Page 1 of 4 CREDIT BUBBLE BULLETIN Stimulus overkill
Commentary and weekly watch by Doug Noland
Not even a week had passed since European Central Bank president Jean-Claude
Trichet's article, "Stimulate No More - It Is Now Time to Tighten", before
Federal Reserve Bank president James Bullard thrust himself into the debate
with his paper, "Seven Faces of 'The Peril'."
Bullard’s concludes his article thus: "To avoid [the Japanese] outcome for the
US, policymakers can react differently to negative shocks going forward. Under
current policy in the US, the reaction to a negative shock is perceived to be a
promise to stay low for longer, which may be counterproductive because it may
encourage a permanent, low nominal interest rate outcome. A better policy
response to a negative shock is to expand the quantitative easing program
through the purchase of Treasury securities."
The New York Times (Sewell Chan) had a reasonable spin on Bullard’s piece: "A
subtle but significant shift appears to be occurring within the Federal Reserve
over the course of monetary policy amid increasing signs that the economic
recovery is weakening. ... James Bullard, the president of the Federal Reserve
Bank of St Louis, warned that the Fed’s current policies were putting the
American economy at risk of becoming 'enmeshed in a Japanese-style deflationary
outcome within the next several years'. The warning by Mr Bullard ... comes
days after Ben S Bernanke, the Fed chairman, said the central bank was prepared
to do more to stimulate the economy if needed ... "
Reading Bullard’s paper - and listening carefully to his comments - recalls
Bernanke’s historic speeches back in late-2002: "Asset-Price 'Bubbles' and
Monetary Policy"; "On Milton Friedman's Ninetieth Birthday"; and "Deflation:
Making Sure 'It' Doesn't Happen Here." Bernanke fashioned the backdrop -
erudite academic justification for aggressive "activist" monetary management -
and today the Federal Reserve appears poised to embark only farther into
perilous uncharted waters. Last month, I presumed that Trichet's stark warning
against further stimulus was in response to market clamoring for additional
quantitative easing from the Fed. It would now appear his comments may have
been directed squarely at our central bank.
"The Peril" in Bullard's title is in reference to a 2001 academic article "The
Perils of Taylor Rules". In simple terms, many accept the thesis that there is
potential "peril" confronting a monetary management regime at the point when
policymakers have lowered rates to near zero - yet the inflation rate remains
stuck in negative territory ("deflation"). Japan is used as a contemporary
example of how policymakers failed to act convincingly to ensure operators
throughout the markets and real economy understood that deflationary pressures
would not be tolerated.
From Bullard: "The policymaker is completely committed to interest rate
adjustment as the main tool of monetary policy, even long after it ceases to
make sense (long after policy becomes passive), creating a second steady state
for the economy. Many of the responses to this situation described below
attempt to remedy this situation by recommending a switch to some other policy
in cases when inflation is far below target. The regime switch required has to
be sharp and credible. Policymakers have to commit to the new policy and the
private sector has to believe the policymaker."
Ten-year Treasury yields dropped to 2.92% on Friday. Benchmark mortgage-backed
securities (MBS} yields sank 15 basis points (bps) in two sessions to 3.49%.
The markets are taking Bullard's talk of a "sharp and credible" regime switch -
quantitative easing two - seriously. The dollar dropped another 1.1% last week
and the CRB Commodities index jumped 2.9 %. The market backdrop is increasingly
reminiscent of the summer of 2007. The initial '07 eruption in subprime incited
market weakness and volatility, an aggressive Federal Reserve response, a weak
dollar and quite a run for commodities markets.
Back in 2002, I thought (and wrote as much) Bernanke's monetary views were
radical and dangerous. He burst onto the scene as the right guy at the right
time to lead an epic battle against the scourge of deflation. I view the period
2001 through 2006 as a historic period of faulty analysis and failed monetary
management. In short, zealous policy measures were implemented from a flawed
analytical framework. While fighting so-called deflation risk, our central bank
accommodated a perilous bubble throughout mortgage and Wall Street finance. The
Fed's "activist" approach was an unmitigated disaster. Bullard's paper
addresses this period from an opposing perspective: "2003-2004 ... This period
was the last time the FOMC [the rate-setting Federal Open Market Committee]
worried about a possible bout of deflation."
From Bullard: "The [St Louis Fed economist Daniel] Thornton analysis emphasizes
how the FOMC communicated during this period, and how the market expectations
of the longer-term inflation rate responded to the communications. At the time,
some measures of inflation were hovering close to one percent, similar to the
most recent readings for core inflation in 2010. At its May 2003 meeting, the
committee included the following press release language: .... 'the probability
of an unwelcome substantial fall in inflation, though minor, exceeds that of a
pickup in inflation from its already low level.' At several subsequent 2003
meetings the FOMC stated that '... the risk of inflation becoming undesirably
low is likely to be the predominant concern for the foreseeable future."
During the three-year period '02-'04, benchmark MBS yields averaged 5.22%, down
significantly from the 7.16% average from 2000-01. The Fed was "successful" in
jawboning rates lower, in spite of the unprecedented surge in demand for
mortgage borrowings. "Activist" monetary policymaking circumvented market
forces, allowing a huge increase in the demand for mortgage credit to be
satisfied at historically low market yields.
Well, you either believe that the market forces of supply and demand should be
left to determine the price (market yield) of finance - or you don't. And you
either appreciate that the price of finance plays a fundamental role in the
effective allocation of financial and real resources in a capitalistic system -
or you disregard this critical dynamic at the system's peril. Inarguably,
Federal Reserve rate policy and communications strategy were instrumental in
distorting market prices (MBS, real estate, stocks, and so forth.) and
perceptions of risk and, in the process, fomenting the great mortgage/Wall
Street finance bubble.
Focusing instead on the general price level, or "inflation", Bullard comes to a
very different conclusion with respect to policy performance during this
crucial period: "In the event, all worked out well, at least with respect to
avoiding the un-intended steady state. Inflation did pick up, the policy rate
was increased, and the threat of a Japanese-style deflationary outcome was
forgotten, at least temporarily. Was this a brilliant maneuver, or did the
economic news simply support higher inflation expectations during this period?"
Regular readers know that I use the terms "Keynesian" and "inflationism"
interchangeably. Inflationism has been an influential concept for centuries;
Keynes just created the most sophisticated and alluring conceptual framework. I
argued against the Keynesians earlier in the decade. The critical flaw in their
theoretical construct is that the Federal Reserve somehow controls "THE"
general price level. This is a dangerous myth perpetuated by those committed to
activist monetary management.
The Keynesians take credit for thwarting the deflationary forces from earlier
this decade. After declining to about a 1% year-on-year rate during the first
half of 2002, inflation was a "safer" 4% or so by 2006. This, it was said,
provided policymakers the latitude they required to ensure the US did not
succumb to the Japanese predicament. In the process, total US mortgage credit
almost doubled in just six years. The aggregate of consumer prices may have
been reasonably tame, but asset prices and economic maladjustment were not. The
Fed used mortgage credit to reflate the system and, not surprisingly, we now
face a much worse predicament.
The problem with inflationism has always been that once it gets ingrained
within the system - in the credit system, the real economy, within market
perceptions, expectations and asset prices - there's just no turning back. The
more protracted the inflationary credit boom - and the more problematic the
associated bubbles - the more unpalatably painful the bust is viewed in the
minds of politicians and central bankers. Historically, it often became a case
of "just one more bout of money printing to get us over the hump". Just get
through the pressing crisis and then it will be time to find monetary religion.
It is the nature of protracted credit bubbles that devastating busts are held
at bay only through increasingly expansive monetary stimulus. Invariably, this
corrosive process destroys the soundness of system debt and the underlying
currency. Too often, a crisis of confidence in private debt incites a dangerous
cycle of public credit ("money") inflation. Commenting on Friday morning on
CNBC, Bullard stated, "In monetary policy, you can never say you're done." This
is precisely the nature of inflationism.
Bullard makes passing mention of bubble risk: "The FOMC's near-zero interest
rate policy and the associated 'extended period' language has caused many to
worry that the [Federal Open Market] Committee is fostering the creation of
new, bubble-like phenomena in the economy which will eventually prove to be
counterproductive. One antidote to this worry may be to increase the policy
rate somewhat, while still keeping the rate at a historically low level, and
then to pause at that level."
When I read (and listen) to such comments from our leading central bankers, I
can only scratch my head and ponder the degree to which they appreciate
financial and economic history - including recent financial crises. Bullard's
paper suggests that the Japanese predicament of long-term substandard growth is
the worst-case scenario for the US economy. It is more likely the
best-case.
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