posted March 25, 2018
Yellen’s Twin Legacies; Powell’s Dilemmas’

This past February 2018 Janet Yellen, chair of the US Federal Reserve bank since 2014, was replaced by the Trump administration with the new Fed chair, Jerome Powell. Yellen leaves the Powell Fed with two contradictory legacies. The question of the day is which will the Powell Fed now follow? What role will the Trump administration’s tax cuts and spending programs play in influencing the choice? And is the Powell Fed now in a ‘no win’ situation, regardless which policy direction it takes?

Yellen’s Fed represents a continuation of the policies of her predecessor, Ben Bernanke—just as Bernanke’s policies continued Alan Greenspan’s, his predecessor. All three Fed regimes are defined by their shared policy of decades-long, massive liquidity injections—beginning with Greenspan’s assumption of the Fed chair in 1987 and continuing through the third of Yellen’s four year term in 2016.
The legacy of their thirty years of unremitting liquidity injection has been excessively leveraged, debt-fueled investment in financial markets that generated asset demand driving financial asset prices into unsustainable bubble territory. With Greenspan it was the savings & loan industry bust in the late 1980s, the US contribution to the Asian currency bubble of the late 1990s, then the US tech stock bubble of 1999-2000, and, together with Bernanke at his side, thereafter the subprime mortgage bond and derivatives twin bubbles of 2004-07.

Yellen’s First Legacy

Like her predecessors, in her first three years at the Fed helm Yellen chose to continue the Greenspan-Bernanke policy of excess liquidity. As the following Table 1 shows, Yellen continued the Bernanke QE program of Fed direct bond buying in her first year as chair.

TABLE 1
Fed QE Bond Buying Through 2014

Type of Security June 2013 February 2014 December 2014
Mortgages $1.3 trillion $1.5 trillion $1.7 trillion
US Treasuries $1.9 $2.2 $2.4

In 2015-16 thereafter, she continued to ‘rollover’ prior debt that was maturing, thereby keeping the Fed balance sheet at $4.5 trillion instead of allowing it to decline. The net liquidity injected into the economy by the Yellen Fed during its first three years, composed of new and rolled over debt, was thus likely in excess of $500 billion.

A comparison of Yellen vs. Bernanke money supply growth further illustrates the Yellen continuation of the Greenspan-Bernanke excess liquidity policy and its effect on the US money supply. The virtual free money from the Fed clearly continued during the first three years of her term, as Table 2 indicates. The Fed benchmark rate remained in the 0.25%-0.5% range through 2016

When measured in terms of the M2 money supply, more of the Fed’s liquidity actually entered the US economy on an annual basis during Yellen’s first three years than had even under her predecessor, Bernanke. Vast amounts of that liquidity flowed into financial markets, both in the US and abroad.

TABLE 2
M2 Money Supply
Bernanke v. Yellen Fed($ Trillions)

Bernanke Fed Yellen Fed
12/05 12/13 $chg/yr. %chg/yr. 12/13 04/17 $chg/yr. %chg/yr.
M2 $6.6 $10.6 $.5 7.6% $10.6 $13.5 $.87 8.3%

In 2017 the Yellen Fed began seriously raising its benchmark rates—albeit gradually. That policy shift of ‘rate hike gradualism’ is also a legacy—the second—of the Yellen Fed. Excess liquidity initially, the first legacy, followed by gradualism in rate hikes constitute the Yellen Fed’s ‘twin legacies’.

The policy shift to gradually higher rates actually began under Bernanke, announced in 2013 but never implemented. Bernanke in 2013 no doubt remembered the consequences of his prior shift and rate hikes in 2006-07—a shift which contributed toward precipitating the 2007-08 housing-derivatives bubbles implosions. Bernanke announced his intention to raise rates in mid-2013 but then ‘blinked’ amidst widespread market negative reactions, in the US and across emerging markets. He likely did not want to leave a legacy that on his watch the Fed’s policy shifts precipitated two—not one—market crashes. The 2007-09 was enough. Let someone else preside over the second.

Bernanke’s legacy was threefold: continuing his mentor, Greenspan’s policy, excess liquidity, followed by too high and too rapid rate hikes in 2006-07, thereafter by still even more excess liquidity post-2008. If excess liquidity was the fundamental source of the bubbles and crisis, in some perverse logic then still more liquidity was envisioned as the solution short term.

Yellen’s legacies would be continuing the three decade long ‘Great Liquidity Put’ set in motion by Greenspan and Bernanke, and then to actually implement the Bernanke ‘rate gradualism’ policy shift in 2017, announced by Bernanke in 2013 but quickly shelved for the rest of his term. The differences between the Bernanke and Yellen legacies were thus minimal: both contributed to the GLP and, whereas Bernanke announced his intention to raise rates gradually in 2013 but didn’t, Yellen began doing so in her last year. The Yellen Fed was thus but an addendum to the Bernanke—except for the latter’s disastrous accelerate rate hikes in 2006-07 that helped precipitate the crash. That experience now looms large on the horizon for the Powell Fed.

The Bernanke Put: Greenspan’s on Steroids

Assuming the Fed chair in 2006, Bernanke attempted to reverse the prior two decade long policy of excess liquidity. By 2007 Bernanke he had quickly raised the benchmark federal funds rate to 5.25%. However, after years of artificially low 1% rates under Greenspan’s Fed, raising rates too high and too quickly, to 5.25%, played a central role in precipitating the housing and derivatives bubble busts—the first commencing in 2007 and the latter in 2008.

The lesson of 2006-07 was clearly: after years of artificially low rates around 1% fueling debt-driven financial asset bubbles, rates could not rise to 5% or more, and certainly not that quickly in 2006-07. Today rates have been low, at 0.25% for almost eight years. And it’s unlikely that rates will have to rise anywhere near 5.25% to precipitate a similar markets’ response.

In the six years that followed the 2008 crash Bernanke would absorb the lesson of decades of excess liquidity, followed by too rapid rate hikes in 2006-07 only partially. To contain the 2008 crisis (fundamentally caused by excess liquidity enabled debt driven financial bubbles) he would resort to injecting even more liquidity in 2008-09. The ‘Bernanke Put’ would succeed the Greenspan’s Put by magnitudes. As a consequence, the Fed’s benchmark rate came down from a high of 5.25% to 0.25% in just months, and would remain there for eight more years.

The Fed rate collapse of 2008-09 was enabled by means of quantitative easing (QE) injections of $4.5 trillion (and more if refinancing debt maturity rollovers are counted), special Fed auctions, central bank currency swaps, and traditional bond buying open market operations. Per some estimates, perhaps as much as $8 to $10 trillion in liquidity was added by collective means to the global banking system by Bernanke during his tenure at the Fed.

If Bernanke failed to heed the dangers of excess liquidity and debt driving financial bubbles, by 2013 he apparently did absorb the lessons of 2006-07—i.e. not to raise rates too high-too fast in an effort to try to retrieve excess liquidity. In 2013, instead of raising rates too rapidly once again, he carefully suggested publicly that the Fed might begin raising rates once again in the near future—albeit very gradually and slowly. He also announced the Fed might even consider selling off some of its bloated $4.5 trillion debt.

However, just the talk of rising US interest rates in the US precipitated a near panic in emerging market economies (EMEs). EME currencies quickly depreciated, in turn accelerating capital flight from EME markets. Bernanke backtracked quickly in the face of what was called then the ‘taper tantrum’. But as he reversed his announcement he made it clear in late summer 2013, up until leaving office in February 2014, that it still was the Fed’s intention to eventually raise rates—as well as begin selling off the Fed’s bloated balance sheet (which would further raise rates)—at some yet undefined future date and at a slow rate. His Fed thereafter ‘marked time’ until his departure in February 2014 and replacement by Yellen. However, in the interim he had laid the groundwork for the Yellen Fed to implement his policy of rate hike gradualism.

Yellen’s Second Legacy

The Yellen Fed began clearly as a virtual extension of the Bernanke Fed: in the early years it continued to provide excess liquidity, like the Greenspan and Bernanke Feds before. Moreover, the Yellen Fed continued to do so for three more years, and only in the last year of her term cautiously began to seriously implement the Bernanke policy of gradual rate hikes.

It took the Yellen Fed two years before it would make even a token increase in rates, and then only a tepid 0.25% hike at the end of 2015. It took another full year before another token hike occurred, in December 2016. Neither together was sufficient to discourage the financial asset bubbles that were growing, still being fueled by the prior eight year policy of continued liquidity provided by the central bank.

It was only in 2017 that the Yellen Fed started to rise noticeably, in hikes of 0.25% well spread out over the year. From 2014 through 2016, the excess liquidity policy continued to feed financial asset markets expansion. The 2017 rate gradualism policy was modest and slow and clearly intended not to discourage financial markets from their steady run up that was set in motion back in 2010. The 2017 rate increases, which raised Fed rates to a level of 1.5%, were thus a cautionary hike in anticipation of potential aggressive Trump fiscal policy on the horizon, as well as a response by the Fed to the emergence of what was called the ‘Trump Trade’—i.e. rising financial markets, especially equities, in anticipation of business-investor tax cuts coming and the release of ‘animal spirits’ boosting business investment.

However, clearly the Bernanke-Yellen policy of rate hike gradualism was becoming less gradual by 2017. Gradualism was being slowly redefined. It was not 2014-16 token gradualism, but nor was it yet 2006-07 of rapid rate hikes! However, signs began to appear in 2017 that perhaps a repeat of 2006-07 (and perhaps its consequences) was not too far away.

Trump promises of accelerating fiscal policies—tax cuts and spending alike—were being taken seriously by financial markets in 2017. The so-called ‘Trump trade’ was boosting financial asset markets. In the face of that, the additional 1% hike in the Fed benchmark rate in 2017 did little to dampen financial asset market speculation and inflation. Stock markets in particular were now being driven by the new ‘animal spirits’ based on little but expectations of a great windfall in profits and capital gains from the Trump tax cuts.

By year end 2017, the thirty year, 1987 through 2016, ‘Grand Liquidity Put’ of Greenspan-Bernanke-Yellen clearly had come to an end. Fiscal policy would now drive monetary. Unlike the preceding period when monetary policy by central banks was the lead and fiscal austerity followed in its wake. By early 2018 it now appears the gradualist Fed rate hikes policy—announced and aborted by Bernanke in 2013 and begun to be implemented 2016-17 by Yellen—will soon be replaced with more accelerated rate hikes 2018-19. That raises the new scenario that future Fed policy may consequently look more like 2006-07—with all its consequences—overlaid with a new taper tantrum in emerging markets that will dwarf the aborted reaction of 2013.

Yellen’s Legacies; Powell’s Dilemma

The Powell Fed now faces a dilemma: Does it continue Yellen’s policy of relatively slow and occasional rate hikes, allowing financial markets to escalate still further into bubble territory, driven now by new forces of fiscal stimulus and the release of global investor ‘animal spirits’? Or does it raise rates faster, and in increments more than 0.25% as in the past, to confront the new fiscal stimulus and investor expectations? More important, what might be the effects of more rapid rate hikes on financial markets? Will it be 2006-07 all over again? How high must rates go until it does? The Fed says it doesn’t care about financial markets. But it is expected to say that. In truth, its past track record shows it clearly does care.

The Powell dilemma may be answered not by the Fed. Not by central bank monetary policy. In 2018 monetary policy may be relegated to a secondary role and forced to follow fiscal once again—something that has not been the case for decades. The Powell Fed may have its direction chosen for it—i.e. by the Trump-Congress fiscal policy already set in motion. By the Trump tax cuts, the accelerating US war spending, possible infrastructure spending, etc.

Yellen’s legacy of ‘rate gradualism’ will likely be abandoned—as trillion dollar annual US budget deficits loom now for years to come as a result of Trump tax cuts and spending plans. That fiscal policy shift already means the Fed will now have to borrow significantly more—in the next two years alone at least $600 billion more to fund the $300 billion in Trump tax cuts and $300 billion in additional budget deficit spending (and perhaps more if defense spending continues to rise as projected next year or Congress itself funds more than Trump has requested).

Beyond the next two years, in the longer run, perhaps $10 trillion more in US deficits over the coming decade, should certain assumptions by Trump and Republicans prove erroneous: i.e. should US GDP not exceed the projected 3% plus annual growth rates; should a recession occur sometime in the next decade which is highly likely; should foreign buyers of US Treasury debt slow their purchases, should US defense spending continue to accelerate; and should the Trump tax cuts cost more than initially reported.
Estimates of next year’s US budget deficit by JP Chase Bank research is already $1.2 trillion, and other sources project even higher. Most independent sources estimate average annual deficits of $1 trillion or more for a decade to come. That’s more than the $10 trillion, to be added to the current US national debt of $20 trillion. And that’s a mountain of Treasury bonds to be sold by the Fed, which will no doubt require more rapid, significant, and sustained Fed rate hikes to finance. The 30 year ‘Grand Liquidity Put’ is over. Central bank Fed monetary policy is henceforth the tail on the fiscal dog.

The question now being asked by ‘Fed watchers’, bankers, and business press pundits is whether Powell will continue Yellen policy of gradually raising Fed rates (not likely) or will he raise Fed short term benchmark rates even faster, perhaps four times or more in 2018, as has been signaled—and even further thereafter in 2019? And will the Fed under Powell accelerate the sell off of its balance sheet—announced by Yellen, but not yet really begun, thus driving rates higher even faster?

A next set of questions is whether a flattening yield curve now underway, and a slowing real US economy by late 2018-early 2019, bring the new rate hike and tightening Fed policy to a halt? Could it even mean, in the medium term, a return to a policy of rate reduction and cheaper money once again? How soon before rising rates precipitate another financial instability event?
Put alternatively: how high (and fast) will Fed rates rise in the short run, 2018-19, before the prior liquidity fueled financial asset bubbles of 2009-18 created by Greenspan, Bernanke, and Yellen begin to burst? The 10% February 2018 stock market corrections may be but a harbinger of things yet to come—a dress rehearsal correction that often occurs before the more sustained corrections that follow weeks, sometimes months, later.

Three to four rate hikes in 2018 may lead to history repeating itself. The Fed’s rate hiking in 2007-08—from a 1% Fed funds rate to more than 5%—precipitated the crash of the bubble in subprime mortgages that spread via derivatives contagion to the rest of the credit system. A similar experience in 2018-19 may be in the making, albeit with new causal transmission mechanisms and other financial asset markets. It won’t be mortgages and credit default swaps next time. Fed rate hikes may burst the current bubbles in stocks and junk bonds—this time transmitted by derivatives in the form of exchange traded notes & products linked to passive investing and quant hedge fund algorithm-induced automated selling. Or it may come from emerging markets, now overloaded with dollar denominated corporate debt, that collapse with massive capital flight and recessions provoked by rising domestic rates that shut down their own economies. It may even originate in China where, even if contained there, will send unknown psychological contagion effects across the rest of the global economy.

When rising rates driven by fiscal policy inevitably meet the financial fragility that exists in key sectors of the US economy, it may bring about the abrupt termination of the Fed rate hike policy about to accelerate at the Fed.

The last time the Fed reversed course and raised rates in 2006-08, rates rose beyond 5% before the bubbles imploded. Given the fundamentally more fragile US economy today, it may take far less a hike to precipitate the same!

As this writer has been arguing elsewhere recently, what’s different today from 2006-07 is that it will almost certainly not take a 5% Fed funds rate to precipitate another crisis. A Fed funds rate of 2%-2.5% may prove sufficient. A 10 year Treasury bond rate of 3.5% could provoke the same. Either could set in motion a serious contraction of bond or stock Exchange Trade Funds’ prices, accelerated by Quant hedge fund algorithmic trading, and amplified by the mass influx of passive index investing in recent years.

While that may not be the immediate short term scenario, it may not be far from the midterm truth, circa 2019-20!

Dr. Jack Rasmus is the author of the recently published book, ‘Central Bankers at the End of Their Ropes: Monetary Policy and the Coming Depression’, Clarity Press, August 2017, which has been previously reviewed on this magazine. He blogs at drjackrasmus and his twitter handle is @drjackrasmus.

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