An unsurprising swan song
The confidence of market participants in the US’s Federal open market committee’s predictability is now a binding contract
On 12 December, Janet Yellen, the chairperson of the Federal Reserve Board in the US, presided over her last meeting of the Federal open market committee (FOMC). The FOMC raised the Federal funds rate by a well-telegraphed 25 basis points and signalled that about three more rate hikes of 25 basis points each were likely in 2018.
She could have gone down in history in a better way had she persuaded herself and her colleagues to raise the Federal funds rate by 50 basis points. That was not to be. Therein lies a big part of the answer to the question of why just under a decade after the biggest financial crisis since the World War II, the world faces a “bubble in everything” (in the words of John Authers of the Financial Times).
In the first week of December, the Bank for International Settlements (BIS) released its December quarterly review. Claudio Borio, its chief economist, said policy predictability and transparency had compressed risk premiums as investors felt confident that they would not face monetary policy surprises. That results in excessive risk-taking, build-up of debt and speculative positions in financial markets. The BIS had a chart that showed that financial conditions tightened after the aggressive FOMC rate increases in 1994-95. They tightened only marginally in the next interest rate hiking cycle of 2004-06. In the current cycle, financial conditions have actually become easier since the FOMC ended its purchase of assets in 2014 and began to raise interest rates from December that year.
Borio wondered if rate increases would be effective if financial conditions eased consequently. Of course, he failed to spell out the obvious answer.
To make rate increases achieve their intended goal of tightening financial conditions, the FOMC must do more and do policy differently. That is what James Mackintosh wrote a month earlier in The Wall Street Journal. He said that the Federal Reserve was poisoning the market with its transparency and that the best antidote to its own poison was to surprise the market with a rate hike that was unexpected in terms of timing and magnitude, without even the courtesy of a press release following the action. Financial market types would throw a fit but that is precisely the point of the suggestion and a test of success of the exercise. Unfortunately, the confidence of market participants in the FOMC’s predictability is now a binding contract.
A benign interpretation of the obsession of the FOMC with ensuring that its actions are aligned with expectations in financial markets is that it’s concerned about negative reaction in financial markets spilling over into the real economy in terms of slower economic growth and job creation. But financial market exuberance until 2016, engineered by the FOMC’s extremely generous provision of liquidity and costless capital, did not result in meaningful gains in economic activity. Manufacturers’ new orders for non-defence durable goods (excluding aircraft) contracted throughout the second term of President Barack Obama. An index of confidence among small businesses languished at recessionary levels. No matter whether media covered it or if so-called experts acknowledged it, both of them have begun to register positive gains since the Donald Trump administration began to deregulate.
Now, in anticipation of the tax cuts, the hiring intention of small businesses is at its highest level since 1983. Aggressive action by the FOMC in the immediate aftermath of the financial crisis of 2008 might have been timely and effective but its tight embrace of the crisis-era extraordinary measures well after the crisis has resulted in a bubble in everything from Leonardo da Vinci and impressionist-era paintings and cryptocurrencies to technology stocks.
The extraordinary rise in the price of bitcoin is a fitting finale to nine years of monetary policy experimentation that has brought the world to the edge of another potential crash in asset prices with unpredictable consequences. As the legendary and successful investor Stanley Druckenmiller said in a recent interview with CNBC, the inability and unwillingness of the Federal Reserve to break free of the preferences of financial markets, and the consequent creation of asset bubbles, will bring about the very deflationary outcome that the FOMC is allegedly trying to prevent.
I wrote at the end of 2016: “In sum, in 2016, risks materialised but stock markets and investors chose to whistle past them. It still is a matter of time before they wake up to the laws and loss of gravity.”
I wrote at the end of 2015: “We expect that global political and economic risks would come to a head in 2016. Put differently, the risk that the year would prove to be a rather long one than a normal one is higher, in our view.”
Both have been premature. No fundamental analysis can stand up to the force of such massive sums of money that feed investor myopia, greed and speculative instincts. But fundamental analysis is what we know and that is what we stick to. It would be folly to wade into areas where one’s ignorance dominates knowledge. If we do so, we would be aping the behaviour of investors. Simply put, that path looks more dangerous than it ever did—even more than it did in 2008.
On that note, I wish readers a happy, healthy, prosperous and peaceful 2018. See you next year.
V. Anantha Nageswaran is an independent consultant based in Singapore. He blogs regularly at Thegoldstandardsite.wordpress.com. Read Anantha’s Mint columns at www.livemint.com/baretalk
Comments are welcome at firstname.lastname@example.org
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