AUTOMATIC STABILIZER ? / PRUDENTBEAR.COM

Automatic Stabilizer?

by Doug Noland

April 18, 2014 


Yellen comforts New York - and the Bulls.

“Fundamental to modern thinking on central banking is the idea that monetary policy is more effective when the public better understands and anticipates how the central bank will respond to evolving economic conditions. Specifically, it is important for the central bank to make clear how it will adjust its policy stance in response to unforeseen economic developments in a manner that reduces or blunts potentially harmful consequences. If the public understands and expects policymakers to behave in this systematically stabilizing manner, it will tend to respond less to such developments. Monetary policy will thus have an ‘automatic stabilizer’ effect that operates through private-sector expectations. It is important to note that tying the response of policy to the economy necessarily makes the future course of the federal funds rate uncertain. But by responding to changing circumstances, policy can be most effective at reducing uncertainty about the course of inflation and employment. Recall how this worked during the couple of decades before the crisis--a period sometimes known as the Great Moderation. The FOMC's main policy tool, the federal funds rate, was well above zero, leaving ample scope to respond to the modest shocks that buffeted the economy during that period. Many studies confirmed that the appropriate response of policy to those shocks could be described with a fair degree of accuracy by a simple rule linking the federal funds rate to the shortfall or excess of employment and inflation relative to their desired values.” Janet Yellen, April 16, 2014

Watching (via CNBC) Janet Yellen’s appearance before the Economic Club of New York on Wednesday just seemed surreal. Contemporary central bankers’ experiment with monetary inflation has spiraled ominously out of control, yet the new Fed chair was welcomed in New York with joy and reverence. She was repeatedly commended for delivering such a clear message. Dr. Yellen smiled. A controlled Q&A had questions coming from Goldman Sachs’ Abby Joseph Cohen and Harvard economist Martin Feldstein. After lavishing praise upon Dr. Yellen, Goldman’s Cohen asked a softball question about the unemployed. Dr. Feldstein took his turn, pitching his softball on how the Fed might respond in the event of higher-than-expected inflation. The Fed chair provided the typical canned response and Feldstein responded that he was “comforted.” I found the whole exercise discomforting: part of history’s most sophisticated and elaborate doctrine of inflationism.

It would be appropriate these days for the Fed to be under intense scrutiny. But with securities prices basically at all-time highs and “The Street” again showered with “money,” there will be no tough questions from the Big Apple crowd. I was struck by the following sentence from Yellen’s talk: “Fundamental to modern thinking on central banking is the idea that monetary policy is more effective when the public better understands and anticipates how the central bank will respond to evolving economic conditions.” It’s a ruse to suggest “public” understanding. Monetary policy has evolved over the years to pander directly to Wall Street and the financial markets. Everything – talk of unemployment, inflation, QE, forward guidance – revolves around maintaining market confidence.

During one of last week’s IMF panel discussions (Charles Evans participated), a member of the audience (from Germany) took exception to Fed policymaking. He stated his view that the Fed’s use of the unemployment rate for targeting monetary policy was “naive.” When the Fed initially discussed using unemployment as a key policy target, I posited that it was mainly for political cover. Heading into the 2012 elections, the Fed’s “money” printing was already under fire. Tying the unemployed with Fed stimulus was clever politics.

I am surely boring readers with my recent focus on central banking. When Fridays arrive and I need to transfer thoughts from brain to keyboard, I find monetary policy weighing particularly heavy on my mind these days. I’m compelled to return to an exchange from an IMF panel discussion I highlighted last week:

Citigroup chief economist Willem Buiter: “Financial stability is a key responsibility of every central bank. And if it’s a choice between inflation or whatever – and financial stability, then financial stability comes first.”

Federal Reserve Bank of Chicago President Charles Evans “Wow, that’s amazing! That’s amazing to me! Are you kidding me?”

Increasingly, monetary policy is regressing into a tradeoff between Financial Stability and the Fed’s obsession with what it considers unacceptably low inflation. Financial Stability has always been elemental to central banking. It was so fundamental that it went without being explicitly stated. Similarly, it was never legislated that our central bank be forbidden from aggressively printing money on a whim. Never was it contemplated that the Federal Reserve would inflate its balance sheet from $900bn to $4.5 TN in six years.

Last week, Chicago Fed head Evans made what is commonly viewed as an obvious statement: “What we own as a central bank is inflation.” But similar to about everything these days in the markets, economy and policymaking, things just aren’t what they seem. What may have been true traditionally no longer applies. The Fed doesn’t own inflation. They actually lost control some time ago.

Inflation is actually an extremely complex issue. The old “Austrians” always had the best grasp of inflation dynamics. Inflation problems come in many varieties: rising consumer prices, asset inflation and Bubbles, over and mal-investment, trade and current account deficits, currency devaluation, etc. Credit excess is at the root of inflationary dynamics. And the interplay between Credit, monetary processes and economic structure plays prominently in determining the types of prevailing inflationary forces. For years I’ve argued that asset inflation and Bubbles were the most prominent inflationary risks associated with the structure of contemporary Credit, monetary policy and financial flows. Unprecedented post-’08 global monetary and fiscal stimulus pushed over- and mal-investment into the realm of a primary inflationary manifestation. Dangerously, the resulting global downward pressure on aggregate consumer price levels further feeds today’s dominant inflationary risk: a globalized central bank liquidity-induced Bubble in securities and asset prices.

I have a difficult time hearing Yellen say “when the public better understands.” The public doesn’t have a clue about “modern” central banking. I seriously question whether our own central bankers understand the ramifications of contemporary monetary policy. I’m increasingly convinced they fail to grasp the key facets of Financial Stability. Early in my career the Federal Reserve would subtly signal changes in monetary policy by adding or subtracting “reserves” into the banking system. Traditionally, system Credit was dominated by bank lending, and bank Credit expansion was restrained by reserve and capital requirements. If the economy, consumer prices or market speculation started running a little hot, central banks would “lean against the wind” by extracting some reserves and tightening bank finance. The nineties explosion of unconstrained non-bank Credit changed everything.

I would strongly argue that central banks only really “owned” inflation when they were willing to use their control over reserves to restrain bank lending, hence system Credit growth. This would come with a political price, something less disciplined Federal Reserve chairmen were not willing to pay. The tendency to tolerate creeping inflation led to a specific mandate to keep inflation below a certain level. It was never contemplated that the Fed would use the inflation mandate as justification for massive “money” printing operations.

Tested and proven central banking no longer applies to U.S. monetary management. Beginning in the nineties, ad hoc policymaking gravitated toward managing the financial markets. This was dictated both by the shift away from bank loans to non-bank and securitized Credit, as well as the attendant propensity for market crisis. To be sure, the deeper the Fed drifted into market intervention the bigger the eventual crises.

Dr. Evans stated that the Fed “owns” inflation, while believing the notion of placing Financial Stability ahead of inflation is today tantamount to central banking heresy. Ironically, when Fed policymaking gravitated away from bank reserves to managing the securities markets more generally, the Fed actually came to “own” “Financial Stability”. And when I write “own,” I'm thinking in terms of the old adage “you break it you own it!”

It’s amazing that monetary policy got to the point where the Bernanke Fed explicitly sought to force savers out of safety and into stocks and higher-yielding risk assets. It all started subtly with Greenspan nurturing non-bank Credit expansion. He moved to openly pegging rates, manipulating the yield curve and backstopping the markets. Policy transparency and asymmetrical policies (disregard asset inflation, speculation and Bubbles, but assure the markets the Fed would aggressively backstop the markets in the event of trouble) provided a boon to leveraged speculation, hence Financial Instability.

Now the Fed is trapped and the crowd at the Economic Club of New York is comforted. “If you owe the bank a million, the bank owns you. If you owe billions, you own the bank.” Wall Street owns the Fed. With total system securities now valued in excess of 400% of GDP (an all-time high and up from what was a record 350% in 1999), the sophisticated market operators must believe that the Fed, at this point, will not have the courage to attempt to restrain what has become conspicuous financial excess.

I was disappointed in (departing) Fed governor Jeremy Stein’s paper “Incorporating Financial Stability Considerations into a Monetary Policy Framework.” Stein had previously broached the possibility that Fed rate increases might be necessary to counter Credit market excess. In his paper he raised the issue of using indictors of financial excess (particularly bond market risk premiums) as a factor that might sway a central bank toward preemptive rate increases. “These variables have the potential to serve as simple proxies for a particular sort of financial market vulnerability that may not be easily addressed by supervision and regulation.” But he then basically threw up his hands and accepted that this type of framework – the empirical research, the construction of models - was at an “early stage” – “there is a ways to go.” Well, it’ll be too late. We don’t need academic studies or econometric models; we need traditional disciplined central banking.

In a section titled “Okay, But How Do You Measure Financial Market Vulnerability,” Stein delves into “Financial Sector Leverage.”

“At an abstract level, the framework that I have sketched corresponds closely to that in Woodford's work. When it gets down to implementation, Woodford suggests that the most natural measure of financial market vulnerability is a variable that captures ‘leverage in the financial sector.’ In other words, faced with unemployment above target, he would have monetary policy be less accommodative, all else being equal, when financial-sector leverage is high. This recommendation rests on three key premises. First, when financial-sector leverage is high, the probability of a severe crisis in which multiple large intermediaries become insolvent is elevated--that is, we are more likely to have a replay of what happened in 2008 and 2009. Second, easy monetary policy is asserted to increase the incentives for the financial sector to lever up. And, third, focusing on leverage as opposed to asset prices avoids putting the central bank in the position of having to ‘spot bubbles’: Even if it is impossible for the central bank to know when an asset class is overvalued, the risks to the economy associated with overvaluation are presumably greater when intermediaries are highly levered.”

In the post-2008 crisis backdrop, there’s been considerable (belated) attention paid to financial leverage. Federal Reserve analysis holds that flawed regulation was primarily responsible for the crisis. So, so-called “macro-prudential” policies are now supposed to ensure that for this cycle banks are better capitalized, carefully regulated and avoidant of inordinate risk-taking. The Fed is confident that financial sector leverage is being contained. And it’s all classic “fighting the last war.”

Meanwhile, the hedge fund industry continues to balloon – with unknown amounts of speculative leverage. The Federal Reserve’s balance sheet is on its way to $4.5 Trillion, leverage that is conveniently outside the purview of the Fed’s framework for assessing financial sector leverage risks.

There’s two ways to look at leverage. The traditional framework is to equate financial leverage with vulnerability. A highly leveraged banking system would be at risk of large losses in the event of declining securities prices or problem loans. As we saw during the 2008 crisis, highly leveraged speculative positions are susceptible to faltering market confidence and self-reinforcing liquidations. The problem with a speculative “risk on” market backdrop – especially when large amounts of leverage are employed – is vulnerability to “risk off” risk aversion and deleveraging. The Fed believes that the 2008 crisis could have been avoided with proper regulation of both mortgage lending and bank risk management. The system would not have been highly leveraged in problematic high-risk mortgages, they believe.

But there’s A Second Way to analyze leverage - overlooked but vitally important. The process of “leveraging” – the expansion of Credit – creates new purchasing power. This “leveraging” could be a bank extending new loans (funding capital investment, auto loans, tuition, mortgages, etc.). Or it could be new securities Credit for leveraging bets on stocks and bonds (or derivatives). Importantly, there is as well the Fed’s leveraging of its balance sheet as it creates new liquidity to implement its QE operations. These various forms of leveraging provide new liquidity/purchasing power for their respective parts of the real economy and asset markets. This liquidity then spurs a series of financial and economic transactions throughout the entire system.

Fed officials don’t appreciate the risks involved in its experimental balance sheet leveraging. For one, officials don't believe inflation is an issue. Moreover, the Fed anticipates no scenario that would force a problematic liquidation of its holdings (largely Treasuries and MBS). The market doesn’t see risk either. I see considerable risk, risks associated with The Second Way of looking at leverage. Fed balance sheet expansion has created incredible amounts of liquidity/purchasing power that have been slushing around the markets and economy for years now. This liquidity has inflated asset prices, spending, corporate cash flows and earnings, and system incomes more generally.

Worse yet, Fed QE operations (“leveraging”) have incentivized what I believe is unprecedented leveraged speculation on a global basis. This additional leveraging has unleashed only more liquidity/purchasing power that has exacerbated inflationary distortions. I argue strongly that all this leveraging has created a deep systemic (financial markets and real economy) dependency to ongoing balance sheet growth (liquidity creation) by the Fed. It has reached the point where even zero rates, massive QE, highly speculative securities markets, pockets of overheated real estate and asset markets, and record securities values spur only modest growth in the general economy.

From Yellen: “If the public understands and expects policymakers to behave in this systematically stabilizing manner, it will tend to respond less to such developments. Monetary policy will thus have an ‘automatic stabilizer’ effect that operates through private-sector expectations.”

The traditional gold standard was so effective because it in fact provided an “automatic stabilizer.” If Credit was created in excess, an economy would suffer a loss of gold. The reduced gold reserve would dictate higher rates and a (stabilizing) contraction in lending. Bankers and politicians understood the mechanics of the system (and were committed to sustaining the monetary regime), so they would tighten their belts when excess first emerged. In this way, the gold standard for the most part provided a stabilizing and self-correcting system. These days, everyone knows the Fed will not respond to excess. Our central bank, however, will be predictably quick to print additional “money” at the first sign of a faltering Bubble, liquidity that will reward financial speculation. Excess begets excess. Today’s system is the very opposite of “automatic stabilizer.”

This all could sound too theoretical. But with the Fed intending to conclude balance sheet leveraging later in the year, this theory might soon be tested.