I have long found Federal Reserve policy pronouncements confusing. This is not for lack of effort in trying to understand policy nuances. Rather, it is due to the purposeful misdirection and misinformation put out by various Federal Reserve chairs, governors, and regional bank presidents at different times, but especially in the last three years. This is about how long the new "open communication" policy has been in place.
We have seen the Fed under Janet Yellen repeatedly change its targets while it was supposedly "data dependent." I think this habit of moving the goalposts at every other meeting clearly shows the ad hoc and unstructured nature of Fed policy in recent years. In fact, I would argue that the Fed has no actual policy (except to have no policy), which would explain why the goalposts keep moving as new data comes in.
There are alternative explanations though, including those that assume that the Fed can't talk about their real goals because either: 1) these goals are outside their mandate, or even unconstitutional, or 2) they're afraid that the real truth about what is happening (i.e., the Fed's impotence to move the economy) will freak out the markets and cause a panic.
Fed Chair Janet Yellen:
The Fed actually set out in 2009 (under QE1) to make speculation easy and prudence difficult in pursuit of the elusive "wealth effect," and surprisingly they've never really backed off on that, in spite of their own internal research showing that QE has not been effective in improving the economy. What did improve was the stock market, and all it wants now that it is addicted to Fed intervention, is more of the same.
The markets since 2008 have thus become utterly dependent on Fed actions, and worse yet, on every twist and turn in Fed Speak. There are Fed officials who seem to thoroughly enjoy their power to move the markets, and like little tyrants, they seem sometimes to say things just to watch and enjoy the reaction. Whether or not this perception is true, it is a fact that the Fed is openly manipulating the markets on a weekly and even daily basis at times, and it is also true that the Fed thinks it has the right, and indeed the mandate to do this.
Fed Chair Janet Yellen has said, "Will capitalist economies operate at full employment in the absence of routine intervention? Certainly not. Do policy makers have the knowledge and ability to improve macroeconomic outcomes rather than make matters worse? Yes." She also is quoted as having said, "While admirers of capitalism, we also to a certain extent believe it has limitations that require government intervention in markets to make them work." As I have said before, her complacency (and that of her colleagues) "is not a result of superior knowledge; rather, it is the result of the deeply satisfying conceit that goes with the psychology of unaccountability in government. No one has ever been held accountable in most governments (with the exception of a few countries like Iceland, Ireland, and Greece), or in the world's central banks for the errors that led to the impoverishment of millions in 2008, nor will they be."
I am also vividly reminded of the warnings against central planning published by the great economist and Nobel Laureate Friedrich von Hayek in 1944, in his book entitled "The Road to Serfdom" (University of Chicago Press, 1994). In this book, he detailed the failures of Communist and Fascist central planners, and the resulting loss of freedom, growth of tyranny, and decline into serfdom of individuals.
While I'm not claiming a decline into serfdom quite yet, I do see a secular decline of the Middle Class that's been made worse as a direct consequence of the Fed's interventions. What's more, Yellen's Fed has continued the arbitrary ad hoc decision-making process used by Ben Bernanke before her. An example pointed out by famous investor Jeffrey Gundlach is the fact that with Personal Consumption Expenditures (PCE) YOY growth at a low 1.70% in September 2012, the Fed felt it was necessary to initiate QE3.
But in September of 2015, when Yellen announced that a rate hike would soon occur, conditions were even worse (see chart below). We are still talking about the next rate hike now, in late April of 2016, and yet headline PCE growth is still only 0.96%, and core PCE growth is still only 1.68%. Thus, under virtually identical economic conditions, the Fed has both printed money and tightened, depending on their whims.
Source: Jeffrey Gundlach, DoubleLine
In the light of Yellen's hopelessly complacent view of her own and her colleagues' abilities as central planners, it is both amusing and alarming to review how badly Fed statements and actions have gone in the past. For example, former Fed Chair Ben Bernanke said on March 28, 2007, "At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained." Bear Stearns failed a year later, kicking off the worst financial crisis since 1932. A few months after this first statement, on October 31, 2007, Bernanke said that, "It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions."
But a year later, he ended up advocating massive bailouts of numerous companies like American international Group (NYSE:AIG) and Merrill Lynch that were not even part of the Fed's mandate. And again, on January 10, 2008 (after the Great Recession had already started in December of 2007), Bernanke said, "The Federal Reserve is not currently forecasting a recession." But a number of good economists and analysts like John Mauldin, Gary Shilling, John Hussman, Jeremy Grantham, Robert Shiller, and David Rosenberg made the right call, and long before that point in time.
Former Fed Chair Ben Bernanke:
Now, back when it was policy to appear inscrutable, as when Alan Greenspan was chair, then the double-speak and pure obfuscation the Fed put out was understandable, as the explicit goal was to be unpredictable. He even once said, "I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I said." Another funny one is this gem, "I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I meant."
Former Fed Chair Alan Greenspan:
But humor aside, Greenspan was the Fed Chair who started what has turned into a permanent move, from a Fed constrained by its mandate and certain standards of behavior, to a Fed making serial ad hoc decisions with the open goal of manipulating the markets and the economy to achieve nebulous and even (sometimes) undemocratic goals. Greenspan started the move to the triumphant central planning theory that now is wreaking havoc on retirees and savers throughout the economy. Not surprisingly, this theory has no evidentiary basis, according to economist John Hussman and a number of other well-known analysts.
The long-trusted Taylor Rule was used to guide Fed policy for many years, primarily by putting certain constraints on Fed behavior. The rule was first abandoned in the emergency of 1987, and then again in the early 1990s, and the resulting easy monetary policy is part of what fueled the Tech Bubble. Then the Taylor Rule was permanently abandoned by Greenspan's Fed in 2001 during the recession in the aftermath of the 9/11 tragedy.
The chart below shows that the Fed kept rates too low from 2001 to 2007, almost certainly causing the housing and stock market bubbles to expand until they popped in 2008, in part causing the Great Financial Crisis. Indeed, we are arguably now in the third serial bubble that has blown up since Greenspan abandoned the Taylor Rule. The chart also shows that (in the light of the Taylor Rule) the Fed should have raised rates as far back as 2011, but instead waited another four years!
Wilshire 5000 Index:
Now, if you really want to examine the way the Fed operates nowadays, it would pay to examine just what the Fed did once the financial crisis that it didn't see coming actually arrived. Pulitzer prize-winning journalist and author David Wessel wrote a very interesting account of the Fed's actions called In Fed We Trust (2010, Three Rivers Press, New York, 341p). A general timeline for the Great Financial Crisis is shown in the chart below.
First, the Fed and the Treasury Department decided to save Bear Stearns in March of 2008, and then more or less arbitrarily let the much bigger Lehman Brothers fail in September of 2008, setting off the Panic. Realizing their error in part, the Fed and Treasury, within a week, completely reversed course and bailed out the enormous AIG with $85 billion, forced a shotgun wedding between Merrill Lynch and Bank of America Corp. (NYSE:BAC), risked billions to bail out non-guaranteed money market mutual funds, converted Goldman Sachs Group (NYSE:GS) and Morgan Stanley (NYSE:MS) into Fed-protected bank holding companies, and requested $700 billion from Congress for the infamous TARP program.
This is not to say that many of these actions were not necessary. Ultimately, the financial system was saved from repeating a complete disaster like the Great Depression. But Bernanke and New York Fed President Tim Geithner and Treasury Secretary Hank Paulson opened Pandora's Box as it were, and it doesn't appear that it's ever going to be the same again.
In the midst of the crisis, the Fed threw out all accepted practice, such as the understanding known as "Bagehot's Rule," and then threw out all legal constraints, and eventually just did whatever it took to try to keep markets from getting any worse. Bagehot's Rule was promulgated by Walter Bagehot, who had studied financial crises and concluded (in his book Lombard Street, 1873) that in a panic the central bank should lend freely on good collateral and charge a high interest rate to discourage overuse; also it should lend only to those who were solvent.
This is clearly not what was done by Bernanke and crew. The Fed even ended up cutting interest rates to zero, initiating ZIRP and revolutionizing how the markets look at risk. Eventually, the Fed set up currency swaps with foreign banks that were worth trillions of dollars, a completely unprecedented action.
In spite of all of this, the markets fell anyway, and apparently only stopped falling because in early 2009, the FASB threw out the rules and exempted the big banks from having to mark-to-market their atrocious assets, according to John Hussman. The chart below shows the lack of impact of lower rates, including the beginning of ZIRP.
Of course, actions to prop up foreign and domestic banks were more effective, so at least something worked. Other government interventions like TARP apparently helped as well. But in the aftermath, it would appear that long-standing concepts about central bank interventions, like the Bagehot Rule, were tossed aside in the name of expediency, and there is no evidence that they are ever coming back into use again.
S&P 500 Plunged in 2008 Despite Fed Rate Decreases to Zero:
In fact, based on the Fed's actions over many years and the statements of people like Fed Chair Janet Yellen (quoted above), there doesn't seem to be any real belief at the Fed in the basic tenets of capitalism. Yellen's kind of thinking makes it official: as David Wessel pointed out in his book, the Fed has become the Fourth Branch of government, with more power than any of the rest, and it will intervene frequently, without the benefit of mandates or empirical evidence, whenever it likes.
The Fed now operates without any real operational oversight, often without proper constitutional authority (i.e., were they authorized to spend trillions of dollars, or take on assets that would lose money?) or any other democratic constraints (checks and balances), and without any standard, or even generally accepted, principles of operation.
In addition to fierce criticisms from John Hussman, other famous economists like Vince Reinhart and Anna Schwartz were highly critical of what the Fed did in the crisis. John Taylor (of Taylor's Rule fame) thought that Bernanke, Geithner and Paulson failed to adequately explain their actions, leaving markets to play a guessing game.
The belief that the Fed was forced to act and had no choice in 2008 is widespread, but I believe that this is wrong, at least in some of its particulars. The Fed completely ignored the lessons of the Depression of 1921, elegantly discussed in economist James Grant's book on the subject (The Forgotten Depression, 1921: The Crash That Cured Itself (2014; Simon & Schuster, New York, 254p). No attempt was made to let markets sort some of the problems out as was done in 1921. Instead, Bear Stearns was bailed out, sending the wrong message to market participants, who promptly bought more bank stocks.
To me this means that the Fed's members collectively have an interventionist frame of mind. The Fed and Treasury apparently never asked Congress for a bank rescue setup like the Reconstruction Finance Corporation of the Great Depression years. Why not? The RFC actually worked. The Fed also apparently never demanded that Congress authorize the expansion of its powers to include all of the non-bank rescues that were conducted, or to clarify their authority to conduct operations aimed at foreign banks.
The Fed simply acted whenever and wherever they felt it necessary, and nobody stopped them. People were shocked by the crisis and just wanted someone to act. As a result of this precedent, and in the face of continued Congressional lethargy on the subject, the Fed now has essentially unlimited power that is in effect extra-constitutional. Good luck stuffing that back into Pandora's Box.
Indeed, I would even venture to say that the Fed's original mandate, which was to ensure price stability, is now completely lost to view. This is evidenced by the chart below, showing the demise of the US dollar over time. I realize that Congress and successive presidents have been the main drivers of the dollar's decline, but the Fed has clearly failed in its main mission nevertheless. Yet its power is the highest ever, far beyond what was ever contemplated by Congress, and it is still completely unaccountable.
As a final exercise in this discussion, let's look at what the Fed is doing now, and what it might do going forward. I think that there are six possible goals that the Fed has considered at different times recently, although they would of course not admit to most of them. Yet, given the paralysis of the Congress and the Executive Branch in exercising fiscal authority, the Fed is the only game in town, and they know it.
Given the fact that they have limited ability to fulfill their Congressional dual mandates (full employment, for which they have no tools, and stable prices, which they have manifestly failed to deliver in the last 100 years), but an almost unlimited interest in using their power for non-capitalistic interventions in the economy and markets, these six goals may be: 1) driving the dollar to cheap relative valuations at times to promote trade, 2) driving stock prices higher to promote the so-called "wealth effect," making risk-taking easy (and prudence painful), 3) driving unemployment to cycle lows and decreasing income inequality, 4) growing their balance sheet when needed to provide excess liquidity and promote lending, 5) holding interest rates low to reduce the service on the national debt and enable larger federal deficit spending, and 6) stabilizing inflation to promote price stability and aid employment expansion.
What tools does the Fed have to deal with these hypothetical goals? I don't mean legal tools, since they are now above the law (for the most part) permanently - I mean what they would consider actually doing. If you look at their statements, and sort out the nonsense about being data-dependent, you can read between the lines and perhaps see what is really driving the Fed: they are the only ones willing to act, and the debt burden is crushing the economy.
They have ZIRP, and even NIRP if they deem it necessary; they can resort again to QE if needed; they might even consider market actions similar to the Japanese Qualitative Easing Program (i.e., purchasing stock ETFs in the open markets) if there is an "emergency"; they can also change banking regulations. And last but not least, they can jawbone the markets, something they are obviously quite fond of.
Now then, at least three of the six potential goals are actually out of their reach, because they lack the necessary tools and/or are not capable of controlling anything related to these particular goals. The three I would exclude then are: 1) driving unemployment lower, 2) promoting lending, and 3) holding inflation and prices stable. It is easy to see that QE actively promoted two of the three remaining objectives: a cheap dollar for better trade, and rising stock prices to help their friends on Wall Street.
The final objective, holding interest rates low to help with service on the federal debt, has worked out well because the long-term secular decline in interest rates continues in the face of our enormous and growing debt burden. But they have at times used QE to monetize a major portion of the federal deficit, and they could do that again.
So when the next crisis begins, what might the Fed do? They could restart QE (count on it); they could add in Qualitative Easing to support the markets; they could completely monetize the federal deficit (count on it), allowing the government to spend hundreds of billions of dollars on "shovel-ready" infrastructure projects and expanded unemployment benefits; they could even invoke Ben Bernanke's famous "helicopter money" idea and distribute money directly into all of our personal accounts to promote spending. In other words, they can enable an unlimited socialist or welfare state at no cost to the political class. I absolutely expect them to do it, although I am not yet sure if they will do the helicopter money trick.
The question is, will the markets ignore the Fed once they are fully risk averse, as John Hussman maintains? Or will the markets fall for it and rally strongly? If you look back on what happened in 2008-2009, each new federal program announcement was accompanied by a sharp rally, followed soon after by another leg down. But that was when people were panicking, readers might be thinking.
Well, what will be the state of the markets when the quasi-religious belief in the Fed's power that has arisen since 2008 is shown not to be effective, yet again? Because it surely will be proven ineffective: the dollar will rise at some stage in a crisis, and stocks will fall no matter what. Interest rates will go down of their own accord, but the Fed can match the trend at least.
Traders can play the counter-trend rallies with momentum plays like the Vanguard S&P 500 Index ETF (NYSEARCA:VOO). All others should deal with a crisis using defensive sector allocations, plenty of bonds (the iShares 20+Yr. Treasury ETF (NYSEARCA:TLT), plenty of cash, and maybe some liquid alternative strategies like long/short funds (Diamond Hill Long/Short Fund [DHLSX], Otter Creek Long/Short Fund [OTCRX], or AllianceBernstein Long/Short Fund [LSYMX]).
The Last Fed Chair to Believe in Capitalism (Paul Volcker):
Another thing investors can do is petition the President and Congress to appoint former Fed Chair Paul Volcker as an advisor in all crisis meetings, because he is the last person to serve as Fed chair that still actually believes in capitalism.
Disclosure: I am/we are long OTCRX, LSYMX, TLT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended.