The Fed Is In The (Wrong) Zone

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by: Adam Whitehead
Summary

Powell Doctrine II is all talk and no substance.

Fed “patience” is a symptom of (slow) procedure, not a policy change.

The probability of a radical change in monetary policy coming from the current framework review is very low.

The probability of a radical change in monetary policy coming from the deteriorating economic environment is very high.

In trying to debunk “QT” James Bullard has inadvertently called the top in U.S. interest rates and the bottom in the size of the Fed’s balance sheet.

(Source: Eric Dodds)

“Patience” is the Fed’s not-so new Comfort Zone. The economic environment is however in the Discomfort Zone, currently heading towards the Alarm Zone. It’s a steep learning curve, even for those at the Fed who are ahead of the forward curve. For a chairman with a cognitive bias against academia, the learning curve is exponential.

Chairman Powell is undergoing a painful reeducation process. This process is taking him away from uninformed cynicism and toward a phony embrace of academia in economic thinking. His inert cognitive biases and traditional caution are viewed by many as consistent with the Fed’s policy of “patience”. The risk is that either his education takes too long to yield timely and tangible policy changes, or that he abandons it at the first sign of growth and inflation and starts tightening monetary policy again.

Powell Doctrine II, which thinks globally and currently acts patiently, was introduced in the last report. The process of public education and indoctrination is now underway. The Fed’s new guidance sub-committee, chaired by Vice Chair Clarida and globally driven by Dallas Fed president Robert Kaplan, is clearly running this process.

(Source: Author)

Kaplan was originally noted introducing the Fed’s global pivot to Chairman Powell. Through the Dallas Fed’s Global Perspectives initiative he is now broadcasting to the masses. The latest broadcast informs that the Fed thinking globally is consistent with the dual mandate; and is also a “net positive” for the global economy.

(Source: Author)

The observer is supposed to conflate the Fed’s dual mandate with the global economy going forward. That way, when it is time for the Fed to come to the global rescue again, the ground and the precedent have been prepared already.

Chairman Powell broadcast his message in preparation for Powell Doctrine II to the American people via CBS’ “60 Minutes”. His message frames Powell Doctrine II in the parameters of interest rates being “roughly neutral” and the US economy facing global risks. This translates into the settings of Powell Doctrine II based on the policy stance of interest rate hikes on hold and balance sheet run-off ending later this year.

(Source: Federal Reserve Board of Governors)

After his recent “60 Minutes” gig for the American people, Chairman Powell took his message on Powell Doctrine II to the economists in their ivory towers at Stanford. The message is that the normalization is in its “later stages”.

(Source: Federal Reserve Board of Governors)

Said “later stages” have now reached the point for the setting of the normal size for the Fed’s balance sheet. This will be driven by demand for Fed liabilities (Reserves) from the banks. Powell expects that the Reserve balance, forecast by the Fed, at 5.7% of GDP in Q4/2019 is there or thereabouts ceteris paribus. The Fed’s balance sheet of assets will then match this liability. On the subject of the hated “dot plots”, in the absence of better signals, we will all just have to wear them and take them with a big pinch of salt.

(Source: Federal Reserve Board of Governors)

Beyond the normalization, Chairman Powell remains primarily concerned that he is following his dual mandate to the best of his abilities. By his own admission, he sets a “high bar” to changing the framework of monetary policy. Having raised expectations for something radical, to come out of his review of the monetary policy making framework, he has just signaled that this is highly unlikely. He is thus remaining an inert one, the term used in the last report. His innate hostility towards academics and newfangled policies to raise inflation remains strongly ingrained. His “high bar” represents his large innate cognitive biases.

(Source: Author)

Powell Doctrine II is therefore not much different from Powell Doctrine I. The last report characterized Powell Doctrine II as “Faux Populism”. Even this is looking like an overstatement, based on Chairman Powell’s latest outline of his cognitive biases.

Furthermore, the “patience” hardwired into Powell Doctrine II is a procedural step to avoid taking action until the Fed’s lengthy consultation and discussion process, about what should finally constitute monetary policy making, has been concluded. Fed “patience” is therefore a procedural step and not a policy change. Powell Doctrine II remains Powell Doctrine I for the immediate future, because the process is lengthy and there is a high bar” at the end of it.

The Fed’s “patience”, combined with Powell’s “high bar”, therefore raises the probability that the central bank is forced to change policy by the speed and magnitude of deteriorating economic conditions. Change at the Fed never comes from within; it is always forced by external conditions.

Simon Potter of the Fed’s plunge protection team, charged with balance sheet management, also sounded further cautionary tones for “patience” in general. Talking specifically about the Fed’s purported sales of mortgage backed securities (MBS), he attempted to frame the debate about the merits of retaining this asset on balance sheet. For him, it is a debate about the benefits (or removal thereof) of the credit stimulus that these bonds create versus the cost/benefit of said adjustments to the taxpayers.

The so-called monetary-policy framework review that is allegedly at the core of expected changes to monetary policy is thus all very underwhelming and typical Powell. It is taking a huge gamble on the state of the global economy that is just pottering along in the meantime. In that respect, Chairman Powell is a huge gambler and not the cautious incremental reformer that he purports to be. It’s not the kind of gambling that forward-looking central bankers should be doing, though. Hiding behind the dual mandate will only serve as long as things remain the same. If things change, the academics and Mr Market will waste little time in shredding Powell Doctrine II. President Trump may not even wait that long.

(Source: Fed Board of Governors)

Fed Governor Lael Brainard administered a “softer” touch to the Powell Doctrine II indoctrination process. She did this by choosing to focus her guidance on the equal and opposing domestic and global forces that are sustaining domestic growth whilst impeding inflation. Resolving these forces comes out with the same policy solution of pausing rate hikes and ending balance sheet run-off later this year.

(Source: Author)

The last report suggested that Powell Doctrine II will be DOA unless the Fed swiftly ends its balance sheet run-off. As explained above, by the analysis of Chairman Powell’s recent expose, it will be dead even sooner if the US economy and inflation drift lower from here before it arrives.

(Source: Econoday)

It would seem that the Fed shares these sentiments, since the latest report on its balance sheet activity shows both the balance sheet and Reserve levels rising for the first time in ages. Even though run-off is scheduled to be tapered in May and ended in September, perhaps this timetable has been brought forward.

The current debate, over what size the balance sheet will ultimately be, has now begun to frame the ending of run-off. Size obviously matters, but the simple timing of the end of run-off may be just as important. The process, of debating and finally agreeing upon the size of the balance sheet, also risks exposing another flaw within the Fed’s current monetary policy stance.

(Source: St Louis Fed)

Whilst trying to debunk Quantitative Tightening, St Louis Fed president James Bullard may have inadvertently exposed this flaw. His recent article is supposed to prove that balance sheet size does not matter under certain circumstances. He makes the case that the size of the balance sheet is a very important signalling tool for unconventional monetary policy at the zero bound. This signal can be translated as the credible commitment to keep rates “lower for longer”.

When interest rates rise above the zero bound into positive territory this signal becomes weaker. Since it is weaker, Bullard believes that there is no reason to keep an expanded balance sheet at this point. As interest rates are now positive and higher, he concludes that the size of the balance sheet does not matter; and hence it can continue to run-off. He however qualifies this, with the disclaimer that this is only the case if there is an ample volume of Reserves in the banking system. He avoids quantifying what this level of Reserves is. He also does not balance the Fed’s balance sheet by accepting that an ample level of Reserves must be matched by an ample level of assets.

In addition to this accounting trickery, Bullard has simply exposed the fact that the new neutral rate has in fact already decided that the Fed’s balance sheet can’t shrink any further. If the reader (and Bullard) accept that we have arrived at the neutral rate, then the fed funds rate can’t go any higher by default. The lack of substantial conventional interest rate cushion, derived from reaching the neutral rate, thus means that the balance sheet (“lower for longer” signal) will have to kick in much sooner in a slowdown.

Since as Bullard says the “lower for longer” signal only works at the zero bound, this also implies that interest rates will have to be cut much sooner in a slowdown. The sooner they are cut then the sooner the “lower for longer” signal kicks back in at the zero bound.

Not only has Bullard undone his case for balance sheet run-off continuation. He has also made the case for the peak in fed funds and the conflated low point in the new shrunken balance sheet. Continuing to shrink the balance sheet at this point is therefore dangerous under the current global and domestic economic circumstances. Bullard has therefore just called the top in fed funds and the low-point in balance sheet size in this economic cycle.

Balance sheet run-off, following Bullard’s thesis, can only continue in a situation in which economic growth is both strong and running much faster ahead of inflation. In fairness to Bullard and the Fed, Powell Doctrine II is aimed at creating such conditions. Continuing with balance sheet run-off, before the expected strength in growth occurs, is however very premature at best and counterproductive at worst. Since growth is currently slowing, it is now strongly trending towards the counter-productive worst case scenario.

Bullard’s cooking of the balance sheet seems strangely coincident with rumors circulating of a new Fed policy tool. This tool is aimed at controlling the fed funds rate, which the Fed is currently finding it hard to stop from rising. The fact that it is rising should not be surprising as balance sheet run-off continues. As Bullard noted, this run-off totally removes the “lower for longer signal”. With interest rates already positive, this automatic run-off is in fact symmetrically making them float higher as there is no heavy handed Fed to put a cap on them. Balance sheet run-off therefore is clearly a tightening of monetary policy by default. This balance sheet run-off tightening, in addition to conventional interest rate hikes, has been going on for nearly three years now.

(Source: Author)

To arrest this rise in the fed funds rate the Fed is considering forcing the banks to convert some of their Treasury holdings to Reserves that pay interest. The Interest on Reserves thus allows the Fed to control the fed funds rate more directly. As Bullard’s missing balance sheet math shows, a rise in Reserves is a rise in liabilities for the Fed especially if these Reserves will pay interest. The Fed must therefore increase its assets in order to match its increased liabilities. Thus the Fed buys the Treasuries that the banks are converting to Reserves. When the Fed buys Treasuries, this is an easing of monetary policy. Balance sheet run-off will thus become balance sheet expansion and hence QE by default. Interest rates may not be at the zero bound, but the balance sheet is now acting as a mechanism to control them at the new neutral rate.

At this point, one can conclude unequivocally that the balance sheet has become a conventional monetary policy tool in conjunction with management of the fed funds rate at the neutral rate. Ironically, Bullard has been noted already as suggesting that the balance sheet is a conventional monetary policy tool enabler. His recent digression into saying that it is only effective at the zero bound is pure disinformation. It is now being used at the neutral rate.

Further evidence that the Fed is going to tinker with Reserves and its balance sheet came from the central bank’s recent macro-stability move or rather lack thereof. Given the experience of 2008, one would expect the Fed to be asking banks to be raising their risk capital buffers during this extended period of economic growth. The Fed on the other hand is keeping its macro-stability buffer requirement the same.

Perhaps the Fed wants to encourage the banks to lend, by making it cheap in terms of capital cost to do so. If the Fed were considering asking for more Reserves from the banks, this would be the same thing as improving their risk position. Furthermore, as the Fed intends to pay interest on said reserves, the banks will now get paid to improve their capital positions.

A stronger capital position should encourage the banks to lend. If the Fed nudges interest rates higher, with its greater control of the fed funds rate through control of Interest on Reserves, then the banks will have a further incentive to lend. By default therefore, the Fed intends to pay the banks to lend with Interest on Reserves. The risk is however that this backfires and the banks just sit back and earn interest on risk-free Reserves rather than lend to riskier borrowers. The way that the global economy is slowing down right now, there is a very high probability that this is exactly what they will do.

For banks it’s all about risk-adjusted return. Since interest rates are still historically low, lending to the Fed through Reserves still may be the most attractive opportunity. If the banks feel that higher interest rates will slow the economy down, then they will definitely cut commercial lending at the expense of building Reserves at the Fed. The recent initiative by the Financial Stability Board (FSB) - which is chaired by Fed Governor Randal Quarles - to “investigate” the leveraged loan market will certainly have done nothing to encourage the bankers to lend.

This move by the Fed seems rather counterintuitive in a situation in which the Fed would like the banks to do some heavy lifting at the lower end of credit spectrum. If it is going to be used as a pretext for forcing the banks to raise Reserves, then it has some merit. But it comes at great cost to the US economy in the form of loans that will not be made. Otherwise it’s a case of muddled logic and poor execution that hasn’t really been thought through. If it’s the latter, then credit creation will suffer.

(Source: FOMC)

Consistent with its guidance since the last FOMC meeting, the FOMC left rates unchanged and lowered its growth forecasts at the latest meeting. On the face of it, the announcement was significantly more Dovish than the verbal guidance at the last meeting to date.

(Source: FOMC)

Balance sheet run-off will be tapered in May and will end in September. The on balance sheet mortgage backed securities (MBS) will be converted to US Treasury bonds, as their coupons and principle redemptions get reinvested, but no outright sale of these securities will occur. The Fed is thus blowing a further headwind into the already weakening housing market. The Fed however also foresees a significant degree of Reserves remaining in place, which implies a significantly large balance sheet for the immediate future.

(Source: FOMC)

The accompanying forecasts left inflation there or thereabouts unchanged. The main surprise was in the rise of unemployment envisaged. Since interest rates are expected to remain lower over this period than initially expected at the last forecast, this can only mean that the Fed is anticipating a significant economic slowdown between now and 2021. Given that the labor market is tight, this slowdown is meaningful.

The latest policy move has certainly elevated the probability (and hence risk to the real economy) that the banks now pull back their lending horns in view of the lower growth prospects and will live off the fat of the land of the interest on Reserves. The sell-off in stocks (especially the banks) and curve-flattening rally in bonds, post-announcement, suggests that Mr Market is busily discounting this negative outcome. The outcome of Mr Market’s discounting will then become the self-fulfilling prophecy of the headwind that the FOMC will then have to address with even looser monetary policy.

The next debate in the public domain will thus be over whether this extended period of slow growth, and Lowflation is a new normal or something worse than that.

(Source: Bloomberg)

The popular press is lauding the recent change in Fed policy as a “Revenge of the Doves”. Strictly speaking it’s a revenge of the academics.

(Source: Author)

First blood was drawn by Neel Kashkari, as noted in a previous report. Back then, of Kashkari’s attack on the Chairman, it was said that:

This kind of urbane sarcasm is inflammatory trash talking. It is also the closest thing that the Fed will get to in terms of insubordination, insurrection and possibly sedition. Kashkari has crossed a red line. Presumably, he has not done this lightly, without a thought to the consequences of his action. It is a warning to Powell, to become more collegiate and less dictatorial. It may also be a warning to him that this inert style-drift into the realms of Constitutional Law is not something that the Fed entertains lightly.

The incoming data and global headlines have caused a desertion from the ranks that had been supporting the avowedly un-academic Chairman Powell. He now finds himself fighting on two fronts. One is with the president and the second is with some of his own team. His own team may soon comprise a staunch Trump ally Stephen Moore. Would-be Fed Governor Moore signaled his clear intentions and capabilities if confirmed by opining that, in his view, the last fateful December rate hike was a “very substantial mistake”. The academics at the Fed must be rolling their eyes at the prospect of the un-academic Moore and Chairman Powell locking horns at FOMC meetings to come. It’s hardly an auspicious moment to be rolling out a policy framework review.

Appositely, post-FOMC meeting, Kashkari was first-up to frame perceptions of the decision and the ensuing reaction by Mr Market. Kashkari’s frame of reference is that the neutral rate is here or hereabouts. As all good academic Fed presidents and governors do, he is now assessing whether the recent soft data is “real or just a blip”. The chairman’s deserting colleagues will no doubt do the same and opine their guidance in due course.

(Source: Atlanta Fed)

Atlanta Fed president Raphael Bostic does not appear to have taken heed of Kashkari’s suggestion. Bostic recently chose to focus on the issue of the Fed’s balance sheet. Previously he was all for pausing the interest rate rising process, yet continuing the balance sheet run-off on auto pilot. Now, suddenly he wishes to advertise that the balance sheet will never go back to pre-crisis levels. Allegedly this large balance sheet has nothing to do with the large requirement for Reserves in the banking system.

According to Bostic, the Fed’s Reserve liabilities apparently have nothing to do with its balance sheet assets which are supposed to balance them out. To prevent Mr Market getting carried away with a risk-on rally, Bostic then warns that the Fed can still hike (or cut) interest rates even with an expanded balance sheet. Achieving the optimal level of the fed funds “floor”, which all asset prices are spread-off, is now his primary focus.

Bostic also contradicts Bullard by alleging that there is no difference in the effectiveness of the transmission mechanism with either a large of small Fed balance sheet. Bullard’s previous thesis about the efficacy of the enlarged balance sheet at the zero bound is thus shredded once again.

Mr Market immediately made a fool of Bostic by raising the rate of interest at which banks clear excess Reserve lending to each other above his “floor” fed funds rate. Having tried to imply future interest rate increases, all things on the balance sheet ceteris paribus, Bostic must now accept that the next move in the fed funds rate should be lower. Since the balance sheet run-off currently does not end until September, this situation calling for rate cuts will only get stronger in the meantime.

Mr Market has thus tightened monetary policy further, thereby making Bostic’s assertions about the effectiveness of the transmission effect being balance sheet independent a fictitious statement. The fiction is that the Fed, and not the balance sheet, is in control of interest rates. The true observation is that the Fed has in fact lost control of interest rates.

No wonder therefore that the aforementioned rumors of a new policy tool to cap interest rates have been circulating of late. These rumors only serve further to substantiate the conclusion that the Fed has indeed lost control of the fed funds rate, because it is tightening too aggressively with both interest rates and balance sheet run-off. No wonder therefore also that James Bullard has inadvertently called the top in interest rates and the bottom in the size of the Fed’s balance sheet simultaneously.

It is becoming clear that not only does the Fed chairman not see eye to eye with his academics, but neither do these individuals do not see eye to eye with each other. The consensus to be “patient” has previously mitigated the lack of common and mutual understanding. In an environment where things change swiftly this “patience” will be exposed as flawed.

(Source: Author)

Despite all the fanfare about a policy framework review, Chairman Powell does not buy in to the newfangled thinking of the academics. The time it will take for him to accept any of it will be lengthy and painful for the US and global economy. A hawk cannot change its claws, feathers and beak. The probability of a regime change of the more personal/personnel type contemplated in the previous report is rising. Patiently reiterating Powell Doctrine with new serial numbers and incremental changes may now be sub-optimal in terms of policy making. The faster and greater the economic environment changes, the more sub-optimal “patience” becomes.

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.