June 18 – Financial Times (Mohamed El-Erian): “In hiking rates and, more notably, reaffirming its forward policy guidance and setting out plans for the phased contraction of its balance sheet, the Federal Reserve signalled last week that it has become less data dependent and more emboldened to normalise monetary policy. Yet, judging from asset prices, markets are failing to internalise sufficiently the shift in the policy regime. Should this discrepancy prevail in the months to come, the Fed could well be forced into the type of policy tightening process that could prove quite unpleasant for markets.”
I’m not yet ready to move beyond the recent focus on global monetary policy. Belatedly, the Fed has become “more emboldened to normalise monetary policy.” Global policymakers may finally be turning more emboldened, though taking their precious time has nurtured alarming market complacency.
Over a period of years, securities markets became progressively more emboldened to the view that higher asset prices were the top priority of global central banks. For years I’ve argued that this is one policy slippery slope. For good reason, markets do not these days take seriously the threat of a tightening of financial conditions. The Fed and fellow central banks will surely seek to avoid what at this point would be a painful development for the global securities markets. When faced with a well-established Bubble, the notion of a painless tightening of financial conditions is a myth.
The current debate, focusing simplistically on interest rates and the level consumer price inflation, misses the overarching issue. U.S. and global central banking shifted to an untested and radical regime of directly inflating securities prices. No longer do central banks attempt to loosen or tighten bank lending through subtle changes in reserve holdings and interbank lending rates. Why not just purchase securities, supporting prices while injecting liquidity directly into the marketplace?
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This momentous transformation of monetary management unfolded over a couple of decades – somehow seemingly unnoticed. Financial innovation played a key role. As more debt was securitized, the impact of marketplace liquidity upon system Credit dynamics became increasingly important. Much to its delight, the Fed recognized that small policy adjustments could exert big effects on risk-taking and leveraging – hence marketplace liquidity, pricing and overall system stimulus.
It was a case of booming Wall Street finance affording the Greenspan Fed the most powerfully alluring monetary policy transmission in history. At the same time, it was power our central bank was ill-equipped to administer. The Fed became increasingly supportive of the debt and equities markets – of Wall Street more generally – nurturing speculation, securities leveraging, derivatives and myriad deleterious financial and economic effects.
In terms of overall system stimulus, securities markets eventually came to dominate traditional bank lending. After disregarding repeated market warnings, the fragility of such a financial regime became obvious in 2008. Rather than using the crisis and its lessons to reposition to a more well-grounded monetary regime, the Fed and central bankers doubled down. Reflating securities markets became priority one, and central banks went so far as to be willing to inject newly created “money” directly into the markets to achieve their objective.
Central banks should not be in the business of favoring individual asset classes, sectors or groups in society. Never should a small group of unelected officials have such discretion to create Trillions of “money” and allocate wealth. After all, if “printing” Trillions to buy marketable debt was such a fine idea, why did central bankers wait until deep crisis to implement such a doctrine?
The new regime that developed specifically favored securities markets, Wall Street and the wealthy. It has fancied the financial speculator at the expense of the saver. The new regime favored financial engineering to productive investment – the white collar to the blue collar. There was no problem seen with deindustrialization and persistent huge Current Account Deficits. No issue whatsoever exchanging new financial claims for Chinese imports.
The new regime has spurred wealth redistribution that is at the root of a divided country, political dysfunction and escalating geopolitical risk. And there is little mystery surrounding weak economic underpinnings, dismal productivity trends and stagnant wages and living standards. Contemporary finance has proven itself especially deficient in allocating resources throughout the economy. Markets have been over-liquefied, too distorted, grossly speculative and too monstrous to be an effective mechanism for resource allocation.
All these consequences of precarious financial and policy regimes – and resulting Credit and assets Bubbles – apparently ensure that the Fed and global central bankers are trapped in policy doctrine beholden to the securities and derivatives markets.
This week I found myself again contemplating contemporary “money” and monetary theory. I pondered the attributes of “insatiable demand” and “preciousness” – and how governments throughout history abused the insatiable demand for money, eventually destroying its preciousness with dire consequences for financial systems, economies and societies.
Central bankers have become way too comfortable creating new “money” and using it to drive the markets. Over-liquefied markets, then, turned too comfortable financing (and leveraging) endless government borrowings. It has amounted to a historic inflation of “money” at the heart of the financial system. Especially since the crisis and Bernanke Reflation aftermath, Washington Finance has come to completely dominate the foundation of contemporary global finance.
Looking back to 1990, there was about $2.5 TN of Treasury Securities, $1.5 TN of Agency Securities and $340bn of Federal Reserve Credit. The three main sources of Washington Finance combined to $4.25 TN, or 71% of GDP. The explosive growth of the GSEs helped push Washington Finance to $8.34 TN (Treasury $3.36 TN, Agency $4.35 TN, and Fed $635bn) by the end of 2000, or 81% of GDP. Nearing the end of the mortgage finance Bubble in 2007, Washington Finance had inflated to $14.4 TN (Treasury $6.05 TN, Agency $7.40 TN, and Fed $950bn), or 99% of GDP.
In terms of Washington Finance, it is simply astonishing to contemplate what has unfolded since the crisis. Outstanding Treasury securities have reached $16.0 TN, with the Fed’s balance sheet ending 2016 at $4.43 TN. After all the fraud, insolvency and receivership, one might have assumed a downsized Agency sector. Not to be. Once Washington Finance takes hold, there’s apparently no letting loose. After a notably strong year of GSE growth, outstanding Agency Securities ended 2016 at a record $8.52 TN. Total Washington Finance ended the year at an incredible $28.93 TN, or 156% of GDP.
This almost $29.0 TN of “money-like” Credit provides a deceptively (Bubble Illusion) solid foundation to U.S. and global finance. Here at home, this unprecedented inflation of Washington “money” has significantly bolstered asset prices, spending, corporate profits and government revenues. Globally, the flow of Washington “money” abroad (Current Account Deficits and financial flows) inflated international reserve holdings, integral to what became booming post-crisis EM financial systems. I would furthermore argue that the unprecedented inflation of Washington “money” was instrumental in bolstering Chinese Bubble inflation to epic proportions. Chinese financial and economic Bubbles then became elemental to powering Bubbles around the globe. And particularly over the past two years, unprecedented U.S.-inspired inflation of government “money” in Europe and Japan (and elsewhere) provided the liquidity to propel a financial Bubble in the face of an increasingly troubling fundamental backdrop.
This has now been going on so long that is seems business as usual. Central banking and contemporary monetary doctrine are held in high esteem. Yet the history of great monetary inflations shows that, once going, they’re virtually impossible to control. And that’s where we are today. Understandably, after accommodating Bubble to this point, markets assume that policymakers (i.e. Washington, Beijing, Frankfurt, Tokyo, etc.) will not dare risk popping them. At the same time, central bankers must by now appreciate that ultra-loose policies are a clear and present danger to financial stability. Beijing at least recognizes the risk of letting their (out of control) Bubble run.
Surely officials in Washington, Beijing, Europe, Tokyo and elsewhere would prefer to begin normalizing policy at this point. But this now goes so far beyond interest rates. We’re talking tens of Trillions of specious “money” and money-like securities and even much larger quantities of equities and corporate Credit whose values have been inflated by the massive expansion of government finance. To be sure, the current backdrop so dwarfs market misperceptions, distortions and mispricing from the mortgage finance Bubble period.
Policymakers everywhere prefer a go slow approach to “tightening,” determined not to upset the securities markets. Beijing this week provided aggressive liquidity injections, taking some pressure off Chinese bond yields, interbank lending rates and stock prices. Market wishful thinking has it that both Chinese officials and the Federal Reserve have largely completed “tightening” measures. Both systems, however, have powerful Bubble Dynamics feeding off the perception of safe government “money” and ongoing government support for securities and asset prices. Policy “normalization” would require that governments retreat from backstopping the markets and dictating system finance more generally.
At this late-stage of the Bubble, markets have no fear that policymakers are willing to risk bursting Bubbles. A cautious go slow approach to tightening and normalization may seem perfectly logical to central bankers, but it’s tantamount to not going at all. Inflation psychology has become deeply engrained throughout global financial markets – and it will be broken only through significant disappointment and anguish.
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