On March 21, the Fed raised its key interest rate by 25 basis points, from 1.5% up to 1.75%. This came as a surprise to no one. Fed Chairman Jerome Powell’s testimony before Congress in February telegraphed his intention to raise interest rates in March, the first of three (or possibly four) rate hikes in 2018. The announcement caused some tremors in the markets, but the near certainty that the Fed would raise rates in March likely helped temper investor reaction.
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There remains fierce debate on the overall impact of the Fed’s low rates, extreme policies, and quantitative easing program that were engaged nearly a decade ago in response to the sub-prime mortgage crisis and ensuing recession. The long-term consequences for inflation and economic growth are unclear. Looking ahead, even as raising interest rates is a valuable check on inflation targets, there is another equally important side to the coin as the Fed continues to climb from the aftermath of its bond-buying frenzy. That is, unwinding the $4.5 trillion on the Fed’s balance sheet.
As the Fed Chairman said at a March 21 press conference, referring to the Fed’s balance sheet normalization (reduction), “Barring a very significant and unexpected weakening in the outlook, we do not intend to alter this program.”
This could be significant in the sense that he is telegraphing that he is willing to suffer more pain in the capital markets than his predecessors. Thus, normalization may be more important than interest rate hikes in the short term.
Shortly after the Fed began withdrawing cash from the system through its selling of bonds on its balance sheet in October 2017, we started to get some volatility after a long period of low volatility. Given that we are still
One reason cited for the timing of the interest rate increase was the Fed’s assessment that the economy is strengthening. However, not everyone agrees the economy is sufficiently strong, and unfortunately, removing accommodation in what some still view as a fragile economy may be the very thing that triggers the next recession. If this happens early enough in the normalization process, the Fed may be facing a recession with very little ammunition.
Thus, a central question about the implications of Fed action under the stewardship of the new chairman is whether Powell will continue the legacy of the “Greenspan put.” Beginning with Alan Greenspan, and later continued by Ben Bernanke and Janet Yellen, investors came to expect that anytime the markets got into trouble, the Fed would implement accommodative policies to “save” financial markets. One could argue the 2008 financial crisis was
The late great American economist Hyman Minsky hypothesized that stability breeds instability as people
One example of easy money side effects is what the Bank of International Settlements calls “zombie” firms. These are companies that don’t make enough money to even pay their taxes and interest. As you can see in the chart below, those firms account for more than 16% of U.S. public companies.
Many argue myself included, that it is much healthier to let an economy go through its normal business cycle, recessions and all, to have a healthy clearing of the system. The problem Mr. Powell inherits is that if you’re far enough down the road of risk-taking (high leverage, high valuations, etc.), you can’t suddenly be a dogmatic disciplinarian as you might cause too big of a shock to the system.
The “Powell Put” (if he doesn’t follow his predecessors of being a helicopter parent) will come down to a game of chicken as we enter the next recession. If he flinches too early, he’s rescuing firms that have been undisciplined with their capital, not forcing enough weak players into bankruptcy. But if he flinches too late, he could lead an over-levered economy into a too severe recession that turns worse when market participants realize the safety net is not what it used to be.
- March 21, 2018 – Transcript of Chairman Powell’s Press Conference
- September 2017 – BIS Quarterly Review
- Hyman Minsky – American Economist
- Alan Greenspan – American Economist
- Ben Shalom– American Economist
- Janet Louise Yellen – American Economist