by Kevin Flynn
My conclusions from listening to the Jon Hilsenrath interview on Tuesday - the one that tipped the markets off to the inclusion of "a considerable time" phrase in the latest FOMC statement, setting off a big rip-reversal rally in the stock market - include the idea that Hilsenrath is beginning to resemble Tim Geithner. The former's anointment as unofficial Fed market liaison has him sounding so steeped in Fed discussions that he's starting to sound more and more like a junior Fed governor and less and less like a reporter. He has some of the same clipped intonations that Geithner was known for, and is quasi-advocating in the same way that Geithner did. Or so it seems to me.
My more immediate conclusion was that so far as the Fed is concerned,
1) There is no bubble
2) There is no timeline
3) There is no exit strategy
There is no bubble
In his Tuesday pre-meeting webcast - surely staged as the opening act to the Fed's main event on Wednesday - Hilsenrath says "The Fed does not think there is a financial bubble right now." Now that's revealing. It's one thing for central bankers to refrain from saying that some market is in a bubble, a protocol that I support, but it's quite another to come out and flatly say there is no bubble. That's the tail side of the no-bubble accusations coin, and the Fed would be better served by respecting it, especially given their dubious record on the subject.
Hilsenrath observed that the Fed is watching debt carried at financial institutions, keeping an eye on their leverage and on things like leveraged loans (the bank just called Credit Suisse (CSGN) in on the carpet for its practices). I would say that as is so often the case, the generals are fighting the last battle.
Have a look sometime at the FOMC minutes from the October 1999 meeting. It's clear that the biggest concern of the members was inflation, as it dominates the minutes. At the time, the "core" year-on-year PCE rate (the preferred measure) was 1.4%. But everyone on the committee was a veteran of 1970s inflation, and by golly it was not going to happen again, not in their lifetime. As for the equity markets, well, they hadn't yet peaked, though there had been some bumpy weather: "Most measures of share prices in equity markets registered sizable declines over the intermeeting period, apparently reflecting not only higher interest rates but also concerns that U.S. stocks might be overvalued and that foreign equities were becoming relatively more attractive as economic prospects brightened abroad." The largest valuation bubble in U.S. history, greater than the 1929 bubble, and all the bank can say is that apparently there are concerns - in the market mind you, the Fed isn't saying anything - that "stocks might be overvalued."
Nor did the committee seem concerned about another issue about to blow up, the rapidly growing glut of telecom gear. Putting the affair down to "competitive reasons" instead of the massive investment bubble, blithely noting with no trace of worry that other business investment spending "pointed to little change."
Move a year later to the October 2000 minutes, and you will see that the bank is still obsessing over inflation. Core PCE had risen to 1.8%! "Risks still were pointed in that direction" (rising inflation). At this point the committee has noticed that the investment bubble in telecom gear ("business spending for equipment and software") "might be moderating." Yes, it did moderate. In fact it crashed, and a recession began six months later. The Nasdaq was getting hammered at the time of the meeting, and the S&P was about to roll over. The committee's outlook: "Looking ahead, they generally anticipated that the softening in equity prices and the rise in interest rates that had occurred earlier in the year would contribute to keeping growth in demand at a more subdued but still relatively robust pace." The committee left rates unchanged.
Fast forward to September of 2007. The economy was clearly in trouble at this point ("the housing sector remained exceptionally weak"), three months away from the official beginning of the recession. Bernanke surprised traders with a cut of 50 basis points instead of 25, leading to a peak in the S&P 500 the following month. The minutes are full of participant concerns about deteriorating financial conditions. Even so, the staff projected that "growth of real GDP was projected to firm in 2009 to a pace a bit above the rate of growth of its potential." That came three months before the official onset of the recession.
In September of 2006, "All meeting participants expressed concern about the outlook for inflation" (core PCE was running at 2.4%). As for the non-existent housing bubble deflating, "Many participants drew some comfort from the most recent data, which suggested that the correction in the housing market was likely to be no more severe than they had previously expected and that the risk of an even larger contraction in this sector had ebbed," though "further adjustment in the housing market appeared likely."
If you still feel good about the Fed seeing no bubble, then in the immortal words of Jules Winnfield (Samuel Jackson in Pulp Fiction), "allow me to retort." The Shiller PE is at levels above every other time but 2007, 2000, and 1929. The S&P price-to-sales ratio is at 2000 levels. Tobin's Q is above every historic level but the tech bubble, and my favorite, the ratio of market cap to GDP, almost up to the level of the peak of the tech bubble:
(click to enlarge)
But there is no asset bubble, you see, because banks aren't as leveraged and the Fed is still fighting the last battle. Put me down with Mohamed El-Erian, who tweeted after the meeting that the "steady as she goes" Fed "supports recovery upfront, underwriting bigger risk of financial instability."
One of the other sentiments that came through in the Hilsenrath interview was the traditional central banker disdain for markets. Hilsenrath was clearly echoing committee sentiment when he complained disdainfully that everyone wants to know "when when when" and that "a lot of them have a trade on." That's true - quite a lot of them do have a trade on and are most interested in how to trade (bizarre behavior for a financial market, I know, but these things can happen in the best of countries). But a fair number also happen to be of the Keynesian/New Keynesian persuasion (e.g., El-Erian - monetarists are not in favor at the Fed) and understand market dynamics and imbalances far better than any members of the committee.
Some of the disdain is understandable. The models that pepper Fed policy and discussion papers are forbiddingly complex to look at, full of Greek symbols and heavy-duty applied calculus and algebra. Even if you do this stuff for a living, it can take quite a bit of serious effort to work out whether a model might be making sense, and to seriously check it takes more time than most researchers have. Once one has sweated out the current dynamic general-equilibrium model favored by the Fed, opening up the Wall Street Journal to read about the latest insider-trading jail term, or putting on a business news channel and hearing one of the fruitier ideologues rant about lunar eclipses being faked to sabotage the price of (fill in commodity name), it can color one's view of the world.
But much of the disdain is sadly misplaced. It's better here than in Europe, where the market is looked at as entirely made up of crooks and morons - here they are looked at as only some crooks and many morons - but having been stripped utterly naked and left in the gutter by the markets twice in the last fifteen years hasn't seemed to help the bank's sense of superiority. It's unfortunate. Indeed, much of the Fed work subsequent to the last two crashes has been devoted to finding esoteric "hidden" factors behind them that let the bank off the hook in one way or another.
I applaud the work the Fed is doing to rein in leveraged loans. The macro-prudential approach that was conspicuously absent in the last bubble is being applied now in the more obvious areas, but the risk isn't ever likely to be concentrated in the same place twice in a row. I suggest listening to the Grosses, El-Erians, Einhorns and Buffetts now and then. Just because they make more money than you doesn't mean they're all venal and stupid. In fact, all of the four but Buffett can read the models, and he would just laugh if you asked.
There is no timeline
The "considerable amount of time" wording was left in, as you all must know. However, the "dots" diagram (individual member rate projections) gave the show away - most participants expect the funds rate to be at or above 1% by the end of next year. Yellen was well prepared for this one, and was at her professorial best at repeating "central tendency" and reiterating that the Fed will read the data and react (what is the over-under, I wonder, on the number of times a Fed chair nods vigorously during a press conference?). So there is a central tendency timeline - that for the moment the committee refuses to divulge. I am sure that last year's "temper tantrum" and this year's "six months" gaffe have nothing at all to do with avoiding the timeline subject.
More likely is that with QE ending, Yellen wanted to throw the doves a bone, as I wrote last week, and so left in "considerable amount of time" until the next meeting, or so Hilsenrath seemed to indicate. Maybe October will see a change to "foreseeable future," or "until conditions dictate otherwise," or some other variation on Halloween magic.
There is no exit strategy
That may seem unfair, as the Fed did lay out a general battle plan for what to do once it decides to embark on the rate-raising path (Hilsenrath had the inside position there too). It just won't divulge what triggers the decision. Yellen did make one meaningful comment, that "full employment" equates to an unemployment rate of 5.2%-5.5%. If the FOMC had made reference to this band before, it was news to me.
However, the committee hasn't yet decided between the "soon and slow" and "late and fast" approaches. The best thing that could happen to the Fed is for everyone to wake up tomorrow morning and read that we had all slept for twelve months and the funds rate was now 1%. The reason I say that is because a 1% rate wouldn't be a problem for the economy at all - recall that 1% is the number Alan Greenspan gets blamed for as leaving in so long that it inflamed the housing bubble.
The problem isn't an absolute level of short rates of 1% or 1.5%, but the transition to that level. The "late and fast" set wants to avoid any blame at all for the next recession, so they would wait until the economy is roaring - which it may not do during this cycle, despite the sudden new mantra of "lower and longer" (reminding me of "new economy" and "decoupling" as other New Plateau theories).
I am very serious when I say that would surely lead to another Minsky Moment (massive instability following artificial stability) and the likely rewrite of the Fed's charter. Despite my criticism of the Fed these past two years, a populist rewrite of the central bank is not an outcome I want to see happen. "Some" committee members favor the soon-and-slow approach as avoiding the eventual overaccumulation of risky assets dependent on ultra-low rates. That's sensible - if it hasn't happened already. Selling another trillion dollars or so of high-yield bonds that will crater when rates move up to one percent is not going to help the Fed's exit. There's no reason for 1% short rates to make credit scarce, but millions of those market morons trying to unload their rapidly depreciating high-yield paper, well, that's going to be a problem.
At the end of the Hilsenrath webcast, he acknowledged the Fed's greatest current weakness - it has no defense against a recession. I don't see one as being likely this year or in the next few quarters, but the problem is that the central bank has little defense against any adverse economic event. They have a way of happening, you know.
At the end of day one, the bond market seemed to think the statement was somewhat hawkish, equities dovish (big surprise, that one). What will the impact be on the stock market? My guess is that it will help sustain the market advance overall for at least the next couple of quarters. However, the longer that stock market gains outpace earnings gains, the bigger the final payback will be when valuations revert to the mean (and they always do). In the interim, the end of QE next month is a moat the market still has to jump across. The last two times, it got soaked.
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