Closer to the End Than the Beginning
How Monetary Policy Weakens Capitalism and Distorts Markets
I’ve argued in past commentary and presentations that Monetary Policy, as practiced by the US Federal Reserve, has reached the point of exhaustion. Policy rates have cascaded ever lower since the 1980s. The Fed Funds Rate has settled at or near zero for nine of the past thirteen years.
The financialization of the modern economy, particularly since 2008, has accentuated the central bank’s bias toward increasingly risky maneuvers. In support of this finance-based economy the Fed has exhibited an alarming willingness to manipulate cyclical economic forces and asset markets for diminishing returns.
The Fed’s monetary policy has painted the central bank and the US economy into a corner. The progression from zero interest rates to Quantitative Easing has doubled the central bank balance sheet to $8.8 trillion since the onset of COVID.
Before COVID the disinflationary powers of the Techno-Global Revolution provided cover for the central bank’s profligacy. Two unanticipated consequences of the pandemic created a risk Americans have rarely experienced in forty years, inflation. A poorly targeted and too generous COVID relief package poured nearly two trillion dollars into the locked down US economy, just as global supply chains ground to a halt.
The resulting price spikes are the byproduct of the most basic of economic laws, that of supply and demand.
The rate of inflation is unnerving, to say the least. The markets and the media have been debating whether this bout of inflation will be transitory or something more ominous and resilient. The dueling inflation narratives seem to have settled on lingering and potentially dangerous, rather than short lived and innocuous.
“Doubt is not a pleasant condition, but certainty is absurd.” My old friend Voltaire penned those words around the time of the American Revolution. Doubt and uncertainty make investors nervous and intransigent. They seek a narrative they can cling to when putting money at risk. And they prefer to have that narrative be delivered with certainty and expedience.
In pursuit of certainty, we often judge too quickly and respond hyperbolically. In the world of modern media many consequential things are reported immediately, accompanied by instant analysis. But when the desired certainty is proven absurd, market volatility ensues.
The word transitory has been stricken from the Federal Reserve’s lexicon. The risk of inflation is no longer seen as sufficiently temporary by Chairman Powell and other well considered pundits to utter that word.
If It’s Cyclical, It’s Transitory
In a cyclical, capitalist economy everything is transitory. Economies and markets are either expanding, contracting or momentarily stable.
Even the dreaded two-headed monster, stagflation, is a transitional phase. When monetary policy acts to tame inflation through higher borrowing costs, the economy slows and stagnates at that slower growth rate. During this transitional phase, higher prices remain sticky. But business and labor leaders eventually adjust to the new reality. Businesses stop raising prices and labor curbs wage demands. Consumers recognize the sea-change and curtail panic buying. Prices stabilize.
The Fed is then free to remove the impediments of tight credit and the economy recovers, beginning the business cycle anew.
A finance-based economy, by its nature, exhibits tremendous interest rate sensitivity. The cost and availability of credit influence economic activity, expansion, and contraction. Economic transitions may be initiated by changing and/or experimental monetary policy. Transitions may result from a policy left in place for too long. The relevant policies being ZIRP (zero interest rate policy) and the experiment, QE (quantitative easing).
Advances in technology, and, as we have been reminded, virulent pandemics, may also encourage economic transitions. The trick to prolonging economic stability is managing the magnitude of change and the pace at which it occurs. A lack of foresight, conflicting interests, and poor communication make policy and economic transition more treacherous. The global economy has entered the danger zone.
Sir Isaac Newton and Frederick Hayek Weigh In
Newton’s Third Law tells us that for every action there is an equal and opposite reaction. Relating this to capitalism and markets is simple; when central banks add liquidity in the form of increased money supply and easy credit, economic activity increases, and asset prices rise. When liquidity and credit tighten, the stimulant for economic expansion, speculation and price increases dissipates.
Hayek put it another way. He wrote,” the continuous injection of additional money at points of the economic system creates temporary demand along with the expectation of rising prices which can only last so long as it continues at the same rate or accelerates at a given rate.”
Combining the messages of Newton and Hayek we can surmise that much of the growth in the economy, the rise of asset values such as stocks, real estate, and even crypto currencies, can be attributed to the injection of money into the financial system. Again, ZIRP and QE must be considered.
As the Fed begins to withdraw financial stimulus, we can expect to see Newton’s and Hayek’s ideas play out as they have in the past. The actions that propelled prices higher will be reversed and prices will begin to turn around. The reversal of stimulus will slow the economy, reduce cash-out refinancing, and ding the markets that have benefited most, reducing inflation risks.
The Components of Today’s Inflation
The emergence of today’s bout of inflation has several sources and has been experienced in different ways. Financial stimulus, meaning zero interest rates and excessive liquidity, has been channeled into investment assets with little consumer inflation to show, except for housing costs.
But a closer look at investment assets is less sanguine. The stodgy old DOW Industrials has climbed 90% off the bottom set on March 23, 2020. The S&P 500 has doubled. Real estate and speculative investments have gone on a similar tear. The Fed’s stimulus programs have been designed to boost the fortunes of the wealthy who save and reinvest rather than spend their gains. The financed-based economy has been rumbling along on a flood of liquidity that produces record company profits, bulging stock and real estate gains, but very little change in wages or consumer behavior.
In 2020 something changed, exposing fissures in the US economy. Companies and markets have been overflowing with cash since 2009, but it wasn’t until $2 trillion in fiscal stimulus found its way into consumer’s pockets that we came to see that consumer inflation was simmering just below a boil.
COVID Relief programs provided wage earners the opportunity to show employers how they felt about their jobs and how they would have been spending their disposable income, if they had any.
The breakdown of the supply chain and employees abandoning their workstations meant that supply would temporarily fail to meet stimulus-fueled, increased demand. While in-person service industries suffered, durable goods sales shot higher. Consumers needed washers and dryers, refrigerators, and automobiles. Prices for these durable goods spiked and inflation expanded from risk assets to everyday consumables. Food and energy costs have jumped as well. Opportunistic corporate greed has played no small role in consumer inflation.
Workers, sensing a shift in power dynamics with employers are demanding higher wages and flexible working conditions. These factors put inflationary pressure on production costs and profits. The $64 question remains, for how long?
Did COVID Kill the Techno-Global Revolution?
In 2004, ICM compiled the 13 components of what we called The Techno-Global Revolution. For decades the world economy has danced to the tune of globalization. Technological advances made the industrial production process portable. Nations with very low labor costs and just enough tech savvy to handle the digitized production process became the bustling hubs of modern capitalism. And whenever labor costs rose enough to eat into profits, businesses sought either cheaper labor or substituted robotics for humans.
Global companies reaped historic profits. American consumers traded wage increases for cheap goods.
The pandemic has exposed important flaws in globalized modes of production. Global wages are rising along with shipping costs. Just-in-time inventory management exposed the vulnerability of international interdependence. A resurgence of the vertical integration business model is coming fast.
Backward looking companies like Tesla, Amazon, General Motors, and IKEA are working to eliminate weak links in the supply chain, reducing uncertainty and inefficiency. These tactics were the backbone of the empires built by Andrew Carnegie and Henry Ford in the 20th century.
The Carnegie Steel Company exemplified vertical integration when it purchased Iron Range mines in Minnesota and cargo ships that crossed the Great Lakes to deliver iron ore. Carnegie bought Henry Frick’s coke fuel company to assure his mills could run continuously and streamlined sales and delivery processes. Henry Ford’s moto mirrored a similar approach, “From mine to finished car, one organization. Raw materials in one door and cars out the other.”
Technology will be deployed in old and new ways to control labor costs. Capital investment in robotics and AI will increase at least as rapidly as wages. Technology’s use as a labor substitute will accelerate.
So, while the disinflationary powers of the Techno-Global Revolution are diminished today, look for technology to reassert its influence over labor costs. An increasing reliance upon vertical integration suggests repatriation of the production process and greater dependence on comparatively expensive American labor. For American workers, vertical integration may be a two-edged sword, but for innovative tech companies it’s a potential bonanza. Cost controls and vertical integration will help reduce inflationary pressures.
What will Jay Powell do if markets crack?
Jim Bianco, president and macro-strategist for Bianco Research, summed up the Fed’s dilemma in his recent newsletter, “They can either look like they are trying to rein in inflation, or they can look like they are trying to support the economy and financial markets. They can’t do both at the same time.”
History suggests that the Federal Reserve is committed to the finance-based business model and trickle-down economics. From Greenspan to Bernanke, and Yellen to Powell, falling asset prices have put a halt to monetary policy tightening and sparked a return to lower policy rates. In the last decade, when zero interest rates failed to invigorate risk markets and the economy, the Fed experimented with an enormous dose of QE.
To understand this line of thinking, let’s examine the origins and intent of QE. These are the words of the former Fed Chairman, Ben Bernanke, as reported by the Washington Post on November 4, 2010.
“The approach (meaning QE1 and QE2) eased financial conditions in the past, and so far, looks to be effective again. Stock prices rose and long interest rates fell when investors anticipated additional action. Easier financial conditions will promote economic growth. Higher stocks boost consumer wealth.
Rather than relying on savings, investment, and income to drive economic growth, QE was specifically meant to lift stock prices. It is not a symptom of QE; it was a direct intended effort. In reverse, the response in stocks should not be a surprise.”
From 2008 through 2014 the Fed printed an astonishing $3.5 trillion in new money. That is equal to three times the sum printed by the Fed from the central bank’s inception in 1913 through 2008. For an illustration of the effects of QE on asset markets, one doesn’t need to look beyond the NASDQ Composite Index. The tech-heavy index bottomed at 2091.79 on July 2, 2010, and peaked on November 19, 2021, at 16,057.44. That’s a 633% gain, an annual average return of 18.36%.
The Powell Pivot, as it has come to be known in financial circles, provides a glimpse into the Chairman’s most-likely response to market dislocation. In 2018, the economy exhibited some healthy signs. Growth and inflation were moderate, and markets appeared stable. It seemed a good time to unwind some of the massive stimulus that had been injected into the financial system. A gradual increase in policy rates was coupled with a partial runoff of assets from the Fed’s portfolio. Powell named that QT (quantitative tightening).
In March of 2018, the Fed had one more rate hike coming. Ominous signals emerged from the Treasury market. Market yields began to collapse, and the yield curve flattened, both signs that tighter monetary policy and QT had gone too far, too fast.
During a three week stretch during December of 2018, the DOW Industrials sent a strong signal to Powell, plunging 15.6%. Powell seemed unfazed and implemented one last rate hike that December. In July of 2019, Powell reversed field, initiating three rate cuts, the last executed in December. The Powell Pivot was in full swing.
COVID lurked in the shadows. When the pandemic took hold, Powell’s pivot became a harrowing cliff dive back to ZIRP, accompanied by massive QE.
The Great Dissenter
Former Fed Chairman Ben Bernanke’s 2015 memoire, The Courage to Act, presents a history of the Fed’s response to the Financial Crisis and the Great Recession. Ben’s self-aggrandizing recollection paints a heroic portrait of men and women of great import saving the nation from economic ruin. The truth is that there was both trepidation and dissent among members of the policy setting committee in 2008. FOMC members Charles Plosser, Richard Fisher, and Jeffery Lacker voiced great concern about Chairman Bernanke’s plan to embark on the grand experiment. Prolonged zero rate policy and QE seemed a rickety bridge too far. A changing of the guard at the FOMC and a strategically timed vote gave Bernanke the support he needed.
No amount of cajoling could persuade the president of the Federal Reserve Bank in Kansas City and FOMC voting member, Tom Hoenig, to support Bernanke’s plan. Hoenig, the great dissenter, compiled one of the longest strings of “no votes” in the history of the collegial Federal Reserve.
Hoenig’s work as a bank examiner in the 1970s and ‘80s gave him a front row seat to the potential danger of loose monetary policy, in particular the effects on asset prices and the banking system. Hoenig had the distasteful job of shuttering banks that had made questionable loans to farmers and energy firms during the speculative fervor. When asset bubbles burst, collateral values fell, and banks became insolvent. Between 1980 and 1994, 1600 banks failed, the worst rate since the Great Depression.
Hoenig was one of the first and most vocal bankers to extoll what he called the Allocative Effect. Hoenig recognized that keeping policy rates at zero encouraged a shift of capital allocation from one part of the economy to another. Left in place too long, what Fed economist Edward Nelson called “monetary policy neglect”, easy money distorts economic forces and inflates asset bubbles. Today, we refer to this phenomenon as Financial Repression.
Hoenig knew that Financial Repression favored the wealthy at the expense of the rest. Hoenig saw increasing benefit to Wall Street and diminishing returns for Main Street. He knew, as did Hayek, that this policy would lead to a money printing quagmire that would be difficult to escape without significant disruption. His fears for the future include a return to high unemployment, increased social instability, and economic malaise. Policy can only tilt the scales to the benefit of the few, at the expense of the many, for so long before people lose faith in a society.
The Lords of Easy Money; How the Federal Reserve Broke the American Economy, by Christopher Leonard, provides an informative take on this decades-old policy issue. Upon reading this treatise, one may get the feeling the Fed is like a cyclist rocketing down a mountain road with failed breaks, looking for a safe off ramp, where none exists.
Financial Repression Whipsaws Markets
When monetary policy dictates the path of investment resources, central bankers pick economic winners and losers. More than that, they increase risk in all markets. Ben Bernanke’s 2010 Washington Post editorial makes clear that the Fed subordinates the interests of fixed income investors to that of risk markets and trickle-down economics.
When rates of return on risk-free assets, like Treasury and agency securities, are forced below the rate of inflation by central bank policy, investors who have a choice have learned to put their money in stocks, derivatives, real estate, and even crypto currency. That’s confirmation of Hoenig’s Allocative Effect.
Those who are restricted by statutes to risk-free assets have their interests sacrificed to revive the struggling finance-based economy. The Faustian bargain embedded in the policies of the Federal Reserve can be denied for only so long. It is my firm belief that we are closer to the end than the beginning of the policy practices that rely upon financial repression and incorporate market manipulation as a baseline philosophy. The Fed must curb its interventionist tendencies and return, however gradually, to a free market directive.
My fear is not that we are facing an unyielding and impervious bout of inflation. Higher borrowing costs, dissipation of poorly designed fiscal stimulus, labor saving innovations, and supply chain repair will all contribute to a return to price stability. The real danger for America lies in the fragility of the economy shaped not by market forces but by zero rate policy and quantitative easing.
These are the words of Neel Kashkari, the Minneapolis Federal Reserve Bank president, as he sums up his take on the Fed’s challenge. “If the macroeconomic forces that kept advanced economies in a low inflation regime are ultimately going to reassert themselves, the challenge for the FOMC will be to recognize this as soon as possible so we can avoid needlessly slowing the recovery, while at the same time protecting against the risk of entering a new high inflation regime.”
Investment Portfolio Performance
In the 25 years I’ve occupied a seat in front of my Bloomberg screens, I’ve learned that the American brand of capitalism strays far from the textbook version. Markets and the economy are distorted by monetary policy. Monetary policy is subject to political and financial pressures that often defy the discipline and common sense of a market driven economy.
I’ve watched with increasing distress, the shift from an industrial and service economy to one built upon debt and Fed accommodation. I’ve seen interest income dwindle with each successive round of financial wizardry designed to boost stocks, mergers and acquisitions, and cash-out refinancings. It’s now more a rigged casino than capitalism. The American and global economies are hostage to the printing press and on a collision course with a financial reckoning. Central banks around the world hold $32 trillion in debt on their balance sheets. They’re all looking for the safe off ramp.
Financial repression has assured that fixed income investors, you, and me, will suffer declines in market values during economic cycles, with little investment income to offset the risk.
For public funds investors, the effects of financial repression will be evident in GASB reporting and account statements.
It’s imperative to remember that changes in market value do not represent realized losses, nor do they reflect a high level of risk. It’s also important to remember we have been through a similar market whipsaw only a few years ago.
2022 will likely be a tumultuous year. ICM will be here to help make sense of the market and economic gyrations ahead. There will be no pretense of certainty leading to absurd prognostications. We will provide the clearest guidance and analysis our decades of experience can provide. We’ve been here before. We’ll be here for you in 2022 and beyond.
The opinions presented within this white paper are the viewpoint of Institutional Capital Management, Inc. (ICM) at the time of distribution and are subject to change. The information contained is prepared from data sources generally believed to be reliable and available to the public, but no representation is made as to accuracy or completeness. This white paper is for general information purposes only and is not intended to provide specific advice or recommendation, nor is it an offer to purchase or sell any securities.
ICM is registered with the Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940. ICM clients include city and local governments, hospitals, and similar public funds investors. www.thinkicm.com