A fictitious memo to Jay Powell from a 'staffer' at the Fed?
3rd March 2021
By Delft Partners
This note is a request to change course and is based on our recent thinking done in the underground bunkers at The Fed. I write as the anointed message bearer akin to the mouse told to tie the bell on the cat.
In the last 6 months the yield on the 10 year note has risen from 70 bps to approximately 150 bps. This move should give us policymakers pause to reflect. For 25 years now, as you all know, we at the Fed, have essentially run an asymmetrical approach to interest rates and in the guidance of policy to the markets. Always lower if we can and very slow to raise and then never back to where we were. We have thus succeeded in bringing down the cost of government and corporate borrowing to very low nominal levels and probably negative in real terms for several years. We can count this as a success. We now however find ourselves at the expected cross roads. We may have gone too far and there are risks in continuing this monetary policy. To quote Keynes, "Once doubt begins, it spreads rapidly". We need to decide where we go from here; now.
Our policy over 25 years has produced and reinforced moral hazard. Monetary issuance at every sign of asset price decline, GDP shortfall, or one-off supply side benefit, has created an unprecedently large balance sheet for the Federal Reserve Bank system, potential instability in the US $, and therefore possibly an enormous burden on future US tax payers.
The consequences of this enormous balance sheet and monetary issuance can be seen in the elevated price of stocks, bonds, real estate, and more worryingly in the steadily lower quality of capital allocation and business formation. The only way current asset prices can be sustained is through the continued expansion of our balance sheet and this would jeopardise confidence in our fiat money system.
Unlike one of your predecessors, we think we should act when we can clearly see asset price bubbles and that time is now. Low levels of CPI increases are used by Fed spokesmen as justification for continued loose monetary policy, but every large asset price crash producing economic and social turmoil, also occurred against this backdrop of 'tame' consumer price inflation. We are frankly ignoring plain warning signs elsewhere.
If we do not act we risk losing control of inflationary expectations, which will eventually drive up the cost of borrowing to levels that the government cannot afford, given its now enormous debt, actually projected by the CBO to grow even bigger as a % of the economy. At such loss of control, the market will cease to function to the benefit of the government and the general population, and we would have to consider measures to introduce the compulsory purchase of government debt by the private sector including the banks and pension funds, to keep borrowing costs from ballooning. This would essentially return us to the 1950s when the USA was growing its economy and reducing the debt incurred by WW2 and the cost of the Korean War. This use of capital controls should remain an option but there are consequences; possibly worse than what we propose below.
We therefore propose that we no longer use the Federal Reserve balance sheet as aggressively to try and manage the yield curve. It is our belief that letting longer term interest rates rise a little from here, with a carefully calibrated and scripted policy of "watchful neglect", will have the dual benefit of reducing inflationary expectations which are now building, and improving the quality of private sector capital allocation through the simple expedient of increasing the cost of capital for business.
We appreciate there are consequences, not the least of which is the scrapping of years of 'academic capital' which have been invested to justify this asymmetrical monetary policy. It is impossible for 'Veterans of Academia' to admit their professional beliefs have come to the end of their useful lives; if they were ever correct in the first place. We will also face examination of, and criticism by, previous Federal Reserve System Chairmen and Presidents many of whom have helped create the monetary policy which has created this bubble. Other consequences of ceasing constant QE will, of course, be declines in the price of some risk assets, and the objection by well-connected investors with powerful lobbying interests, but we all remember that a crucial part of capitalism is that it is based on 'risk' capital.
We now however cannot see a connection between continually inflating the price of an asset and a productivity enhancing investment being thus generated. To quote Keynes again, "…the position is serious when enterprise becomes the bubble on a whirlpool of speculation". In short protecting asset prices from market forces hasn't really worked to the benefit of the economy nor Main Street. It has been essentially 'monetary policy for rich people", as your friend at the NY Fed, John Williams, said recently . We need to return risk to the markets; we need to reduce the speculation.
Therefore this constant QE now needs to be replaced with something fiscal in nature as a transition to avoid a recession and loss of 'animal spirits'. Such an investment to repair and grow the capital stock (including the educational attainment of the general population) would raise the productive potential of our economy and help to reduce the ratio of debt to GDP.
We therefore need to pivot toward a fiscal policy designed to raise wages relative to corporate profits. We can avoid inflation if these wage rises are accompanied by productivity gains which require the aforesaid increase in public and private sector investment. Consequently we suggest you ask your colleagues at the Treasury to produce such a plan which encourages companies to invest in expanding their capital stock, re-tooling and re-training Americans, and to plan for the public sector to do likewise.
This message to the markets can be handled in a way that highlights the successes of our monetary policy and doesn't denigrate those who argued for and implemented it. We can portray it as "mission accomplished stage 1" wherein we have saved the financial system and the global financial system and created the basis for lower interest rates in the long run. We can argue that by acting now, we will spare ourselves from the necessary need to raise further later on, and thus avoid the unemployment costs of the 1980s and its ruinously high interest rates. Stage 2 should be portrayed as a coordinated fiscal policy with investment incentives and higher taxes to drive capital away from speculative activity and toward raising the productive potential of the economy.
Essentially our scripted message should be: "Look what we have done from Alan onward; produced lower interest rates, minimal inflation expectations, a stable financial system, and now we strive for fuller employment through fiscal policy".
We essentially have moved to a "National Industrial Policy" already with "Build Back Better; Buy American" and this would represent an execution of that political slogan.
In short we believe it's time to change our macro-economic policy such that the inevitable increase in long term interest rates is kept to a minimum. Act now and the pain will be less than if we wait.
Please accept this as an independent apolitical perspective.
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