The Fed was on a good path last year. After nearly a decade of punishing savers with zero and ultra-low interest rates, Chairman Jerome Powell oversaw a move toward more normal monetary policy. From his start in January of last year through December, the Fed hiked interest rates a total of four times and allowed its asset portfolio to fall by about $325 billion.
Over Bernanke’s eight years at the helm of the Fed, interest rates were increased a grand total of three times. Yellen wasn’t much better. It took here four years to get in five hikes. Powell did four in one year.
Powell’s more humble and pragmatic approach to monetary policy had been a refreshing change. Had been, because it seems Powell has either had a change of heart, or he was pressured to flip on policy by colleagues at the Fed.
Powell increased rates in mid-December and told the public there were more hikes to come in 2019 with the Fed’s balance sheet roll-off staying on auto-pilot. Then, only a couple weeks later at a conference in early January (not so ironically with Yellen & Bernanke on stage) Powell turned outright dovish. He told the public, the Fed would be patient and flexible with its balance sheet unwind. Markets cheered the flip.
What changed over the course of about two weeks?
The company line at the Fed is that softening global growth, tame inflation, and uncertainty over the strength of the U.S. economy were to blame. But all three of those factors were true when the Fed hiked rates only a couple of weeks prior.
The Fed Panicked
As we see it, the Fed panicked as the stock market tumbled in late December. What should now be evident to all is that the Fed underestimated the impact of its quantitative easing program on the way up, and quantitative tightening on the way down. It is true the Fed had been winding down the size of its asset portfolio for over a year, but the fourth quarter was the first that global central bank balance sheets started to contract.
It is rather disturbing how fixated the Fed has become with the stock market. Investors don’t need a babysitter. The stock market will take care of itself if you let it. It appeared Powell was on board with that thinking, but his recent about-face argues otherwise.
Implications of the Fed’s Flip
The Fed’s focus on back-stopping equity markets can’t be positive for long-term productivity growth in the U.S. Misallocation and mispricing are being underwritten by Fed policy. The bad actors get bailed out, and the zombie firms are able to survive and suck up capital that could be put to higher and better uses.
The Fed’s obsession with the stock market also likely points to a new paradigm where big boom (bubble) and big bust define every cycle. That has held true for the last two cycles and it’s looking more and more likely for the current cycle.
Lastly, and probably most importantly, the Fed’s focus on financial markets has helped feed the narrative of AOC and company. The top 20% of the U.S. population owns almost the entire stock market. Of course you are going to foment left-wing populism when you continually provide a back-stop to the well-off.
As the late Fed historian Alan Meltzer pointed out in his study of historical Federal Reserve Policy, the Fed’s biggest mistakes have come from focusing too much on monthly and quarterly data and relying on discretion as opposed to a rules-based approach.
Powell is a step-up from Bernanke and Yellen, but emphasis on the long-term implications of Fed policy is still lacking.
Jeremy Jones, CFA
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