This morning’s must listen interview is last week’s Benn Steil appearance on HedgeEye. Benn is the Director of International Economics at the Council on Foreign Relations. In the discussion, Benn nails the internal politics facing Yellen and the FOMC. I have transposed a couple of key excerpts:
My personal view is that she is clearly beginning to fear the emergence of dissents. Bernanke didn’t want to see those if he could avoid them as well. Bernanke ushered in this era of rock stars amongst Federal Reserve Presidents where they are shooting off their mouths every two minutes. And now the ethos is “let’em blow off steam in public. But when we get behind closed doors at the rate meetings, we got to make sure we are all in this together.”
I have long held the view the members of the FOMC are too vocal with varying opinions (The Fed Talks too Much). All these different Fed Presidents espousing their differing views only serves to confuse markets. Participants are forced to discount how much influence each FOMC member holds, and whether their opinion is swaying other members. During the open period for Fed speeches, opposing forecasts randomly hit the news wire like tape bombs.
And all this communication is made even worse by a Fed Chair forced to appease Committee members with her public comments. From Benn’s interview again:
Although Dudley and Fischer are clearly the most important voices, even if she [Yellen] doesn’t want to raise rates this summer, she wants to make sure there aren’t going to be dissents if she can avoid them. And what do you do if you want to try to damp down the pressure for dissent? You throw them a bone. You say you are leaning in the direction of a rate hike in the near future. And then when you get to the meeting, you do your best to push that off into the future.
Under Yellen’s leadership the Federal Reserve has slowly withdrawn liquidity and tightened monetary conditions. But it has not been a straight journey. There have been too many stops and starts.
The Federal Reserve has failed to realize how reflexive the economy is to their rhetoric. The moment the economy picks up, FOMC Presidents rush to forecast higher rates. Well, what do you think that does to an over indebted balance sheet constrained economy? It immediately causes private sector to reign in spending. The Federal Reserve’s much anticipated rate hike promise then needs to be withdrawn as the economy sinks.
PIMCO’s Paul McCauley realized this a decade ago when he wrote about the need for Central Banks to be “responsibly irresponsible.” Without the concern the Central Bank might overshoot, the private sector correctly understands the most pressing worry is deflation, not inflation.
Japan spent a decade and a half figuring this out. During this period their economy was mired in a stop and go moribund mess. All the while, debt just kept increasing without the economy ever achieving escape velocity.
The Federal Reserve risks making the exact same mistake as the Bank of Japan. Now at this point you might argue the Fed needs to install some discipline on the market. The economy needs higher rates. And that well might be correct. But make no mistake, that sort of tough love medicine would cause an economic depression akin to the 1930’s policy error.
It is especially frustrating because we all know the Federal Reserve has little chance of ever venturing down this road again. The end game is for the debt to be inflated away, but this lack of intellectual honesty only puts off the needed reset.
Japan is close to admitting the inevitability of this outcome, and the ECB has adopted an “inflate at all cost” mantra. But the Federal Reserve is still stuck in the belief the old world order can return.
Remember when Bernanke tried to jump start the economy with the various Quantitative Easing programs? Each time he announced a program, he stated the total size of the program. As markets began to understand the effects of QE, they simply started discounting the program’s end earlier and earlier. Bernanke was shrewd enough to understand this dynamic and the QE program that eventually proved most effective was dubbed QE infinity because it had no set size or end date. Bernanke announced the Fed would keep expanding their balance sheet until their economic goals were met. It was only at this point that the market realized the Fed was serious.
Without this full pedal down to metal attitude, the natural state of the economy is for debt to be destroyed. Even if Yellen understands this, unless she communicates a “we will not allow deflation to take hold” attitude and instead continues to appease the hawks who are worried about inflation, the economy will stutter.
If the Federal Reserve Open Committee members are truly as “data dependent” as they claim, they should just shut their pie holes, stop making forecasts that alter the outcome of what they are forecasting, and conduct monetary policy based on the data.
As for Yellen, she is is in a tough spot. She needs to stop trying to achieve consensus, and take leadership. There is a decent chance that to appease the hawks, she has tightened into a slowdown. If she continues listening to them, it might well get much worse. All those hawks encouraging Yellen to look through the recent bad employment report are living in a past era. The world has changed, and the longer the old guard rules the Fed, the worse it gets.
Buying the 2/10 spread
I am hopeful Yellen will realize the potential grave policy error the Federal Reserve might be making, and the recent terrible employment report will give her cover to be openly dovish.
The 2/10 US Treasury yield spread has been declining for the past couple of years, and I think it has hit a point where it worth a shot on the long side.
One of my readers Dylan D’Costa sent me this great tweet with a terrific chart highlighting the fact the recent flattening now coincides with the same amount as the previous cycle:
I have bought 2s and sold 10s. There are a bunch of reasons I like this trade, but I will save that for another day. I am hopeful we get a summer bounce back up to 1.50%.
Thanks for reading,