Hedgeye CEO Keith McCullough is joined by former Fed advisor Danielle DiMartino Booth in the replay of this special investing webcast. Danielle and Keith discuss the current economic set-up, Fed policy and the implications for financial markets.
Also below is an excerpt transcribed from the interview.
https://cdn.jwplayer.com/players/Tp5zwBrQ-KY3o17gg.js
Keith McCullough: Hi, I'm Keith McCullough. Welcome back to another Real Conversation with my friend Danielle DiMartino Booth. We're going to start this conversation with a tribute.
Danielle DiMartino Booth: William McChesney Martin said the Fed's job is to take away the punchbowl. William McChesney Martin and Paul Volcker are my two central banking heroes. The passing of Paul is just devastating. And it reminds us of the futility of the people who have followed him and what they've tried to do and how much it is against Paul's philosophy.
McCullough: I cited Paul Volcker’s book today. There's this great passage where Volcker says this about Treasury Secretary James Baker. “He wanted everyone to think that we'd keep interest rates low to support the depreciation of the dollar. I'd never made such a commitment.” He was very consistent on that point.
DiMartino Booth: His favorite word was stability. And that was what dictated his entire tenure. He knew that when he entered office, he had to make a decision between rip roaring inflation and himself instigating recession. So he knew he had a really bad choice to make and he made it. The country was better off for it in the end.
He was completely apolitical. He could have cared less if he shocked Wall Street or not. He was there to serve his country. He was a true public servant and we shouldn't think of him as being anything but that. I was hoping the same thing would happen with current Fed Chair Jerome Powell.
McCullough: Yeah. What's really interesting about Volcker, and we'll get into why this matters today, but what Volcker did has been long forgotten. In 1982, his choice was to raise interest rates and strengthen the dollar and tame inflation. For those of you that don't know, through Volcker’s brute force inflation went from 12% to 3%. Inflation is now below two and everyone on Wall Street is begging for is the literal opposite. That’s the literal opposite of what Volcker would have believed. He'd say if you devalue the dollar, the cost of living of the people goes up. Why would we do that?
DiMartino Booth: Exactly. Volcker wrote this great Bloomberg op-ed in 2018 about the fallacy of the 2% inflation target and how idiotic it was. It's like targeting failure. It makes no sense. Volcker was bold enough to come out and say that what Bernanke did was wrong.
McCullough: Bernanke devalued the dollar to a 40-year low in 2011 and said that there was no inflation. This is where the inequality gap really started to widen. I don't think that there's anyone who could unpack that and say the Fed had nothing to do with it.
DiMartino Booth: This goes to the smoke and mirrors of the Fed’s inflation target using PCE. That's not what anybody on Planet Earth pays.
I'm intrigued that the Fed says, “Maybe we can let inflation run a little hot.” I'm like, if you actually counted inflation correctly then you'd find out that we’re already on fire. If you were to bring into account, Oh, I don't know, apartment rent and home prices and stocks and bonds, but no, no, no, no, no. But maybe we should let the bad inflation metric run hot.
McCullough: It's hard to fast forward from all of what we've just talked about to where we are today. But today, like James Baker, a successful lawyer, you’ve got Jerome Powell. I call him PE Powell because he’s a pal of Private Equity and a former lawyer at the Carlyle Group. Who is he today relative to who you would have wanted him to be, like a Paul Volcker?
DiMartino Booth: Well, in theory, Jay Powell's resume was what we wanted it to be. This is the guy who in October 2012 said that “the Fed's QE policy was creating a fixed income duration bubble across the entire credit cetera spectrum.” So he knows what he's talking about and he knows what the Fed's policy has done.
In the beginning of Powell’s tenure before the credit markets threw up a year ago now in December 2018 it looked like he was sticking to his guns. It looked like he was saying it's not the Fed's job to backstop the stock market. And it was great. I mean that was the kumbaya for me.
The Powell we have today is clearly not comfortable in his skin. He knows what he's doing is wrong. I think unlike Volcker, Powell got to the edge of the abyss. He had a choice to make between two really bad outcomes and he chose to make neither.
McCullough: Can the Fed slowly deflate the credit bubble? That's the ongoing question.
DiMartino Booth: Powell is choosing to circumvent making that hard decision because he saw in December 2018 that the credit bubble was set to burst. Greenspan made a very famous speech because he recognized the irrational exuberance in the stock market in December 1996 and he chose to do nothing about it. His advisors said, ‘Well, we could raise margin requirements. We can get out in front of this mother of all stock market bubbles.’
And Greenspan said, No, the only thing you can do to address a bubble is in its aftermath. And that was Bernanke and Yellen philosophy. So even though you have sufficient identifiers, you're not going to do anything about it until you're coming in as the cleanup crew. As Jim Grant would say, ‘The Fed is both arsonist and firefighter.’
Jay Powell is breaking this mold in a big way and it’s a huge gambit. He has seen what the bubble could be. He watched liquidity dry up in November and December of 2018. Last time we spoke we talked of this ludicrous idea of rate cuts and QE ongoing at the same time. Powell has decided to try and get out in front of this and see if he can prevent credit from bursting and maybe let the air come out of the balloons lowly.
McCullough: That sounds like getting halfway pregnant to me. You're the one who taught me this, which is he basically knows that once you've cut by three times and you go to the fourth that that's bad. This would be the Fed acknowledging that the first three rate cuts didn't have any causal impact that was positive to the economy.
So this is why I care. We're at a half a percent on headline GDP for the fourth quarter. We haven't seen a one nevermind a zero in front of GDP in a very long time. So that's a problem. What happens if Powell says, ‘Hey, we did our three and we're good,’ willfully knowing that he's got something in the credit market. The catalyst to get the market to go down again could be him just not being dovish enough at this stage of the game if my numbers are right.
DiMartino Booth: If your numbers are right, I think that something as fractional as a half a percent is truly a rounding error.
McCullough: So you just walk down the line and Powell is still not dovish enough then he's the catalyst for him not being dovish enough. Therefore, if I'm right and it's Quad 4 in Q2 of 2020, our forecast 100% of the time that the Fed sees Quad 4 they have to go dovish because credit stops trading and the S&P goes down 20% in a straight line. If we’re right, the preconditions are there for him to look as politicized as he's ever looked.
DiMartino Booth: If the bulls on Wall Street are right and we have a fundamental reacceleration in underlying GDP growth in the United States in 2020 then Powell can pat himself on the back.
McCullough: And smooth right out of this.
DiMartino Booth: But if anything goes wrong anywhere, then he will either have to increase the size of QE, formalize QE and start buying coupons or lower rates or both… in an election year.