For decades, the Federal Reserve has run not on a gold standard but on a Ph.D. standard. Academics such as Ben Bernanke and Alan Greenspan thought they could manage the most complex and most important price of the market economy—the interest rate—with a few mathematical equations.
The 64-year-old Jerome Powell could prove to be different, because he has had more practical experience in business and government than Greenspan, Bernanke, and Janet Yellen, who, apart from their time with the Fed, have been academics. Powell is a trained lawyer who made a career in investment banking, private equity, and public service, and has been serving as a Fed governor since 2012.
The main difference between him and his predecessor Yellen? He doesn’t seem to care what the market does and just follows his policy of rate normalization, based on a strong economy and the Fed’s mathematical models.
The first press conference by Powell as chairman of the Fed in March betrayed as much.
Powell was clearly cautious with long-term estimates, an Achilles’ heel of a Fed that consistently missed its own inflation and growth expectations. His response to a reporter on his predictions for 2020 was perfect: The Fed has to monitor the changes that are taking place right now and avoid giving optimistic estimates that only make them lose credibility.
And now, credibility is key, as the Fed doesn’t have much of it left.
Powell was technical, correctly agnostic to stock-market reactions, and exceptionally aware of the risks in a market extremely oriented toward external stimuli.
For market operators, having a new Fed chair with such an unpolitical and market-agnostic profile may not seem like good news. But it is. Too many investors play the “bad news is good news” game. That is, to expect poor macro data so that monetary stimulus is perpetuated.
This carry trade leads market participants to bet on cyclical assets and inflationary themes, while expecting economic stagnation and more expansionary policies. This is dangerous.
What Powell explained is very important, and the path of rate increases is clear. The “buy anything” party is over. And that’s good.
The U.S. economy can absorb a rate-increase path up to 2.75 to 3 percent in 2019 without a problem. In fact, if the economy couldn’t absorb it, we would have to be very concerned about the kind of growth and investments we have.
Will He Blink?
However, with the market down more than 20 percent as of just before Christmas, his resolve will be put to the test.In 2012, writing on what was then the latest round of easy money (in the form of quantitative easing), fund manager
Paul Brodsky said, “After professionally watching Fed chairmen cajole, threaten, persuade, and manage sentiment in the markets since 1982, we argue this latest permutation is understandable, predictable, and, for those willing to bet on the Fed’s ultimate success in saving the banking system (as we are), quite exciting.”
He argued that the Fed’s congressionally mandated objectives of maintaining price stability and full employment are secondary to keeping the banking system solvent.
Given that the Federal Reserve System is
owned by its private member banks, this analysis is not too far-fetched, and borne out by history.
Whenever a financial crisis threatened the banking system (that is, the Federal Reserve System), the Fed and its chair would do whatever it took to save it from collapsing.
Greenspan oversaw the bailout of savings and loans in the early 1990s, as well as of hedge fund Long Term Capital Management (LTCM) in 1998, both private-public initiatives greased with Fed liquidity, loan guarantees, and lower rates. The bailouts led to what economists call moral hazard, in which participants think they can take excess risk because they will be bailed out.
“When LTCM was rescued, there was a general thought: ‘Hey, these guys are on the job if we screw up. They’ve got our backs,’” said Barry Ritholtz, chief investment officer at Ritholtz Wealth Management.
Easy financial conditions enabled the tech bubble of the late 1990s, and Greenspan again juiced the markets after the tech bubble popped and the economy suffered a relatively mild recession in 2001.
This led to another round of moral hazard and the subprime bubble, which popped in 2007, and, in turn, led to a real financial crisis and a harsh recession in 2008–2009.
After taking over in 2006, it was Bernanke’s job to announce zero interest rates and quantitative easing programs, and to broker various bailouts for insolvent banks by other banks or the federal government.
Contrary to the Fed’s narrative, the banking system could have been restructured in a different way, one that would lead to less moral hazard in the future.
“Let’s use Bank of America as an example,“ said Ritholtz. ”Bank of America gets nationalized, which really means Uncle Sam provides debtor-in-possession financing. This is really what happens normally with small companies. Someone who takes them out of bankruptcy gives them some operating money to keep functioning. The equity gets down to zero—senior management out the door. There is certainly a layer beneath, which can get promoted without a problem.”
In comparison, Yellen’s job was relatively easy: She just had to make sure rates didn’t rise too quickly as to cause stock and bond markets to crash, and hope there wouldn’t be an external shock (for instance, China) on her watch that would push the fragile system over the brink.
Unfortunately for Powell, he’s now in the hot seat when the next recession or financial crisis hits, and hit it will. Then, his background in business will cease to matter, and he'll probably continue the unofficial Fed policy of keeping the banking system afloat, just like his predecessors.
This article is part of a special Epoch Times series on the Federal Reserve. Click here to see all articles. Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.
