Faced with a choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy with the proof.

J.K. Galbraith

I’ve learned so much from my mistakes, I’m thinking of making a few more.

Anonymous

I was prepared to dislike our new Fed Chairman, Kevin Warsh. His past track record at the Fed stood out for all the wrong reasons. He was the resident hawk, remaining that way even after the deflationary shock of the 2008 financial crisis. He wrote a Wall Street Journal Op-Ed in 2010 that seemed overtly political, criticizing the Obama administration’s fiscal, trade and regulatory policies. It wasn’t so much what he said – I didn’t particularly care for the Obama administration’s policies either – but more how he said it and where. Monetary authorities need to stay in their lane and avoid even the appearance of political favoritism. In that opinion article Warsh laid out a very supply side view of the economic malaise, as he called it, of the post financial crisis era. Supply side economics is generally associated with Republicans so it was perceived as a partisan piece. So, being appointed Fed chair by a President who has made it clear what he expects from monetary policy, seemed a bit worrisome. 

Warsh hasn’t been on the job long and I’m not ready to anoint him as the second coming of Walter Bagehot*, but I’ve spent the last week thinking I may have misunderstood and misjudged Mr. Warsh. I am not a fan of central banking, seeing it as the central planning nose under the flap of the free market tent. I am of the opinion that an appointment to the Fed ought to come with a gag order, a huge dose of humility and a preternatural ability to do absolutely nothing until absolutely necessary. The Fed was formed in the wake of the Panic of 1907, when J.P. Morgan and National City Bank (which over the years evolved into Citibank) acted to resolve the Knickerbocker Trust run. The original purpose of the Fed was to be a lender of last resort, to make sure the US was no longer dependent on a private citizen to resolve a banking crisis.

The Bagehot dictum provides the guide for what central banks ought to do in those situations: lend early and freely to solvent firms, against good collateral, and at a high penalty rate. And that’s how the Fed operated for the first few decades of its existence. Over time it moved steadily away from its original purpose and eventually developed into the macro-economic micro-manager we have today. It has not done a good job of it in my opinion but given the legal boundaries it has been given it would be hard to go back to just being a lender of last resort. Still, I think the Fed needs to adhere to a monetary Hippocratic oath to, first, do no harm. The Fed that has emerged over the last 15 years, in the wake of the 2008 crisis, has, in my opinion, turned that on its head, doing harm on a near daily basis. For most of this century the Fed also seems to have forgotten all but the first four words of Bagehot’s dictum – lend early and freely. 

There have been two big changes in the conduct of monetary policy in the last 50 years. The first was the Federal Reserve Reform Act of 1977 when it was given its “dual mandate”, to promote maximum employment and stable prices. The problem with the mandates is that the Fed’s control over either of those variables is rather limited. Monetary policy has been used for years to try and smooth out the business cycle with, to be generous, mixed results. But no matter how successful those market interventions it doesn’t change the fact that long term employment and wage growth are driven by structural factors like demographics, immigration, technological innovation, education, labor laws and fiscal policy. Any Fed impact on employment is likely to be overwhelmed by other factors.

The Fed’s ability to control inflation in the current system is also limited. The Fed has little control over money supply; money creation is mostly endogenous, emanating from commercial banks in response to the demands of the real economy. The Fed has some control over the price of money but the Fed doesn’t “print money” the way most people think. For the Fed to determine the value of our money – which is what inflation is really about – it would have to have some control over both the supply of and the demand for dollars. The truth is that the Fed has little control over either. It can and does certainly influence both, but it doesn’t have control. 

The other big change was Bernanke’s insistence that the Fed be far more explicit about its deliberations by providing forward guidance. They did this through constant speechifying and the introduction of the so-called ‘dot plot’—a chart mapping individual members’ guesses about future growth, inflation, and interest rates. Markets responded to this extreme openness by pricing in future policy changes today. Rather than reacting to the real economy, bond traders began reacting to the Fed, parsing every statement about the future as if it were handed down from on high. Market interest rates effectively became the collective opinion about the opinion of the Federal Reserve. Before forward guidance, the bond market provided a wisdom-of-crowds view on the state of the economy. After forward guidance, it simply provided a wisdom-of-crowds view on the ignorance of central bankers.

The Fed used this communication policy in conjunction with QE in the years after the 2008 crisis in an effort to induce a better economic recovery and to try and raise the inflation rate to its target of 2%. What Warsh argued in that long ago Op-Ed was that the lack of growth was a supply side problem and that the Fed couldn’t do much about it:

Monetary policy also has an important role to play. However, the Federal Reserve is not a repair shop for broken fiscal, trade or regulatory policies. Given what ails us, additional monetary policy measures are poor substitutes for more powerful pro-growth policies.

And he was right about this; QE and forward guidance had a big impact on the markets, especially stocks, but it didn’t raise economic growth and it didn’t get inflation up to target. The average year over year change in Real GDP in the 10 years prior to 2008 was 3.1% and in the 10 years after the crisis, during the golden age of QE and forward guidance, the average year over year change in real GDP was 1.7%. The average year over year change in the CPI was 2.6% before the crisis and 1.8% after the crisis. But that doesn’t mean the policies had no impact. After the crisis, Bernanke believed that forward guidance and QE would raise stock prices and a wealth effect would create a “virtuous” circle that would spur economic growth. He expected lower interest rates to encourage corporate investment and other forms of risk taking. What happened instead is that companies used lower interest rates to fund stock buybacks, dividends and M&A. Private equity used low rates to fund leveraged buyouts across multiple industries. Investors took the guarantee of accommodative monetary policy as a green light to speculate on anything and bet on everything. Forward guidance and QE created the mother of all moral hazards.

And now Kevin Warsh appears determined to end forward guidance and reduce the Fed’s market footprint by shrinking the Fed’s balance sheet. Indeed, he has already ended forward guidance and raised quite a ruckus in the process. Economists, traders and Wall Street analysts are not happy with the change which I guess makes sense as having the Fed chair tell you what to think about the economy is a damn sight easier than figuring it out yourself. I have good news for them though. Forward guidance was always only as good as the Fed’s forecasting track record which, as it turns out, was pretty darn bad. If fact it was so bad that the word “transitory” is no longer spoken aloud in the Marriner Eccles building. With the Fed out of the public forecasting business, the markets will now return to their former role as the best forward economic indicator available. No, it isn’t infallible – the crowd isn’t always wise – but it will be right a lot more than the Fed ever was. 

Warsh hasn’t yet started on reducing the size of the Fed’s balance sheet but we know that’s on the agenda because he’s spoken about it in public repeatedly. He has said that the Fed’s balance sheet suffers from “mission creep” and has been used improperly to, among other things, accommodate fiscal policy and influence the housing market by holding mortgage backed securities. He also argued that QE is an emergency tool, not permanent policy and said as early as 2010 that it had passed the point of diminishing returns. If you’ve been paying even casual attention to Fed policy the last 15 years, you know he’s right. He wants to return the Fed’s balance sheet to all Treasury bills and has also discussed a change in the current abundant reserves system which he believes distorts short term funding markets and insulates banks from market discipline. He’s probably right about that too but getting to where he wants to go is not going to happen quickly or smoothly.

What does all this mean for investors? Over time I would expect:

  • A return to more normal term premiums, a rise in long term rates and a steeper yield curve.
  • More volatile interest rates which in turn will mean more volatility in other markets.
  • Higher interest rates will likely reduce stock valuations. Stock performance will be more about earnings growth and less about multiple expansion. Returns will likely fall to closer to NGDP growth, plus dividends (mid to high single digits). 
  • Growth stocks and other long duration assets will suffer while companies generating near term cash flows (short duration) will be relatively better off (value and quality).
  • Higher bond rates will offer competition for low yielding common stocks.
  • Banks, especially regional banks, should be a beneficiary of a steeper yield curve. 

In short, fundamentals will matter again and I think that is good news.

It was always going to take a fundamental change in monetary policy to start to end this era of speculation and gambling and I think Kevin Warsh is off to a great start. I do wonder though, what happens when President Trump discovers that Warsh sees his job more like William McChesney Martin Jr., than Arthur Burns. Martin once said:

The Federal Reserve… is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.

Burns, on the other hand, is the guy who did a President’s bidding and unleashed the inflation wave of the 1970s. 

I don’t know what Kevin Warsh will do with the rest of his term as Chairman of the Federal Reserve but he’s off to a good start.

Joe Calhoun 

*Bagehot was the Editor in Chief of The Economist for 16 years starting in 1861.