While the Fed appears to be getting nervous about increasing (and long overdue) criticism for its undue coziness with banks, it has for the most part ignored opponents of its aggressive monetary policies. And for good reason. Most of them have been fixated on the risk of inflation, which is not in the cards as long as labor bargaining power remains weak. There are other, more substantial grounds for taking issue with the central bank’s policies. For instance, gooding asset prices widens income and wealth inequality, which in the long term is a damper on growth. Moreover, one can argue that the sustained super-accommodative policy gave the impression that Something Was Being Done, which took the heat off the Administration to push for more spending. Indeed, the IMF recently found that infrastructure spending pays for itself, with each dollar of spending in an economy with high unemployment generating nearly $3 in GDP growth. And a lot of people are uncomfortable for aesthetic or pragmatic reasons. Aesthetically, a lot of investors, even ones that have done well, are deeply uncomfortable with a central bank meddling so much. And many investors and savers are frustrated by their inability to invest at a positive real yield without being forced to take on a lot of risk.
Stephen Roach, former chief economist of Morgan Stanley and later its chairman for Asia, offers a straightforward, sharply-worded critique: just as in the runup to the crisis of 2007-2008, the Fed’s failure to raise rates is leading to an underpricing of financial market risk, or in layspeak, to the blowing of bubbles. He argues that has to end badly. Key sections of his article at Project Syndicate:
Steeped in denial of its past mistakes, the Fed is pursuing the same incremental approach that helped set the stage for the financial crisis of 2008-2009…[T]he Fed’s incremental approach led to the near-fatal mistake of condoning mounting excesses in financial markets and the real economy. After pushing the federal funds rate to a 45-year low of 1% following the collapse of the equity bubble of the early 2000s, the Fed delayed policy normalization for an inordinately long period. And when it finally began to raise the benchmark rate, it did so excruciatingly slowly…
The Fed, of course, has absolved itself of any blame in setting up the US and the global economy for the Great Crisis. It was not monetary policy’s fault, argued both former Fed Chairmen Alan Greenspan and Ben Bernanke; if anything, they insisted, a lack of regulatory oversight was the culprit.
Yves here. Note that these causes are not mutually exclusive. As we discussed in long-form in ECONNED, it was a particular combination of financial market “innovations” that created the “wall of liquidity” that by early 2007 had led to extreme underpricing of risk across all credit markets. The big driver was leverage on leverage strategies, such as hedge fund of funds borrowing when the underlying hedge funds they had invested in were levered too, and CDOs, which were resecuritizations of junior mortgage bond tranches and thus effectively turbo-geared. These would not have been attractive if risk were not widely underpriced.
But a still-not-well understood aspect of the crisis is that these strategies became even more active as the Fed was raising rates. That’s the opposite of what normally happens in credit cycles. When the central bank starts tightening, what normally gets choked off first is the most speculative activities. Indeed, in 2004, Countrywide predicted that its mortgage originations would fall in 2005. Instead, as prime mortgage originations fell, subprime mortgage originations rose. Why?
The culprit was CDOs. They were insulated from the Fed’s tightening because the bulk of the CDO was rated AAA, which made it less vulnerable to the effects of the Fed’s tightening. Worse, for Eurobanks and even some US firms, retaining an AAA tranche hedging it with an AAA rated counterparty allowed book all discounted future profits in the current period. These were massively profitable trades, and a big reason why so many banks were stuck with so many toxic CDOs when the music stopped. Another big contributor was the heavily synthetic CDOs (as in made largely of credit default swaps) devised by Magnetar, which drove demand to the very worst mortgages.
None of the financial regulators had any idea that this was happening. Indeed, as the crisis was escalating, the authorities were still not looking in the right places for trouble. For instance, it was clear that when Bear Stearns was rescued, one of the big reasons was concerns about its credit default swaps counterparty exposures. As we said at the time, the Fed, in concert with the Bank of England and the ECB, should have gone into overdrive to understand the who was exposed to whom, and in what types of risks. Instead, they went into Mission Accomplished mode.
And the Fed is as in the dark about shadow banking now as it was in 2006. As the Wall Street Journal wrote earlier this week:
The so-called shadow-banking system is growing again in the U.S. after declining from 2008 through 2011 in the wake of the financial crisis. The value of U.S. financial assets held by money-market funds, hedge funds, trust companies and financial firms other than banks reached $25.2 trillion in 2013, for the first time exceeding the precrisis peak of $24.9 trillion, according to a November report by the Financial Stability Board, an international body of regulators.
U.S. shadow-banking assets accounted for about one-third of the global total of $75.2 trillion in 2013, which was up from $70.5 trillion the year before. And in the U.S., shadow banking is bigger than the more tightly regulated traditional banking system, which according to the FSB had $20.2 trillion in assets as of 2013….
“No U.S. agency yet has access to complete data regarding bank and nonbank financial activities,” Fed governor Lael Brainard, a member of the committee, said in a speech earlier this month…
Aside from the gray area about its authority to oversee nonbank financial firms, the Fed lacks some “macroprudential” regulatory and supervisory tools used by other central banks in recent years. Such macroprudential measures aim to maintain the stability of the whole financial system, in contrast with “microprudential” efforts to ensure the soundness of individual institutions.
The Fed, for example, can’t impose limits on loan-to-value ratios for home or business loans, as some other central banks have done.
Yves again. So this is a long-winded way of saying that monetary policy alone isn’t to blame for the last crisis. Bank deregulation created a lot of dry kindling that the easy credit match set ablaze. But since perilous little has been done in the way of reregulation, Roach is correct that the general conditions look a lot like those of the pre-crisis era, where easy money is going to all the wrong places. Stephen Roach again:
[O]fficials..focus on a new approach centered on so-called macro-prudential tools, including capital requirements and leverage ratios, to curb excessive risk-taking by banks. While this approach has some merit, it is incomplete, as it fails to address the egregious mispricing of risk brought about by an overly accommodative monetary policy and the historically low interest rates that it generated…
[T]oday’s Fed seems likely to find any excuse to prolong its incremental normalization, taking a slower pace than it adopted a decade ago…In these days of froth, the persistence of extraordinary policy accommodation in a financial system flooded with liquidity poses a great danger. Indeed, that could well be the lesson of recent equity- and currency-market volatility and, of course, plummeting oil prices…
Central banking has lost its way. Trapped in a post-crisis quagmire of zero interest rates and swollen balance sheets, the world’s major central banks do not have an effective strategy for regaining control over financial markets or the real economies that they are supposed to manage. Policy levers – both benchmark interest rates and central banks’ balance sheets – remain at their emergency settings, even though the emergency ended long ago.
While this approach has succeeded in boosting financial markets, it has failed to cure bruised and battered developed economies, which remain mired in subpar recoveries and plagued with deflationary risks. Moreover, the longer central banks promote financial-market froth, the more dependent their economies become on these precarious markets and the weaker the incentives for politicians and fiscal authorities to address the need for balance-sheet repair and structural reform…
The unprecedented financial engineering by central banks over the last six years has been decisive in setting asset prices in major markets worldwide. But now it is time for the Fed and its counterparts elsewhere to abandon financial engineering and begin marshaling the tools they will need to cope with the inevitable next crisis. With zero interest rates and outsize balance sheets, that is exactly what they are lacking.
Roach isn’t the first to point out that the Fed and other central banks have painted themselves into a corner, but his article make a particularly terse and urgent statement of the severity of the problem. But what seems particularly troubling is the degree to which the Fed is in denial. The central bank spends so much time cheerleading that it seems to believe that the economy is well on the way to normal and that the markets are healthy. While the degree of delusion may not be as bad as in 2005, when economists at Jackson Hole tore into Raghuram Rajan for outlining why financial deregulation had made the world riskier, this degree of difference does not appear to amount to a difference in kind. The Fed is wedded to being overly solicitous about the markets it can see, and that perversely includes the stock market, which prior to Greenspan was never considered to be relevant to central bank policy. Just like a decade ago, the Fed’s drunk under the streetlight behavior has high odds of producing bad results.