This special guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst. Click link to watch the recent "Real Conversation" interview between Whalen and Hedgeye CEO Keith McCullough.
"[F]rom early spring throughout 2009 and until mid-year 2010, the Fed engaged in the first major quantitative easing program of purchases of government agency debt and agency-guaranteed mortgage-backed securities. The Fed’s purchases reached a cumulative total of $1.285 trillion, and excess reserves reached nearly $1 trillion. Essentially, the new reserves provided by the purchases program enabled the banking system to fund the repayment of about $1 trillion of various forms of advances to financial institutions under the [Fed’s] emergency lending program. The emergency lending program ended, but quantitative easing replaced it."
Walker F. Todd
"The Problem of Excess Reserves, Then and Now"
American Institute for Economic Research
May 2013
Press reports indicate that the Trump Administration finally has decided upon at least two new appointees for new Federal Reserve Board governors. President Trump is expected to nominate investment banker Randal Quarles and economist Marvin Goodfriend to two of three vacancies at the central bank.
Despite the media attention to these new appointments, Wall Street does not yet seem to appreciate how the eventual selection of three new Republican governors could change the policies and personal chemistry at the central bank. At a minimum, the arrival of two and eventually three GOP appointees on the Fed board may have a significant impact on how Fed policies impact the credit markets.
Since the appointment of Janet Yellen in February 2014 for a four-year term ending February 2018, the Federal Open Market Committee has followed a predictably neo-Keynesian path, at least in rhetorical terms. The Fed’s use of “quantitative easing” or QE was an attempt to synthetically create the economic impact of deficit spending by the federal government.
Yet as the above quote from our friend Walker Todd suggests, the central bank has pretended to focus on stimulating growth and employment, when in fact it has been bailing out the big banks once again. This symbiosis between the Fed and the largest banks, who are the chief beneficiaries of QE, has seen the central bank create trillions of dollars worth of risk-free assets for the biggest banks in the form of $4 trillion plus in excess reserves.
The massive overhang of liquidity created by the Yellen Fed has swelled the monetary base of the US economy, but has had little or no impact on employment, consumption or inflation – at least not yet. To quote from Todd’s important talk at Levy Institute last year:
“The Fed should have learned from the experience of the earlier quantitative easing programs that its purchases of securities do little or nothing to increase the quantity of bank credit actually supplied to the general economy. Purchase programs might make sense in some circumstances if they helped make real interest rates positive, but generally real rates have been negative since 1Q 2009. The Fed’s methodology is not necessarily entirely irrational, but the evidence is that it simply has not worked.”
Once there are three new Republican governors on the FOMC, however, Chair Yellen may find herself being challenged on some of the most basic assumption that underlie current Fed monetary policy. The incredible description of QE as a form of economic stimulus, for example, may be questioned given the paltry success of the policy so far. Both Quarles and Goodfriend are reliable conservatives who are unlikely to acquiesce in this view of current Fed policy.
For example, Goodfriend’s current position as the “Friends of Allan Meltzer Professor of Economics” at Carnegie Mellon’s Tepper School of Business and his published research makes it seem improbable that he would support the FOMC’s direction under Yellen.
His 2014 essay, “Why Monetary and Credit Policies Need Rules and Boundaries,” illustrates how he differs from the radical monetary policy regime under Yellen. But as one reader of The IRA does note, Goodfriend did advocate NIRP in his remarks at Jackson Hole.
It is important to recognize that the Yellen Fed has diligently worked to weed out any dissenting voices among the regional Reserve Bank presidents, thus dissonant views among the governors will represent a new challenge for Chair Yellen, a change that could see her step down before the end of her term. Fed Chair's have traditionally resigned when they are on the losing end of policy votes by the FOMC.
The unfortunate departure of Richmond Federal Reserve President Jeffrey Lacker, who announced his resignation in April after admitting that he indirectly discussed sensitive information with an analyst regarding the Fed's plans for economic stimulus, conveniently eliminated an important dissident on the FOMC who had consistently questioned the efficacy of QE.
"I wouldn't have gone down this asset-purchase path. I'm in the camp that we should taper and stop right now," Lacker told CNBC’s Squawk Box in a 2013 interview. "I think a reasonable case can be made that path of unemployment wasn't affected much by quantitative easing we've seen over the past few years."
The big change facing the Yellen Fed is that the chair actually may start to hear questions from the Republican governors asking what the FOMC is doing in terms of monetary policy and why. The fact that the Fed did not immediately start to shrink its balance sheet following QE 2-4 speaks volumes about the intellectual orientation of the FOMC, which has been entirely willing to accept the neo-Keynesian, Paul Krugman worldview that additional open market intervention was required even after the abortive 2009 fiscal stimulus.
But the true irony is that the supposed stimulus of QE was in fact a sop for the banking industry, especially the largest banks. As Todd notes, the start of QE 1 was not meant to help the economy, but instead a move by the FOMC to liquefy the US banking system in the immediate aftermath of the 2008 financial crisis. Without QE1, the major US banks could never have raised sufficient liquidity to repay the emergency loans made by the Fed in 2009.
In addition to the immediate subsidy for the largest banks, the Fed’s open market purchases of securities since 2009 have compressed credit spreads but done little to help boost employment or consumption. As we noted in previous issues of The IRA, the cost of credit in bank loans and bonds has been suppressed by the Fed's actions, suggesting that above-average credit losses await banks and bond investors down the road. The chart below shows relative corporate and government credit spreads going back a decade.
With the significant exception of the China market hiccup at the start of 2016, high yield spreads have been consistently below the long-term average during Yellen’s tenure. The current FOMC frets about the potential dangers of unwinding the Fed’s bond portfolio, but the reality is that today the duration-starved capital markets could easily absorb the entire amount over a period of a couple of years.
Keep in mind that new issuance of mortgage backed securities by the GSEs is running several hundred billion dollars below last year’s levels. With this significant decrease in bond issuance by the GSEs, it is unlikely that the Fed can raise interest rates until the central bank’s portfolio has been significantly reduced.
The prospect of Quarles joining the Fed raises an interesting historical question. The last Mormon banker to sit as a Fed governor was Marriner Eccles, who became associated with the term “pushing on a string” after his testimony to Congress in 1935. Then as today, Eccles knew that monetary expansion such as QE did not work because consumers were unwilling to spend.
But the Eccles was not doctrinaire in his economic views and actually became a strong advocate of fiscal stimulus to offset a deficit in investment spending, a situation very similar to that existing today. As Allan Meltzer noted in his classic book, “A History of the Federal Reserve: 1913-1951,” Eccles went further than any of his colleagues on the Fed and attributed the excess of savings to inequitable income distribution.
“Eccles differed from his predecessors in his belief that government had to take responsibility for the economy,” wrote Meltzer. “He devoted much of his time to advocating fiscal measures, especially increased spending on investment financed by government borrowing to expand demand.”
Like Donald Trump and the Republican majority in Congress, both FDR and Henry Morgenthau believed in the 1930s that a balanced budget and cuts in government spending were the surest path to economic recovery. Yet Marriner Eccles believed just the opposite and became a leading advocate for deficit spending to address the lack of investment and consumption during the Great Depression.
As noted in our 2010 book “Inflated: How Money & Debt Built the American Dream,” John Kenneth Galbraith would later describe the Fed under Eccles as “the center of Keynesian evangelism in Washington.”
It seems pretty clear that confirmation of Randall Quarels and Marvin Goodfriend will mark a significant and welcome change at the Fed, but observers of the central bank should remember the case of Marriner Eccles when it comes to predicting the behavior of Fed governors. That said, the transition from Democratic to Republican control on the FOMC may finally signal the return of a bear market in the world of fixed income after decades of manipulation by the US central bank.
EDITOR'S NOTE
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the new 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. This piece does not necessarily reflect the opinion of Hedgeye.
