Yves here. It’s been astonishing to see members of the Fed in denial about their own handiwork, so when St. Louis Fed President James Bullard berates his fellow central bankers for their abject refusal to notice pre-crisis bubbles, it’s an all too rare departure from their usual insularity and willful blindness.
Moreover, there’s one issue that Bullard mentions only obliquely that deserves more notice. Bullard specifically criticizes the way that the Fed decided to increase interest rates in the face of extreme spread compression in all credit markets in a measured, deliberate way. That well-signalled, cautious process in fact was part of a pattern of insulating investors as much as possible from losses, which of course simply encourages more recklessness. Many writers, including your humble blogger, have written at length about the Greenspan, and later Bernanke and presumed Yellen puts, that if financial markets got too upset, the Fed would ride in to their rescue.
But that was not the only way the monetary authority over the years has shielded investors more and more from risk. Another way is the well-telegraphed, slow and steady rate increases when the Fed does tighten. That policy dates from 1994, when the Fed unexpectedly increased interest rates by a mere 25 basis points when investors were almost universally convinced that the central bank’s next step would be to lower rates further. The result was a derivatives wipeout that produced losses bigger than the 1987 crash (as well as lots of hearings). But rather than rein in deriviatives, Greenspan extended his intellectually confused policy of “free markets” as in pushing over time for even more deregulation of derivatives, while intervening more and more in financial markets to blunt the impact of the resulting increased risk taking.
An important article this past Sunday by John Coates in the New York Times explained how various Fed policies meant to increase the safety of the financial system were having the reverse effect. Key extracts:
If we understand how a person’s body influences risk taking, we can learn how to better manage risk takers. We can also recognize that mistakes governments have made have contributed to excessive risk taking….
Over the past 20 years, the Fed has pioneered a new technique of influencing Wall Street. Where before the Fed shrouded its activities in secrecy, it now informs the street in as clear terms as possible of what it intends to do with short-term interest rates, and when. Janet L. Yellen, the chairwoman of the Fed, declared this new transparency, called forward guidance, a revolution; Ben S. Bernanke, her predecessor, claimed it reduced uncertainty and calmed the markets. But does it really calm the markets? Or has eliminating uncertainty in policy spread complacency among the financial community and actually helped inflate market bubbles?…
Our challenge response, and especially its main hormone cortisol (produced by the adrenal glands) is particularly active when we are exposed to novelty and uncertainty…Uncertainty over the timing of something unpleasant often causes a greater challenge response than the unpleasant thing itself. Sometimes it is more stressful not knowing when or if you are going to be fired than actually being fired. Why? Because the challenge response, like any good defense mechanism, anticipates; it is a metabolic preparation for the unknown….
In one of my studies, conducted with 17 traders on a trading floor in London, we found that their cortisol levels rose 68 percent over an eight-day period as volatility increased. Subsequent, as yet unpublished, studies suggest to us that this cortisol response to volatility is common in the financial community. A question then arose: Does this cortisol response affect a person’s risk taking? In a follow-up study, my colleagues from the department of medicine pharmacologically raised the cortisol levels of a group of 36 volunteers by a similar 69 percent over eight days. We gauged their risk appetite by means of a computerized gambling task. The results, published recently in the Proceedings of the National Academy of Sciences, showed that the volunteers’ appetite for risk fell 44 percent.
Most models in economics and finance assume that risk preferences are a stable trait, much like your height. But this assumption, as our studies suggest, is misleading. Humans are designed with shifting risk preferences. They are an integral part of our response to stress, or challenge….
THE Fed, however, through its control of policy uncertainty, has in its hands a powerful tool for influencing risk takers. But by trying to be more transparent, it has relinquished this control.
Forward guidance was introduced in the early 2000s. But the process of making monetary policy more transparent was in fact begun by Alan Greenspan back in the early 1990s. Before that time the Fed, especially under Paul A. Volcker, operated in secrecy. Fed chairmen did not announce rate changes, and they felt no need to explain themselves, leaving Wall Street highly uncertain about what was coming next. Furthermore, changes in interest rates were highly volatile: When Mr. Volcker raised rates, he might first raise them, cut them a few weeks later, and then raise again, so the tightening proceeded in a zigzag. Traders were put on edge, vigilant, never complacent about their positions so long as Mr. Volcker lurked in the shadows. Street wisdom has it that you don’t fight the Fed, and no one tangled with that bruiser.
Under Mr. Greenspan, the Fed became less intimidating and more transparent….Mr. Greenspan notoriously spoke in riddles, but his actions had no such ambiguity. Mr. Bernanke reduced uncertainty even further: Forward guidance detailed the Fed’s plans.
Under both chairmen fed funds became far less erratic. Whereas Mr. Volcker changed rates in a volatile fashion, up one week down the next, Mr. Greenspan and Mr. Bernanke raised them in regular steps. Between 2004 and 2006, rates rose .25 percent at every Fed meeting, without fail… tick, tick, tick. As a result of this more gradualist Fed, volatility in fed funds fell after 1994 by as much as 60 percent.
In a speech to the Cato Institute in 2007, Mr. Bernanke claimed that minimizing uncertainty in policy ensured that asset prices would respond “in ways that further the central bank’s policy objectives.” But evidence suggests that quite the opposite has occurred.
Cycles of bubble and crash have always existed, but in the 20 years after 1994, they became more severe and longer lasting than in the previous 20 years. For example, the bear markets following the Nifty Fifty crash in the mid-70s and Black Monday of 1987 had an average loss of about 40 percent and lasted 240 days; while the dot-com and credit crises lost on average about 52 percent and lasted over 430 days. Moreover, if you rank the largest one-day percentage moves in the market over this 40-year period, 76 percent of the largest gains and losses occurred after 1994.
I suspect the trends in fed funds and stocks were related. As uncertainty in fed funds declined, one of the most powerful brakes on excessive risk taking in stocks was released.
Yves again. When you consider how systematically wrong-headed the Fed’s efforts to condition traders has been, it’s hardly any surprise to see how many bubbles have reflated in the post crisis era. The central bank clearly wanted a certain degree of reflation to occur, but they seem to have no idea of how much reflation is enough or how to let the air out of incipient or actual bubbles.
By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Testosterone Pit.
Perhaps accidently wiping out in one fell swoop six years of carefully orchestrated and minutely maintained Fed propaganda, St. Louis Fed President James Bullard admitted to reporters on Monday after a speech in Palm Beach, Florida, that the Fed had dropped the ball in dealing with the prior bubble, that the Fed’s tightening cycle of 2004-06 was “too methodical and did not react sufficiently to economic developments.”
The Fed hadn’t been focused on the ballooning bubble but on the calendar, he said. The very bubble that Alan Greenspan, who was in charge at the time, didn’t see, couldn’t have possibly seen, and denied ever seeing? Yup, that one. “So, the committee was tightening policy,” Bullard said, “but the bubble was nevertheless developing under our noses.”
And the bubbles that are now “developing under our noses,” to use Bullard’s term? Numerous indices have hit all-time highs, often beating prior bubble highs by a wide margin. So here are a few of these craziness indicators. Surely, Bullard and his colleagues at the Fed must have noticed them, especially since some of these indicators are produced by the Fed itself.
- The Financial Stress Index, issued by the St. Louis Fed, hit an all-time low in the latest reporting week, beating the low reached in February 2007, a time when the foundation of the financial system was already cracking. Extremely low “financial stress” means even the most reckless decisions are getting funded and the riskiest crap is getting sold no questions asked as risk has been eliminated from the calculus [Last Time this happened, The Financial Crisis Broke Out].
- Margin Debt spiked from record to record until it hit $465.7 billion in February, or 2.73% of GDP, the highest ratio ever! But in the following two months, it dropped 6.1%; the last two times it dropped after a magnificent spike was in March 2000 and July 2007, with terrific results [This Happened Twice Before, And Each Time Stocks Crashed].
- The VIX volatility index dipped on Friday to the lowest level since February 2007 and remains at half of its historical average. It’s a sign that market participants don’t expect big price movements, and if the selling starts, no one is prepared. Hence, the notion of utter “complacency.”
- Unprofitable IPOs – companies that go public without having made a profit, such as Twitter, and often without a clear picture of how they’ll ever make a profit – were back at record level in the first quarter. The record – 84% of all IPOs – was set during the dotcom bubble in Q1 2000 just before all heck broke lose.
- The spread between junk-bond yields and Treasuries is the tightest since October 2007, the craziest of all junk-bond times when “Merger Mondays” – which are now back in full bloom – were adding spice to TV news shows. Another signs that investors are simply no longer demanding compensation for the risk they’re taking.
- A record $355 billion in new leveraged loans – the riskiest loans out there – were issued last year in the US, and this year started out just as hot. Insatiable demand by desperate investors driven to near insanity by the Fed’s interest-rate repression.
- Banks have issued a record amount of commercial loans, now $10.5 trillion.
- Home prices have surpassed their prior bubble highs in numerous cities, including San Francisco, though those bubble prices are now running into the buzz saw of reality.
- Corporate profits as percent of GDP – how much profit companies can wring out of the economy by, among other strategies, keeping real wages down – has hit all-time highs for two years in a row.
- Ha, and don’t even mention Money Supply, which has rocketed into the stratosphere.
- Not to speak of stock market indices bumbling from one all-time high to the next without a 10% correction in years, while corporations borrowed crazy sums and bought back record amounts of their own shares, to where in Q1, according to CapitalIQ, they’ve become the most prolific buyer of stocks.
And then, there is the whole craziness in San Francisco and the Bay Area that is spreading to other parts of the country. The sums of money being thrown around are breathtaking. And not just Facebook’s paying $19 billion for a texting app maker with 55 employees and a trickle in revenues, or the $18.2-billion “valuation” for Uber – maker of an app that provides a mix of unregulated taxi service and expensive hitch-hiking. It’s getting so crazy they’re even joking about it on local talk radio.
So Bullard’s speech focused on “how far” exactly the FOMC was still from its “macroeconomic goals.” He had his own math. The FOMC is “closer to target” in terms of inflation and unemployment than it has been about 75% of the time since 1960, he said.
To target – that’s the thing. The Fed’s policies of printing $4 trillion in five years and imposing its ZIRP relentlessly on the country – in conjunction with similar actions by other central banks – has created a tsunami of money that washed over the land, made a small group of people immensely rich, inflated all sorts of record-breaking bubbles, and caused the craziness indicators to spike “under our noses.”
During the last bubble, the Fed did eventually tighten, even if belatedly and timidly, and not until after it had nurtured the bubble to its full glorious bloom to where its implosion took down the financial system. This time around, the bubbles have far outgrown those of yore. Yet the Fed is still printing money. And raising interest rates just a tiny bit won’t even be discussed seriously until next year. But unlike the prior bubbles that blew up the financial system, today’s bubbles are different. They’re a sign, apparently, that the economy is healing and getting back to normal.
It was a very basic question: Have there been times when you did not have enough money to buy the food you or your family needed? In wealthy countries, the percentages should be small, and given all the money-printing in the US, it should be zero, you’d think. Read…. QE, Bailouts, And Families Struggling to Buy Food