Dear Valued Clients and Friends,
If media coverage was a good barometer, one would think investors and workers should be petrified of the Federal Reserve daring to raise the short-term interest rate up to a ZERO percent real level (i.e. net of inflation), after the nearly decade-long period of unprecedented free money. You could be forgiven for believing, if the punditry class was your guide, that a Fed which added $3.5 trillion (with a “t”) to its balance sheet through three rounds of quantitative easing, was risking the health of the economy by seeing that balance sheet shrink at the snail’s pace of $20 billion per month. But you would not be capturing the real risk out of our central bank that should be our primary focus at this time …
A lot has been said over the last 100 years about the efficacy of the Federal Reserve, what it does, what it was instituted to do, where it has gone wrong over the years, where it has gone right, etc. There are two schools of thought that appear to perfectly get it wrong in analyzing the Fed – one is a school of thought that views the institution as inherently conspiratorial, created to benefit a few elite bankers, and fundamentally inflationary. In this case, the actually obvious and visible flaws in Federal Reserve management of monetary policy, most striking being their penchant for allowing asset bubbles to form, requiring a painful bust later, is essentially ignored (or relegated to a secondary cause of concern), so that wild, sometimes comical, highly charged conspiracy views can be presented. For this camp, the Fed’s major flaw is not the tension behind the dual mandate (full employment and a stable currency), or their rampant failures to execute over the years. Rather, it is that the mere attempt to centrally oversee money supply in a multi-trillion dollar economy, and stave off deflationary money supply inadequacies, must be part of a master plot to enrichen already rich bankers. It is an accusation rooted in sociological condition, and it misses the mark by a wider margin than the Fed has missed their own inflation targets over the years.
The other side of the equation is equally wrong and dangerous, and that is the idea that the need of the hour is greater Fed intervention, greater freedom from monetary price rules and disciplines, and greater autonomy to use the power of the Fed to attempt to manipulate various economic outcomes. This camp either ignores the side effects that such distortions and manipulations create, or finds sweeping malinvestment to be a tolerable consequence. The great error in this camp is the infinite confidence they place in third parties to mastermind a complex economy, with unwarranted discretion, divorced from the rules and disciplines that are a prerequisite to sound central banking.
Markets do not want or need a vacancy in ensuring that money supply is adjusted to economic growth, but nor do they benefit from an excessively interventionist central bank, either. A rules-based, humble, data-driven Fed with a keen understanding of business cycle realities, market forces, and the hangover-effect of excessive accommodation is the ideal target for our nation’s central bank to be. Deflationary negative feedback loops can be compounded profoundly if liquidity is not provided in periods of collapsing velocity. And inflationary forces can unnecessarily compound when a resolute Fed does not work to remove excess liquidity.
The issue that ought to concern investors is not the mere existence of a Fed, and it is not that the Fed be allowed carte blanche authority over the economy. Rather, it is a politicized central bank whose resources become a tool of a federal government hell-bent on excessive spending. A central bank who becomes an enabler of a no-discipline tax-and-spend magistrate is a true monetary nightmare. In countries around the world, admittedly, countries who lack the sophistication, maturity, growth, size, and reserve strength of ours, where the central bank has become the lender of last resort to the government, the results have repeatedly been high inflation, economic distress, governmental instability, and worse.
A Congress which taps the resources of the Federal Reserve is far more dangerous than a Fed that raises interest rates too slowly, or too quickly. Congress can (and does) do this in several ways: It requires certain levels of excess in its surplus account to be paid out to the Treasury, it restricts the Fed’s member banks from replenishing reserves, it has required the Fed to fund and oversee various projects (such as the Consumer Financial Protection Bureau, not funded through regular budget appropriations), and it is capped the dividend the Fed can pay to its member banks. These transfers of payment from one government body to another allow for the appearance of new revenue to the Treasury, when in fact the right pocket just moved funds to the left pocket.
A Fed removing surplus funds to the Congress is barely helping Congressional budget abuses, but it could substantially impact central bank flexibility and policy administration. Worse, it violates the independence of apolitical aspiration of the Fed which is pivotal to maintaining strong and credible financial markets.
No central bank in history has ever been totally free of political influence or governmental reach. But that does not mean one should not try or should capitulate to actions that have historically accelerated than a breakdown of disciplined central banking. Recent statements by the President expressing his negative views on rising interest rates are not helpful, but they are not new. A truly depoliticized Fed would not require the central bank to monetize Congressional debts, and would not intervene in the Fed’s management of capital flows.
These stories are too dry for the media to cover. Financial markets, though, are not concerned with how dry a story is, only how relevant it may be to the credibility and efficiency of capital.
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group, HighTower