February 21, 2018
NOTE TO THE NEW FED CHIEF: EMBRACE PAIN
Please read important disclosures HERE.
February 21, 2018
Please read important disclosures HERE.
SPECIAL SECTION: This is a new section of Perspectives intended to encourage a discussion and dialogue. A previous version of the following article appeared as an OpEd in the December 18, 2017 issue of the San Francisco Chronicle and is available to read here.
Jerome “Jay” Powell, the newly elected chair of the U.S. Federal Reserve (Fed), seems to have inherited a fairly sunny economic outlook from his predecessor. Markets had been on a steady climb (at least until early February’s decline), unemployment is down, the economy continues to grow steadily, and investors have been happy. Perhaps too happy. Because, where some see sunshine, others see clouds on the horizon.
Just as stock prices have soared in recent months, so has investor complacency. The main cause: too much central bank interference. Risk has not been allowed to play its proper role in helping markets or the economy to function normally. The financial markets seem to be experiencing their own “opioid crisis.” Investors have become addicted to the Fed’s painkillers—monetary accommodation at unprecedented levels. And unless it’s corrected far more quickly than the Fed indicated at its September 20 meeting, we could be setting ourselves up for episodes even more painful than the financial meltdown of 2008.
The Fed said that for the fourth quarter of 2017, it will begin unwinding $10 billion in Treasurys and mortgage bonds from its balance sheet every month. The quarterly amount will rise until a year later, when up to $50 billion will expire.
We believe those expirations need to be greatly speeded up.
Interference in the markets by our leaders is nothing new. But as with any addiction, the impulse to avert near-term pain has too often led to longer-term suffering. In 1998, the Fed orchestrated the “orderly liquidation” of hedge fund management firm Long-Term Capital Management (LTCM) to stave off its likely bankruptcy. In later testimony to Congress, then Fed Chair Alan Greenspan dismissed the notion of any entity being “too big to fail,” focusing instead on the narrower perceived problem of “too big to liquidate quickly.” It was the start of a slippery slope into greater intervention and experimentation.
Just two years later, the overheated tech stock bubble burst. The U.S. economy faltered, ultimately stumbling into a recession between March and November 2001. Negative investor sentiment was exacerbated by the attacks of 9/11. In an attempt to stimulate the economy, the Fed moved aggressively to bring down the federal funds rate (FFR), from over 6% in early 2000 to 1% in 2004 — a level not seen since the 1950s.
The resulting recession was relatively mild, lasting just eight months. U.S. gross domestic product shrank by less than 0.5%. But the policy response and its aftermath were dramatic and long-lasting. As liquidity flooded the market and borrowing costs declined, investors and consumers went on a buying binge. Real estate prices took off like crazy. We all recall what happened next: an explosive asset bubble in housing prices and the ultimate reckoning known as the 2008-2009 financial crisis.
In response, the Fed initiated yet another huge shift in the FFR, dropping it from 5.25% in 2007 to an unprecedented 0% by the fall of 2009, a policy that remained in place until December 2015. The Fed’s balance sheet soared from around $800 billion in 2008 to about $4.5 trillion (as of December 2017).
The seemingly successful resolutions of such crises as LTCM engendered investor confidence that regulatory and congressional action could provide better control over markets, preventing adverse outcomes and even smoothing normal economic cycles. This abiding faith in the benefits of intervention led to the bailout of banks that made bad loans, changes in bankruptcy codes to slow foreclosures and constrain lenders, and the bailout of General Motors. One could argue this intervention has produced a dangerous level of hubris on the part of public officials and an equally disastrous “heads I win, tails you lose” mentality in the private sector, now insulated from the consequences of poor capital allocation decisions.
Who’s paying the price for all this intervention? You are. For seven years savers earned near-zero percent on bank deposits. It’s only been since December 2015 that the Fed has slowly started raising interest rates, which as of December 2017 the FFR is 1.50%. Insurance companies, which traditionally rely on bond-heavy investments to meet future obligations to policyholders, have been squeezed as the Fed drove down interest rates. Pension plans have felt the effects too, as low interest rates cause them to be chronically underfunded. According to a January 2017 Willis Towers Watson report, pension plans at 410 of the Fortune 1000 companies were underfunded by an estimated $325 billion at the end of 2016, holding an average of just $80 for every $100 of promised benefits to pensioners — a shortfall of 20% of your money.
This commentary is not to decry intervention categorically. Judiciously applied, measures to protect citizens from systemic risks are vital to general safety and encourage a well-functioning economy and society. We believe the Fed was absolutely correct to step in strongly in 2008 to ensure liquidity and keep the financial system afloat. By the end of 2012, however, it seemed clear that the economy was strong enough to function satisfactorily without the persistent application of the Fed’s policy medicine. Yet the Fed keeps on prescribing it and is only now in the early phases of reducing the dosage.
Our new Fed chair is said to be a pragmatist who is likely to “stay the course” if the economy keeps growing. As he considers future policy, however, we believe he should call for three changes: 1) Be more discerning before interfering, and when doing so, limit both the dosage and duration; 2) Let bankruptcy be a normal byproduct of the business cycle, playing its cleansing role to keep the banking and financial system in check; and 3) Unwind the Fed’s own balance sheet more quickly (at the current rate, it would take at least 6 1/2 years to reduce it to its pre-2008 level). Such moves may prevent future financial sector addictions, bring risk back into balance with rewards in capital markets, and shorten the duration of withdrawal symptoms for investors.
We must ask ourselves if we haven’t miscalculated the potential costs and overestimated the benefits of our interference — and that, in fact, some amount of pain today may well head off a greater amount of suffering tomorrow. To paraphrase Gordon Gekko, Michael Douglas’ character in the 1987 movie Wall Street: Sometimes pain is good. Pain works.