The FOMC's Brexit Flip-Flops

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Summary

Janet Yellen follows the Dallas Fed's new guidelines on communication policy.

James Bullard's failure to adopt the Dallas Fed's communication guidelines has introduced a conflict within the Fed that Yellen is addressing.

The UK Brexit vote puts the FOMC on hold in July and a question mark over its activity in the future.

Analysts are drawing historical parallels with the Great Depression to infer central bank policy options and actions going forward.

Mario Draghi's call for the aligning of central bank policies implies that the FOMC's tightening process will end and then reverse course soon.

The latest FOMC meeting was controversial, to say the least, as the committee flip-flopped once again after feigning to tighten leading up to the meeting. The air of controversy was heightened by the publication of analysis from the Dallas Fed suggesting that the method of communication should change to address the low attention span of the audience.

Unfortunately, the communication in the Dot Plots raised the attention of the audience for all the wrong reasons. Specific audience attention was drawn to the "outlier" who refused to give long-term projections, and also the "outlier" who now only sees one rate hike this year. The controversies surrounding these plots served to undermine the faith in the consensus and cohesion within the FOMC.

(Source: Seeking Alpha)

Evidently, Chairman Yellen has read and understood the Dallas Fed's research on communications, so she has swiftly moved to draw a line under the "outlier" controversy. In her semi-annual Congressional testimony, she reinforced the message that despite the global uncertainty, she is still looking for the opportunity to tighten; thus following the Dallas Fed's edict to speak meaningfully.

Away from lawmakers' scrutiny, Yellen also tightened up the communication process at the Fed in a knee-jerk reaction to the "outlier" controversy. In the brief witch hunt that followed, James Bullard was forced to come clean and fess up to being the outlier. In order to cloak his dubious proclivity to always seek the limelight, he recused himself from the current process of FOMC forecasting. Allegedly, the St Louis Fed, of which Bullard is the president, has recently stopped forecasting beyond 2.5 years. He therefore enforced the St Louis Fed process onto the FOMC's process and refused to fill in the long-term dots. Having covered himself with the institutional process cover of the St Louis Fed, Bullard then immediately stuck the boot into his FOMC colleagues in an almost personal attack.

According to him, the Fed is losing its credibility with its Dot Plots, communications and follow-up behavior. Bullard failed to admit that he is as prone to flip-flop as his colleagues; and is, therefore, part of the problem and not the solution. In his own words: "The Fed's actual pace of rate increases has been much slower than what was mapped out by the committee in the past. This mismatch between what we are saying and what we are doing is arguably causing distortions in global financial markets, causing unnecessary confusion over future Fed policy, and eroding credibility of the (Federal Open Market Committee)." Having become part of the lost credibility problem, ostensibly he now wishes to impose the rubric of the St Louis Fed's process onto the FOMC as the solution. One can see this conflict ending in tears for both the St Louis Fed and the FOMC.

Rather than clearing up the controversy, Bullard's recusal and criticism only served to deepen it. The heterogeneous forecasting process across the regional Fed members, whilst being an advert for diversity, evinces a not-joined-up methodology that undermines the whole point of forecasting and communications. A process is only as useful as those who uphold it. Once members of the process fail to sincerely engage, the whole process and its results are invalidated.

Worse still, if one of the constituents fails to participate because it actually sees no validity in the process and has its own favoured process, one could argue that there is a lack of belief and even conflict within the organization. Bullard has struck a blow against groupthink, but this has come at the cost of the FOMC losing credibility. Said credibility was already in trouble because of the last Employment Report flip-flop on interest rates, so this is yet another nail in its coffin.

Bullard's strike seems to have begotten an equal and opposite strike that has damaged his reputation and authority. The above suggestion that Janet Yellen has instigated a witch hunt against errant FOMC members, who are breaking with the Dallas Fed's new edict on communication to speak less frequently but to speak with greater authority, can be applied to the case of Bullard. He now finds himself guilty of breaking with the new convention on guidance. A campaign to undermine his credibility has already started, with an article in the Wall Street Journal which opined that his fame as a flip-flopper has damaged his credibility with his Fed peers.

Whilst being careful to say that his flip-flopping is characteristic of the equivocal data and signals from the global and domestic economy, the article did Bullard no favors, framing him as the tail being wagged by the data dog. The inference is that FOMC members should have the experience and skills not to get wagged by such signals. Speaking less but speaking authoritatively, as the Dallas Fed suggests, would be the ideal way to evince such skills and maturity. It would appear that Yellen's tactics to promote a new form of guidance are subtle and resourceful. All eyes will be on Bullard to see if he has the common sense to get with the new communication programme, or whether he possesses the self-destruct character defect that makes him try and be the star by speaking frequently and erratically. Any dreams he may have of becoming Fed chairman are now fantasies. FOMC speakers observing the fate of Bullard at the hands of the press may be less inclined to extemporize so often and to follow the Dallas Fed's new guidelines on communication.

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Dallas Fed President Robert Kaplan became the most recent FOMC member to flip-flop away from tightening, in light of the deteriorating domestic and global picture. Kaplan's reversal took him in the direction already being marked out by San Francisco Fed President John Williams. In a recent report, Williams was observed to be lowering the natural rate of interest so that the tightening process could be ended sooner rather than later. In a follow-up report, his strategy for nudging his FOMC colleagues beyond the tightening cycle was observed to be endorsed by Stanley Fischer.

Kaplan's recent U-turn is based on his claim that "I (Kaplan) am strongly persuaded by arguments that aging demographics in advanced economies, a decline in productivity growth and the continued emergence of the U.S. as a source of safe assets have all contributed to the decline in the neutral rate." It would thus seem that Kaplan has been persuaded by Williams and Fischer's ideas about the neutral rate.

His recent speech also shone a light on how the Fed may now be looking at the challenge of stimulating growth. With only a small interest rate cushion to begin easing from, there is little that interest rate cuts can do. Kaplan is, therefore, calling for fiscal policy to be expanded. With such a small interest rate cushion, the Fed may also be forced to consider other unconventional measures. Indeed, negative interest rates may be forced onto it by flows out of negative yield environments in the global economy. Whilst Helicopter Money is academic, at this point in time, it could also be framed as a fiscal policy stimulus to make it more attractive.

The UK Brexit vote unequivocally confirmed that the Fed will be even less likely to hike rates in July. Since this event was highlighted in the last FOMC minutes and in Yellen's Congressional testimony as being a significant downside risk, the FOMC has no choice other than to sit tight. Should the Fed unexpectedly hike in July, whilst destroying its credibility even further, it would be laying the seeds for a market meltdown that would significantly damage the US economy. The FOMC must, therefore, be consistent with its comments on Brexit at the last meeting and sit on its hands. By the time of the next meeting, there may even be calls for easing, based on the market reaction to the Brexit vote.

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(Source: Bloomberg)

Analysts have looked for convenient historical models and precedents with which to frame the current economic environment. Morgan Stanley's historical search yielded what Ben Bernanke would recognize as a good model. This would certainly be the kind of "unusual situation" that Chairman Yellen could opine to justify the creation of Helicopter Money. According to their thesis, the global economy is following the footpath of the Great Depression of the 1930s.

Learning from the mistake made by the central banks of the time, which allegedly tightened monetary policy prematurely, the lesson for the Fed is that it should be in no hurry to tighten. The analysis is seductive, but fails to address the current issues of what the global economy should do with its substantial industrial overcapacity. The inference is that this industrial overcapacity will continue to exist in stasis, until demand has been stimulated to consume its output. Economic resources are, therefore, wasted in support of this overcapacity until such time as its output can be consumed. Zombie companies could be with us for years. Capital that could be invested to create growth in new industries is therefore used to keep the Zombie companies alive. It is easy to see the next step of the unfolding events, whereby Helicopter Money is used to put money in the hands of those who can then create the demand for this industrial overcapacity. The process will therefore be protracted, costly and wasteful.

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(Source: Bloomberg)

The last report discussed the destruction of private capital through the application of negative interest rates. Docile bond holders and the death of the alleged Bond Vigilante have created a growing universe of useful idiots in the process of the destruction of private capital. Zombie industrial overcapacity is egregiously paid to borrow, in order to sustain its existence until aggregate demand for its output comes back. The most useful idiots of all in the process are the central banks, which ultimately crowd out the private holders of bonds, perhaps ultimately passing the Helicopter Money to the governments themselves in order for them to pass it on to their chosen recipients in the polity who will provide the aggregate demand for the Zombie industries.

Rather than see industrial overcapacity cut through liquidation, bankruptcy or - worst still - wars, the application of negative interest rates simply means new capacity will not be formed, because financing for the associated risk of its creation does not get adequately compensated. The current overcapacity, however, remains until new money is put into the hands of those who can use its output. This new money may be called Helicopter Money. The response by private capital then triggers the chain reaction that will necessarily follow.

Private capital migrates into physical cash and the speculative short-term activities that this will finance. The appearance of Helicopter Money will then dilute the value of cash, just as negative interest rates have diluted the value of investing. Helicopter Money is an IOU based on the government's promise to repay the debt that is incurred to create it. Recipients of Helicopter Money will then be able to compete with private holders of cash, even though they have done nothing in return for receiving this money. The incentive to hold cash and participate in productive activities that lead to it as a reward then becomes corrupted.

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(Source: Bloomberg)

Shrewder analysts will observe that these government IOUs will never get repaid, and will then decamp from cash into hard assets. Morgan Stanley analysts will then be able to finish their parable with the story of the Weimar Republic and its experiment with Helicopter Money. What goes around comes around, if one repeats historical behavior rather than tries to do something new or different.

As the dust settled, after Janet Yellen's latest press conference, analysts revisited the transcript in search of actionable signals and greater context. The subject of Helicopter Money was found, along with Yellen's attitudes towards it. In her own words, it could be used "only in an unusual situation." Her definition of the word "unusual" therefore becomes key to understanding the events that will unfold since she first used it. It is easy to make the case for Brexit being such an "unusual situation" if the fallout is particularly painful for American capital markets, which then triggers an abrupt economic slowdown. In her post-announcement speech, Yellen drew specific attention to Brexit tempering the FOMC's enthusiasm for tightening. The conditions for Helicopter Money are, thus, closer than people think.

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Yellen then went on to make a meal of it, postponing her visit to the ECB's version of Jackson Hole in order to deal with the "unusual situation" presented by the Brexit vote. She will, however, be fully aware of what she missed when Mario Draghi spoke in her absence. Draghi called for the "aligning" of central bank policies to deal with the root causes of low growth and low inflation. This should be read as code for the FOMC ending its rate hiking process and joining in the easy monetary policies of the other global central banks. If Yellen fails to observe and respond with alacrity, Stanley Fischer can be relied upon to remind her of her aligned global responsibilities. Fischer's original influence on the thinking of Mario Draghi at MIT can now percolate through the global economy back to the FOMC.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.