I’d like to make a distinction between the physical “real” economy and the mental “capital” markets.[2] Another distinction is between physical monetary policies, e.g. buying bonds, and mental monetary policies, e.g. forward guidance. To continue the analogy with medical treatments the former resemble medicines whereas the latter are similar to therapies. Of course, the reader is free to decide whether monetary policies are healing or harmful. Still, it is crucial to realize that in our reflexive world of economics dependence is an appropriate concept because the distinction between cause and effect of a crisis is even less clear compared to an emergency in the medical world.[3]
Specifically, is unemployment the ‘true’ underlying economic factor on which monetary policy depends, in the sense that it will “cause” the Fed to taper? The same question can be asked for price stability and financial stability. All three, explicitly or implicitly, form part of the Fed’s mandate but it remains unclear where they are along the fine line of cause and effect of monetary policy. More importantly, how do they relate to the tools the Fed has at its disposal? Apart from this operational aspect there’s the broader institutional issue concerning the Fed’s dependency. Formally, it is allowed to function (by US Congress) if it operates within, and achieves, the goals stated by its mandate. But who sets these goals, or in the words of CNBC’s Rick Santelli: “who does the Fed really work for?”[4] Via these leading questions I will try to make clear that the Fed’s ‘dependency’ problem is twofold.
First, viewed from an institutional point of view, the Fed is part of the financial system. Within this system it serves two masters, namely the US Treasury and the private banking sector. Elsewhere [5] I have quoted Bernanke, who admits that the Fed and the Treasury are in tandem to create inflation if this is required for price stability, like it is now. In addition the Fed serves the private sector banks, which was formalized in the most recent addition to its mandate, namely maintaining financial stability. Specifically, the Fed makes sure the private banks that are “too large to fail” do not do so. In short, the Fed does not work in isolation within its modus operandi nor is it independent.
Second, from an operational point of view, the Fed uses monetary tools, the most important of which are interest rate policy and quantitative easing. The dependency between these tools is easily identified: the risk/return profile of the Fed’s balance sheet is heavily skewed because its bond holdings, which have grown in size to roughly trillion, only “balance” positively if interest rates do not rise. Apart from holding the bonds to maturity, the only way for the Fed to hedge this risk is if the US Treasury takes it on. The latter has recently taken a step in this direction by issuing floating rate notes which, once bought, would allow the Fed to gradually “swap” its holdings.
What is more difficult to grasp is how these policies are actually causing the circumstances that trigger their use. I have written about this previously. The short summary is that the Fed has been explicitly targeting the capital markets with these policies. Consequently it has interfered in price discovery, which is the delicate underlying process with which markets provide us with the benefits of efficient resource allocation across the broader economy. Among the main consequences is that we get saddled with the wrong type of inflation. By manipulating interest rates, i.e. keeping them artificially low, the Fed promotes debt-fueled risk taking, (more commonly known as leveraged speculation) in financial assets. The flip-side of sustaining these booms is the postponement of their busts, which is required under such circumstances because those same assets constitute the collateral for the debt. This strategy, in fact, jeopardizes financial stability. As the late Sir Andrew Crockett of the Bank for International Settlements (BIS) warned[6]:
“ . . . the tools of prudential regulation are themselves based on perceptions of risk which are not independent of the credit and asset price cycle. If prudential regulation depends on assessments of collateral, capital adequacy and so on, and if the valuation of assets is distorted, the bulwark against the build-up of financial imbalances will be weakened.”
So, the Fed is aiming to fuel consumption by generating a wealth-effect from (inflated) assets rather than from (inflated) income. The latter could be achieved if the policies would explicitly target the real economy by promoting hiring, which would lead to rising wages (as well as “real” economic activity in the form of increased production). For example, to lower the costs of hiring as well as stimulate corporate lending, the Fed (in cooperation with the US Treasury) could design a policy which links employee costs related to government claims, e.g. payroll taxes/medical costs/etc, to bank loans. Banks could lower the rate of their loans to companies if these payments, acting as collateral, are guaranteed by the government. Of course, the banks could then securitize and package these loans with the Fed providing additional liquidity by becoming a “guaranteed” buyer of the resulting “employment bonds”.
Don’t get me wrong: I would rather have the Fed and the US Treasury stay mostly out of markets. But as an interim step towards an eventual “exit” this could provide a major improvement in the type and quality of the collateral underlying new debt: from speculative (financial) assets to productive (human) assets. It would be in the spirit of The Tenth Annual Report of the Federal Reserve Board which stated that the Fed was supposed to extend credit only for “productive” and not for “speculative” purposes.[7]
Then again, I could be wrong and current policies will work. Other analyses assume the Fed is an “independent” bartender who serves alcohol to (alcoholic) pub goers, or a responsible parent who can take away the punch-bowl at his children’s party. However, in light of the above I would argue that the Fed itself is very much involved in keeping the party going and has become dependent on the punch-bowl. In fact, the dependencies of the Fed are inherent to the nature of its party, both in terms of party-goers and the type of consumption. The dynamics involved are akin to medical conditions that concern both the physical and mental states. In short, the Fed is dependent on using medicines and therapies which lead to the symptoms that these measures are supposed to suppress! In turn, the market shows ever clearer symptoms of dependence, in particular tolerance and withdrawal, as the recent turmoil showed. All in all, the often-used analogy which compares the market’s random behavior to the walk of a drunk gets a whole different meaning.
Resources:
[1] https://www.economist.com/blogs/dailychart/2010/11/drugs_cause_most_harm
[2] The reason to view capital markets mainly from a mental point-of-view is that our financial system is based on fiat currencies whereby their monetary value does not reflect their physical value.
[3] There are many reasons for this, not least of which is the collective nature of the “condition” which involves ‘animal spirits’, ‘sentiment’ and other elusive phenomena.
[4] https://www.nbcnews.com/video/cnbc/52451264#52451264
[5] https://www.financialsense.com/contributors/patrick-schotanus/inside-the...
[6] https://www.bis.org/review/r010216b.pdf
[7] https://www.nber.org/federalreserve_SI2013/Rotemberg.pdf
