Thursday, April 15, 2021

Outcome Rather Than Outlook; Reacting Rather Than Preempting

The Fed I: Backward Looking. Just in case we didn’t get the Fed’s memo on the change in its monetary framework, Fed Governor Lael Brainard explained it very clearly in a speech on March 23 titled “Remaining Patient as the Outlook Brightens.” Throughout her talk, she stressed very important distinctions in meaning between “outlook” and “outcome” and between “preempting” and “reacting.” She concluded her speech with her punchline: “By taking a patient approach based on outcomes [emphasis added] rather than a preemptive approach based on the outlook, policy will be more effective in achieving broad-based and inclusive maximum employment and inflation that averages 2 percent over time.”

Brainard acknowledged that the efforts of public health, fiscal, and monetary policymakers “have contributed to a considerably brighter economic outlook.” However, she stated that the Fed’s “reaction function” had changed in response to the pandemic. The Fed governor explained: “The FOMC has communicated its reaction function under the new framework and provided powerful forward guidance that is conditioned on employment and inflation outcomes. This approach implies resolute patience while the gap closes between current conditions and the maximum-employment and average inflation outcomes in the guidance.”

In effect, the Fed’s policy responses will be backward looking rather than forward looking. In an April 11 interview on CBS 60 Minutes, Fed Chair Jerome Powell reiterated this message as follows:

(1) Inflection point. He started with a very upbeat outlook: “What we’re seeing now is really an economy that seems to be at an inflection point. And that’s because of widespread vaccination and strong fiscal support, strong monetary policy support. We feel like we’re at a place where the economy’s about to start growing much more quickly and job creation is coming in much more quickly.” He concluded the interview by saying “I’m in a position to guarantee that the Fed will do everything we can to support the economy for as long as it takes to complete the recovery.”

(2) Recovery redefined. Got that? The Fed will keep policy ultra-easy until the recovery is complete. But wait a minute—real GDP is likely to be back in record-high territory by the second quarter. It is on the verge of a complete recovery. That’s true, but Powell and Brainard said that “broad-based and inclusive maximum employment” is one of the outcomes they want to see before the Fed starts tightening. Both also want to see inflation moderately above 2%. Powell explained: “And the reason for that is we want inflation to average 2% over time.”

(3) Fed funds rate staying put. Once the Fed achieves this outcome, “that’s when we’ll raise interest rates,” Powell said. When asked whether interest rates might remain unchanged around zero through year-end, Powell said, “I think it’s highly unlikely we would raise rates anything like this year, no.”

The Fed II: Ghost of Greenspan Past. What about asset inflation? In his interview, Powell was asked about it and responded: “[W]e do look at asset prices. And I would say, you know, some asset prices are elevated by some historical metrics. Of course, there are people who think that the stock market is not overvalued, or it wouldn’t be at this level. We don’t think we have the ability to identify asset bubbles perfectly. So … what we focus on is having a strong financial system that’s resilient to significant shocks, including if values were to go down.”

What about Archegos? This hedge fund, disguised as a “family office,” blew up earlier this month when its speculative bets in the stock market crashed and burned, leaving billion-dollar craters in the earnings of a few of its brokers. Powell’s response gave me an unsettling sense of déjà vu all over again. He said:

“This is an event that we’re monitoring very carefully and working with regulators here and around the world to understand carefully. What’s concerning about it … and surprising, frankly, is that a single customer, client, of one of these large firms could result in such substantial losses to these large firms in a business that is generally thought to present relatively well understood risks.”

That reminds me of the following remarks by Alan Greenspan for his October 23, 2008 testimony before the House Committee on Oversight and Government Reform at a hearing on the role of federal regulators in the Great Financial Crisis:

“As I wrote last March: those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets’ state of balance. If it fails, as occurred this year, market stability is undermined.”

During his Q&A exchange, Greenspan acknowledged the error of his ways: “I made a mistake in presuming that the self-interest of organizations, specifically banks and others, [was] such [that] they were best capable of protecting their own shareholders and their equity in the firms.”

(For more thoughts regarding that testimony, see my 2020 book Fed Watching for Fun and Profit, particularly Chapter 5 titled “Alan Greenspan: The Great Asset Inflator.” Chapter 8 is titled “Jerome Powell: The Pragmatic Pivoter.” When and if I write a second edition, I might have to change that to “Jerome Powell: Another Great Inflator.” His policies have the potential to inflate not only asset prices but also consumer prices.)

The Fed III: New Monetary Policy Approach. All this amounts to a backward-looking, rather than a forward-looking, monetary policy approach. Ironically, all the talking Fed heads now are saying that their “forward guidance” is no longer relevant since that was based on their outlook, which has not been relevant since the pandemic started. What matters now is the outcome, which can only be known after it happens!

Forward-looking guidance has now morphed into backward-looking guidance. In effect, Fed officials are saying, “We’ll let you know when we are ready to raise interest rates after we get the outcome we were seeking.”

Confused? If not, you should be. Now take a deep breath and try to fathom the following Fed speak from a March 25 speech by Fed Vice Chair Richard Clarida:

“The changes to the policy statement that we made over the past few FOMC meetings bring our policy guidance in line with the new framework outlined in the revised Statement on Longer-Run Goals and Monetary Policy Strategy that the Committee approved last August. In our new framework, we acknowledge that policy decisions going forward will be based on the FOMC’s estimates of ‘shortfalls [emphasis added] of employment from its maximum level’—not ‘deviations.’ This language means that going forward, a low unemployment rate, in and of itself, will not be sufficient to trigger a tightening of monetary policy absent any evidence from other indicators that inflation is at risk of moving above mandate-consistent levels. With regard to our price-stability mandate, while the new statement maintains our definition that the longer-run goal for inflation is 2 percent, it elevates the importance—and the challenge—of keeping inflation expectations well anchored at 2 percent in a world in which an effective-lower-bound constraint is, in downturns, binding on the federal funds rate. To this end, the new statement conveys the Committee’s judgment that, in order to anchor expectations at the 2 percent level consistent with price stability, it will conduct policy to achieve inflation outcomes that keep long-run inflation expectations anchored at our 2 percent longer-run goal.”

You can come up for air now.

The Fed IV: By the Numbers. The Fed’s balance sheet continues to expand to infinity and beyond. That’s been happening since the Fed adopted QE4ever on March 23, 2020. Here are the mind-boggling relevant stats since then through the April 7 week:

(1) Assets. The assets side of the Fed’s balance sheet is up $3.0 trillion over this period to a record $7.7 trillion (Fig. 1). The Fed’s holdings of securities is up $3.2 trillion to a record $7.1 trillion. The difference between these two series is composed mostly of the assets held by the Fed’s emergency liquidity facilities, which has declined $167 billion since March 23, 2020 (Fig. 2). It remains $260 billion above last year’s low during the week of February 26.

(2) MMT. Over the past 12 months through March, the US federal budget deficit totaled $4.1 trillion (Fig. 3). The Fed financed 51% of this deficit by purchasing $2.1 trillion in US Treasury securities over this period. As of March, the Fed held a record 25.6% of the total of marketable US Treasury debt (Fig. 4). That’s Modern Monetary Theory (MMT) on speed and steroids.

(3) Notes and bonds. Over the past 12 months through March, the Treasury issued $2,081 billion in notes and bonds (Fig. 5 and Fig. 6). Over that same period, the Fed purchased $1,615 billion in the Treasury’s notes and bonds. It bought them in an effort to keep a lid on bond yields. The 10-year Treasury bond yield has rebounded nonetheless, but it would probably be higher today but for the Fed’s purchases.

(4) Reserve balances. As a result of the Treasury’s record budget deficit and the Fed’s record purchases of securities, the total deposits at all US commercial banks has increased $2.4 trillion y/y to a record $16.7 trillion through the March 31 week (Fig. 7). Another result of T-Fed’s MMT on speed and steroids is that reserve balances with the Fed has jumped $1.2 trillion y/y to a record $3.9 trillion during the April 7 week (Fig. 8). That well exceeds the impact of the previous three QE programs on reserve balances.

(5) The others. Meanwhile, the assets on the ECB’s balance sheet also continue to soar. During the April 2 week, this series was up €2.3 trillion y/y to a record €7.5 trillion (Fig. 9). The BOJ’s assets rose 18% y/y to a record ¥714 trillion during the March 26 week (Fig. 10).

I also track the assets of the People’s Bank of China (PBOC). However, we believe that China’s bank loans data are a more useful measure of the PBOC’s ultra-easy monetary policy since the Great Financial Crisis. From the end of 2008 through March 2021, they are up a staggering $23.3 trillion from $4.4 trillion to a record $27.7 trillion (Fig. 11). Over the past 12 months through March, these loans are up a record $3.1 trillion (Fig. 12).

All together in US dollars, the assets of the Fed, ECB, and BOJ are up $6.9 trillion y/y through the March 26 week to a record-high $23.1 trillion (Fig. 13 and Fig. 14).

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