Market Review Q123: Reading the Monetary Tea Leaves
The strong first quarter for the S&P 500 belied a lot of thrills and spills for other parts of the market. Banks were ground zero for most of the problems, but stress also radiated out through rates and currency and many less visible asset markets.
One of the clear messages for investors is that policy responses matter. The S&P 500 bottomed shortly after Silicon Valley Bank failed, but then quickly rebounded. The lesson being: In this age of activist central banks, the best assumption is somebody will do something when something breaks. As a result, gauging potential policy reactions is every bit as important as analyzing fundamentals.
What is the Fed doing?
Of course, this activist tendency of central bankers emerged long ago. After great strides were taken to stanch the market decline during the GFC, the Fed took a liking to its newfound freedoms and maintained extra-easy monetary policy for another twelve years. In doing so, it fundamentally transformed its role from monetary supervisor to financial asset facilitator.
More recently (just a year and a half ago), the ten-year Treasury yield was only a little over 1% while inflation was breaking solidly into mid-single digits. Later in the fall, almost overnight, the Fed’s role flipped from facilitator to inflation fighter.
The transformation caused a great deal of consternation, and rightly so. It’s hard enough for investors to get the economic fundamentals right. It’s far harder to nail both the fundamentals and the Fed’s sometimes cockamamie policy response to them.
A common explanation for the Fed’s occasional unpredictability is incompetence. I’ve certainly done it myself. It quickly becomes evident, however, that calling the Fed names doesn’t help anything. What does actually help is trying to glean insights from the pattern of Fed policy actions.
On the first point, it’s not hard to deride the Fed’s performance in setting monetary policy. The deflation of the Great Depression and inflation of the 1970s and early 1980s stand out in history as colossal mistakes. More recently, the extended period of Quantitative Easing (QE) after the GFC is increasingly looking like recklessness and the complete misread of inflation in the summer of 2021 as gross incompetence. There are countless other examples.
What is interesting is the Fed is not even built for performance. There are no systemic processes to ensure performance. There is no accountability. There are no regular performance evaluations. There are no formal feedback mechanisms on current policy. There is no devil’s advocate function. The culture is not one of curiosity and humility but one of arrogance and aloofness. Given these preconditions, if the Fed did happen to execute monetary policy in an incredibly competent way, it would almost have to be by luck.
This crumbly foundation for competence is further weakened by the fact that multiple, and often inconsistent, objectives have been assigned to the Fed. We are all aware of the explicitly stated objectives of price stability and full employment, but interpretations of both vary. In addition, while financial stability is not listed explicitly as an objective, it clearly is considered one in practice.
The way in which these often-competing goals get resolved is a function of starting conditions and the preferences of decision makers. As a result, the range of possible outcomes from this monetary amalgamation is vast. It is just not designed for consistent, high-quality policy.
The broader mandate
What is the Fed designed for then? Whose interests does its kludgy design and conflicting goals best serve? The simplest, most obvious answer is the interests of the political class.
As such, it is best to think of the Fed’s job as that of doing monetary policy while also serving other political goals. The conflicting goals allow politicians enough flexibility to bend the Fed’s mandates in ways that support any given administration’s policy trajectory while still ostensibly conducting monetary policy. In this case, the Fed acts as a facilitating agent. Its imperfections are not so much a bug as a feature.
Let’s look at the Fed’s decision to start raising rates in early 2022. Inflation had started heating up early in 2021 and the Fed pretty loudly dismissed the threat of inflation as being “transitory” and maintained its position of keeping rates low.
Later in 2021, the Fed completely reversed its assessment of inflation and abandoned the characterization of “transitory”. By early 2022, it had set out on a path to not only substantially raise rates, but also to begin Quantitative Tightening (QT). What changed?
While part of the problem was the Fed’s own flawed analysis of inflation, the main thing that changed was politics. Higher prices were eroding the real income of a core base of voters. After Russia invaded Ukraine in early 2022, oil and gas prices shot up. As it turns out, those are extremely visible reminders of inflation to most people. Finally, midterms were coming up later in 2022. In short, the Fed’s views on inflation changed when inflation became a political problem.
While this is only one example, it demonstrates how the rationale of monetary policy decisions can be illuminated by including a political calculus. Tradeoffs that are difficult to understand from an exclusively monetary position can be clarified by including the priorities of political authority.
While the intrusion of politics into monetary policy is not uncommon, it is probably fair to say its magnitude at the Fed has not been fully appreciated for some time. After the GFC, Congress was rendered largely impotent due to bitter partisan divisions. In its stead, the Fed was considered, “the only game in town”. Those were good times for central bankers.
Covid changed things. First through lockdowns and then through stimulus checks direct to consumers, government quickly became much more active than it had been for years. Both in terms of fiscal policy (i.e., spending) and broader public policy, government became more active and more proactive.
It is instructive to apply the mental model of the Fed as a facilitating agent in this new landscape. In doing so, the concern is not so much with monetary policy per se. Rather, the effort involves working backwards by identifying the political goals that are most consistent with observed Fed actions. By revealing political and policy motivations, we can better understand monetary machinations.
So, what are some of the problems that are likely to be on a public policy “to do” list that are also related to monetary policy? Unsustainable growth in debt threatens the country’s financial condition. Shadow banking and asset-backed securitizations move lending outside the purview of regulatory authorities. Cryptocurrencies facilitate unsanctioned and/or illegal activities.
While none of these items have been on the front burner of issues to be addressed by public policy in the past, it’s easy to understand why it’s likely they are now. With the increasing hostility between the US and China and Russia, and the increasing use of financial and economic warfare, each of these items has also become a threat to national security. As a result, they move straight to the top of priorities.
Interestingly, a big part of the answer to these problems is higher rates. Debt grows faster when it’s cheap. If you want to slow it down, make it more expensive to borrow. Shadow banking exploded during the era of low rates because investors chased yield. That gets reversed by offering more competitive rates on US Treasuries. Higher rates and greater regulatory scrutiny also undermine much of the attractiveness of cryptocurrencies.
What all this does is provide insight into how tradeoffs are made. From a purely monetary standpoint, for example, it would be fair to expect the Fed to loosen its grip on policy as soon as signs of economic slowing and credit contraction begin to emerge.
Insofar as higher rates are an important plank of national security, however, it is easier to see why the Fed might want to keep rates higher for longer. From that perspective, the benefit of improving financial system resilience could be worth the cost of a little unemployment.
The case of the failures of Silicon Valley Bank and Signature Bank New York in the first quarter also provides some interesting insights. A conventional perspective would suggest the bank failures were simply a function of rates being kept too high for too long. It’s only a matter of time before something breaks, and break it did.
According to this line of reasoning, the solution is simple. Just stop doing what caused the problem. Lower rates, stop QT, and restart QE. Pundits everywhere have been advocating exactly this position.
Such a broad-brush policy reversal overlooks the newly prominent priorities of financial system resilience and national security though. According to those priorities, there is a lot more work to do to pare back debt growth and there has barely been any impact yet on the shadow banking and asset-backed securitization sectors.
As a result, monetary policy has been far more constrained in its options. Not only was policy needed to stop the bank runs initiated by the run on Silicon Valley Bank, but it needed to do so without materially changing the course set by higher rates and tighter liquidity.
The answer, in the form of the Bank Term Funding Program, largely accomplished this. As Steven Kelly explains in a terrific blog post, the BTFP is very different from, and more limited than its predecessor emergency response, Quantitative Easing (QE):
Thus, despite the generosity of the BTFP’s par valuation, its market-based pricing means the Fed is effectively just helping banks term out their losses. Instead of being forced to sell today, the banks are just paying funding costs higher than the asset yield.
This shows the BTFP’s resolution framework to be far more constrained than outright QE and much more surgical in addressing the threat to stability. As such, it reveals a very different set of policy priorities than those in the aftermath of the GFC.
After the GFC, the Fed persisted with exceptionally loose monetary policy and in doing so, essentially forced investors to follow the Fed’s cues. Since then, the Fed’s policy direction has become much harder to predict. Now, investors must anticipate Fed policy responses even as they have become more uncertain.
One way of trying to resolve the uncertainty is by examining higher level public policy objectives and determining how they might influence the tradeoffs involved in monetary policy.
This is especially relevant today as higher interest rates are beginning to put the skids on many parts of the economy. From a purely economic perspective, the signs point to caution.
Economics is not the only consideration here, though. Rather, as the confrontation between the US and Russia and China has ratcheted up, so too have public policy priorities evolved. Along with financial and economic warfare has come much greater scrutiny of weaknesses in the financial system.
As a result, monetary policy has taken on a decidedly tougher tone. The bottom line is, if you want to read the tea leaves of monetary policy actions and reactions, you need to consider political (and geopolitical) motivations as well.