He is the most dangerous man in the world. It’s not necessarily that he means to be. In fact, I think he actually means quite well. Instead, the fact that he is so dangerous simply comes with the position. So much absolute power. So little oversight and accountability. So many cheer him when times are good. So many turn their desperate eyes to him when times get tough. Mild mannered and careful with his words, but decisive and dangerous with his actions. Who is this most dangerous man in the world? Why none other than the chairman of the Federal Reserve.
Why so dangerous?
Who else in this world can conjure up nearly $4 trillion of global reserve currency almost like magic and inject it into the financial system?
Who among us can freely deviate from our stated job responsibilities and assume entirely new mandates such as supporting risk asset prices in the spirit of sustaining global financial stability?
Who else can effectively make even the most systemically reckless corporations among us effectively immortal by all but preventing their failure with a stroke of a policy pen?
Who among us can continue to boldly explore previously unchartered solutions to problems whose implications effect each and every individual across the planet?
Who else can shrug their shoulders in wonderment about the “mystery” of why their bold actions are not achieving their intended objectives for more than a decade, yet is still able to act freely to simply double down on these same actions again and again and again and again . . . ?
Who among us can be primarily responsible for serving as the catalyst for two (and likely now three) major asset bubbles that have nearly sent the global financial system careening off a cliff, yet is then hailed as the savior upon acting to rescue the world from the same problems for which it was the root cause?
And who among us can do all of these things while being held accountable by seemingly nobody (other than the President of the United States, but they are even limited in how much they can hold the Fed to account at the end of the day)?
More than the elected leader of any country, more than any autocrat, more than any other major global central banker with comparable policy freedoms, the chairman of the Federal Reserve is the most dangerous man in the world. He can go from heading to bed one chilly December night with plans to raise interest rates three times in the year ahead while draining $600 billion from the global financial system to waking up the next morning with thoughts over his cornflakes about cutting interest rates as many as three to four times and bringing the liquidity drain on the financial system to a complete stop. And he doesn’t even need a widely accepted reason other than feeling froggy enough to make such an extraordinary policy leap.
To describe this person as dangerous is an understatement. Yet here we are for another day.
A decade of danger. The Fed spent the better part of five years from 2009 to 2013 fanning the flames of the next major global financial bubble. They did so under the leadership of arguably an even more dangerous man given his extraordinary and relentless policy actions that eventually spread to major central banks around the globe.
The Fed then spent the next five years from 2014 to 2018 slowly and carefully working to extract themselves from these extraordinary policies that 1) did not work in generating sustained economic growth and inflation and 2) encouraged even more bad global financial actors to reengage the same wildly reckless speculation that already got us into so much trouble twice before. Both of these left the Fed trapped in a tight corner with little flexibility in finding its way out.
In the process, the Fed did manage to get nine quarter point rate increases totaling 2.25 percentage points. They also managed to shave roughly $700 billion from its bloated balance sheet. A good start, but not enough for a monetary policy body in the FOMC that has cut interest rates by an average of 6.875% over the course of the last nine recessions. And the balance sheet is still more than four times bigger than it was before the crisis to boot.
Clear and present dangers. All of this brings us to 2019. Once again, the Fed was planning three rate hikes and trimming its balance sheet by another $600 billion this year back in December. But no sooner did the calendar flip to 2019, and this plan was entirely out the window. And now in the last two days we had first the President of the St. Louis Fed and then the most dangerous man in the world himself out on the speaking circuit openly musing about cutting interest rates.
So what changed so much that it would cause such a dramatic shift in the most important policymaking body in the world, the one filled with academics that are supposedly free from political influence and whose decision making is supposedly done with care, deliberation, and precision? From three rate hikes to up to four rate cuts in just a few months? The economic data must simply be coming apart, right?
Let’s take a look. Quick review. The Fed’s mandate is to promote full employment and price stability. Got it.
Let’s start with full employment. We’ve got the May employment report coming on Friday, so maybe the really nasty numbers are soon to come. But the April employment report gave us an unemployment rate of 3.6%. Not only is this not a high unemployment rate, but it is the lowest unemployment rate in fifty years. For the last time the unemployment rate was below 3.6% was back in 1969 when Nixon occupied the White House, we just landed folks on the Moon, and people were still cleaning up the fields from the first Woodstock.
Put simply, employment is about as full as it can get right now. If employment was a character in a Monty Python movie, it would be Mr. Creosote. And one has to search with a microscope to find any measurable uptick in the unemployment rate since December that justified the Fed completely abandoning its monetary tightening post.
OK. Let’s move on to price stability. The Fed’s goal is 2% inflation. They haven’t been able to get back to 2% and hold it for a decade and counting. Fingers crossed for year 11, right? But to justify what may amount to potentially more than a 3-percentage-point swing in the intended direction of interest rates over the course of 2019, we must be seeing pricing simply falling out of bed.
Yes, inflation has backed off its 2% target since the start of the year, but what else is new? We saw the same thing back in 2017 to an even greater extent, but the Fed maintained their intestinal fortitude to stay the course with tightening monetary policy. And when looking at the chart above, prices look fairly stable for the last eight years and counting. Maybe the Fed should set their new inflation target at 1.6% and things might be a bit less “mysterious”.
Employment is full. Prices are stable. Yet the Fed has completely flipped itself upside down. What else could justify such a dramatic policy reversal back in December and continuing through today?
Economic growth? The 2019 Q1 GDP growth number came in strong at 3.1% per the latest estimate. If the Fed was looking out with such trepidation in December on how the U.S. economy was going to hold up in the first half of 2019, such concerns have proven unfounded at least so far.
Corporate earnings? Heading into 2019 Q1, quarterly corporate GAAP earnings were set to grow by a modest but still positive 3.19%. Not great, but not weak enough to completely ditch your monetary policy tightening program seemingly overnight. How did 2019 Q1 earnings turn out? Growth nearly doubled expectations at 6.27%. I’m the first to trash the “beat earnings expectation” charade Wall Street puts on each quarter, but 2019 Q1 is an instance where companies legitimately beat expectations, and by a solid margin to boot.
Real personal income growth? This continues to rise at a healthy clip. Not it.
Retail sales? The data has been a little soft lately, but the overall trend remains higher.
Manufacturing activity? We have seen some weakening here, but given the global trade war gunslinging that’s been going on over the past year, it’s arguably more notable that manufacturing activity remains in a net expansion.
Leading Economic Indicators? The Fed, of course, is forward looking. And while they wait until the aftermath to clean up the mess when things run too hot, they love to act well in advance in response to any inkling of potential weakening at some point down the road. Heaven forbid we ever allow the economy to recede and work off some of its excesses and malinvestment. Nonetheless, the LEI from the Conference Board is back to steadily rising after leveling out in the second half of 2018.
Bank lending activity? Banks are still increasing lending on net.
Corporate bond spreads? Sure they’ve widened a bit lately, but this is widening from historically tight levels. And the recent widening is merely a blip on the radar screen versus the stress that we have seen during past episodes.
Maybe the Fed knows something that the rest of us don’t know? Sorry, but I stopped buying that narrative years ago. Enough evidence has been demonstrated to show that the Fed is largely playing in the same sandbox as the rest of us from a data and information standpoint.
So what was it then? What is it? What caused this supposedly cool as a cucumber and measured governing body that is charged with guiding the world’s reserve currency to go from three hikes and a $600 billion balance sheet trim to talking about rate cuts and phasing out the balance sheet haircut?
To answer this question, I introduce the following exhibit, which unfortunately over the past decade has effectively become the data tool more than anything else that guides the Fed’s policy actions.
We have seen it time and time again in the post crisis period. The S&P 500 Index falls at any point in time between -5% and -12%, and the Fed completely freaks out and throws in the towel on any tightening of monetary policy. Up until December 2018, the most dangerous man in the world was resolute in raising interest rates with a balance sheet reduction program on autopilot. But then the markets threw a fit, and suddenly rate hikes became rate cuts and autopilot turned into an emergency shut off switch.
Relying on the stock market for guidance on how to set monetary policy is likely allowing a petulant five-year-old child to dictate the household rules on discipline. It simply doesn’t work. Moreover, you’ve got an even bigger mess on your hands when that five-year-old eventually grows into a 17-year-old storming out of the house with the car keys. Unfortunately, our overvalued stock market is getting older by the day. Should be interesting to see how this one plays out for Papa Fed and the rest of us once the excrement hits the fan.
Looking forward. We may very well see the U.S. economy falling toward recession by the end of 2019 or 2020. Then again, we may not. But the Fed only has so much firepower to fight the next recessionary fires, and it’s a lot less than what they’ve had stowed away in the past. It is squandering these accumulated monetary policy resources preemptively during what is still the expansionary phase of arguably the longest period of sustained economic growth in history. That is even more misguided than enacting a massive deficit ballooning fiscal policy tax cut during a similar phase of the economic cycle, where the benefiting corporations have a greater incentive to simply transfer the lion’s share of the benefit back to their shareholders instead of using the additional capital to shore up the balance sheet or engage in new fixed investment.
I may strongly disagree with it, but I can sympathize with the Fed’s thinking on not raising interest rates any further in 2019, as one can see the same economic storm clouds on the horizon that have been looming there for so long. I cannot say the same for pulling the plug on the balance sheet reduction program, however. More significantly, the mere notion that the Fed might start lowering interest rates once again given where we are currently in the economic cycle is dangerous in many ways.
It is dangerous for the scarce monetary policy resources likely being squandered ahead of the next economic recession.
It is dangerous for the potential further inflation of asset prices beyond their already unsustainable levels.
It is dangerous for the fact that it further encourages unproductive behaviors from other policy makers as well as the markets. To this point, it is not the Fed’s job to make up for any lack of fiscal policy support over the years. It’s not the Fed’s job to try to offset an escalating trade war that could eventually come to an end. And corporations already have taken on more than enough debt and do not need to be encouraged to take on even more, particularly when it’s largely being used to buy back shares and pay out dividends.
It is dangerous because these latest changes in monetary policy are taking place seemingly at the direction of a stock market that is inherently unstable in its own right.
And it is dangerous because these important decisions are being carried out by one man and his committee who are essentially free to make such dramatic shifts at their own discretion. It’s good they have this flexibility when they need it, but now is not one of those times.
The bottom line. Stocks may love the latest short-term sugar high that potentially will come with another round of interest rate cuts. So stay long stocks as we have all along as the music continues to play. Be prepared by emphasizing low volatility and defensive allocations to continue participating in remaining upside while protecting against potential downside. And know that some day the music will finally stop. Lastly and most importantly, make sure to plan and position your portfolio today so that it is as ready as possible in advance to weather the danger that will follow.
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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.
Additional disclosure: I am long selected stocks as part of a broadly diversified asset allocation strategy.