This guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst. This piece does not necessarily reflect the opinion of Hedgeye.
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"I used ta do a little but a little wouldn't do Guns & Roses (1987)
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January 21, 2022 | As we enter the last week in January, it is becoming pretty clear that the FOMC has lost all credibility when it comes to financial markets or managing inflation.
Market stability, lest we forget, has been a managed concept since 2009, thus when the FOMC decided to explicitly lean in the direction of "liquidity" (aka inflation) and forget the rest of the Humphrey Hawkins mandate regarding price stability, the cost was paid in credibility. Of course there is a 1:1 correlation between the Fed's credibility and its loss of independence from the US Treasury, the primary beneficiary of QE.
Bill Nelson at Bank Policy Institute published an important article on January 11, 2022: “The Fed is Stuck on the Floor: Here’s How It Can Get Up.” Nelson describes how the FOMC under Jerome Powell deliberately chose inflation of the Fed’s balance sheet as a means of managing the liquidity stress that almost cratered the US money markets that year and in December 2018. He wrote:
“The Fed announced that it would conduct monetary policy by over-supplying liquidity to the financial system, driving short-term interest rates down to the rate that the Fed pays to sop the liquidity back up. Previously, the Fed had kept reserve balances (bank deposits at the Fed) just scarce enough that the overnight interest rate was determined by transactions between financial institutions; those transactions consisted of banks with extra liquidity lending to those that needed it. Now the rate is determined by transactions between banks and the Fed. Moreover, the Fed has committed to providing so much extra liquidity that it would not need to adjust the quantity of reserve balances it is supplying in response to transitory shocks to liquidity supply and demand.”
Now it goes without saying that the Humphrey-Hawkins mandate is impossibly conflicted, as we wrote in American Conservative. You cannot have price stability and full employment at the same time.
But when people like Chairman Powell and his predecessors, including Treasury Secretary Janet Yellen and former Fed Chairman Ben Bernanke, decide to play g-o-d with the global financial markets, bad things happen. The inflationist chorus of economists who decided that deflation was a “problem” essentially convinced the FOMC that a little inflation was a good thing.
Our friend Fred Hickey, publisher of The High Tech Strategist, reminds us of the words of Ludwig von Mises, who predicted the age of inflation in the US fifty years after the passage of Humphrey Hawkins:
“The incorrigible inflationists will cry out against alleged deflation and will advertise again their patent medicine, inflation, rebaptizing it re-deflation…. What generates the evil is the expansionist policy. Its termination only makes the evils visible. This termination must at any rate come sooner or later, and the later it comes, the more severe are the damages which the ultimate boom has caused.”
Hickey adds that the fact that global central bankers, led by celebrity politicians like ECB chief Christine Lagarde, figured out that if they all printed money at the same time, they could inflate their slumping economies without the nasty penalty of currency devaluation. “The end result of their collusion was that the boom lasted much longer than it would have normally,” Hickey wrote, “and now we’ll have to deal with more severe consequences.”
The great inflation of 2020-21 will be reckoned as one of the blackest periods in the history of the Federal Reserve System, but the intellectual and institutional rot goes back more than a decade to 2008, when many senior officials of the US central bank lost their nerve after watching the US financial system nearly melt down.
The central banker rule book written by the likes of Martin, McCabe and Volcker was tossed out the window of 33 Liberty Street, leaving only a culture of accommodation and endless liquidity that was cheered by liberal politicians.
The start of QE in 2009 under then- Fed Chairman Bernanke was the beginning of the end of the Fed’s credibility. Bernanke laid out the rationale for providing endless liquidity support in a 2009 speech at the Bank of England:
“The abrupt end of the credit boom has had widespread financial and economic ramifications. Financial institutions have seen their capital depleted by losses and writedowns and their balance sheets clogged by complex credit products and other illiquid assets of uncertain value. Rising credit risks and intense risk aversion have pushed credit spreads to unprecedented levels, and markets for securitized assets, except for mortgage securities with government guarantees, have shut down. Heightened systemic risks, falling asset values, and tightening credit have in turn taken a heavy toll on business and consumer confidence and precipitated a sharp slowing in global economic activity. The damage, in terms of lost output, lost jobs, and lost wealth, is already substantial.”
Rather than allow the private markets to reset after the mortgage bubble of the 2000s, Bernanke and his colleagues on the FOMC embraced inflation. Readers of The Institutional Risk Analyst know that the problem with QE and the other liquidity measures put in place by the FOMC is that they cannot be stopped without severe deflationary consequences.
If the Fed stops buying securities for the system open market account (SOMA), then reserves start to fall and with it the aggregate level of bank deposits. As reserves fall and banks are forced to buy Treasury debt and GNMA MBS for their reserves, interest rates fall and collateral becomes scarce. Imagine what happens to short-term interest rates, for example, if the $1.6 trillion in reverse repurchase transactions moves back into Treasury and agency securities. The chart below shows the S&P 500 and the Fed's portfolio.
Nelson notes that any program by the FOMC to now shrink its balance sheet must be accompanied by more robust open-market operations to deal with any “transitory” liquidity pressures.
But now that the global equity markets have grown accustomed to trillions of dollars in excess liquidity, going back to the pre-2019 system of fine tuning is likely to be a rough ride. Nelson concludes:
“The Fed is on track to stop expanding its holdings of securities by March 2022, and it is currently making plans for whether and how to reinvest payments of principal. If the Fed allows principal to be repaid without reinvestment, its securities portfolio will decline, reducing reserve balances and the ON RRP. Most likely, the Fed will reinvest payments of principal for a while before beginning to shrink. If it were to reinvest in Treasury bills rather than longer-term securities, it would be able to shrink more quickly once it decides to do so. Consequently, now is a critical time for the Fed to receive input from policymakers outside the Fed and from the public about how it should conduct monetary policy and its role in society.”
Chairman Powell is already receiving a lot of “input” about the future course of US monetary policy. As the FOMC desperately attempts to regain lost credibility, the US financial markets could be in for an extended period of volatility and confusion.
As the central bank redefines what is meant by price stability, asset classes from MEME stocks to crypto tokens to Treasury securities will all come under selling pressure. And appointed officials like Yellen, Bernanke and Powell may not survive the adjustment process, at least in political terms.
There is, after all, nothing new in this world when it comes to inflation.
ABOUT CHRISTOPHER WHALEN
Christopher Whalen is the author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. Currently, he serves as the editor of The Institutional Risk Analyst.
