"Too Late to Turn Back Now"
by Brian Maher
"The Federal Reserve’s balance sheet presently exceeds $7 trillion - a record. Yet consider the 2012–14 comments of then Federal Reserve Board member Jerome Powell - before he was chairman: "I have concerns about more purchases. As others have pointed out, the dealer community is now assuming close to a $4 trillion balance sheet and purchases through the first quarter of 2014. I admit that is a much stronger reaction than I anticipated, and I am uncomfortable with it for a couple of reasons.
First, the question, why stop at $4 trillion? The market in most cases will cheer us for doing more. It will never be enough for the market. Our models will always tell us that we are helping the economy, and I will probably always feel that those benefits are overestimated…. What is to stop us, other than much faster economic growth, which it is probably not in our power to produce? When it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response…"
Continued the previous Federal Reserve Board member and present chairman: "My next concern is the problem of exiting from a near $4 trillion balance sheet. It just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think… I think we are actually at a point of encouraging risk-taking, and that should give us pause. I kind of think that a large balance sheet might prove to be a magnet for trouble over time. So I tentatively land on a floor system with the smallest possible balance sheet…"
Why Stop at $7 Trillion? If Mr. Powell was so flummoxed by a $4 trillion balance sheet, how must he regard a $7 trillion balance sheet? Do not the same concerns arise? We must conclude they do, only with far heavier gravity. $7 trillion is - after all - nearly twice $4 trillion. And so we parrot Federal Reserve Board member Jerome Powell: “Why stop at $7 trillion?”…“It will never be enough for the market”. “A large balance sheet might prove to be a magnet for trouble over time”.
But Powell was left no option, you say. Cruel fate twisted his arm… and yanked his hair. The virus and its consequent lockdowns waylaid the United States with the grimmest economic crisis since the Great Depression. Absent a vast engorgement of the balance sheet, markets could have gone careening 50% - or more. Years and years of stock market gains would have vanished into the electricity… taking with them the retirement dreams of millions.
But Mr. Powell fell into action with swift and delirious abandon. And the balance sheet took on dimensions truly obscene. And sure as sugar, markets soon found their legs. By summer, they were back atop the glorious heights. Merely 148 trading days after its March bottom, the S&P returned to record highs, and Dow 30,000 was in view.
The stock market has slid backward recently. But we are confident that more determined action by Mr. Powell and his mates will have it going again. An expanded balance sheet will do the pushing. How they can ever slash the balance sheet without sinking the market, we do not know. Yet what is true of the balance sheet is likewise true of interest rates…
Into the “Tractor Beam” of Zero Rates: As a dog returneth to its vomit the federal funds rate has returned to zero. The Federal Reserve has implied it will linger there through 2022. Yet we hazard it will remain at zero as far as eyes can gaze. Hedge fund grandee Kyle Bass has said the economy has fallen within the inescapable “tractor beam” of zero rates: "As we have all learned, once an economy falls into the tractor beam of zero rates, it’s almost impossible to escape them. Growth numbers are going to come down and real growth might go to zero. We’re probably never going to go away from zero rates."
We fear Mr. Bass is correct. Like a man hooked to a respirator, the economy cannot breathe on its own. The previous financial crisis collapsed its lungs. The Federal Reserve rushed over, plugged in the oxygen… and never took it out. The economy’s natural breathing apparatus atrophied from disuse.
In 2018, Dr. Powell attempted to wean the patient off support. He increased rates on four occasions. That December he also pledged that quantitative tightening would proceed apace. But the stock market gurgled, sputtered and flailed on the news. It turned in its worst December since the Great Depression.
By early January 2019, Dr. Powell emptied his medical kit into the trash can. Anon he was pumping in more oxygen. The stock market was sitting up in no time, and back in the pink of health. Packed with oxygen-rich blood, it went on another lovely spree.
Then this March a microscopic marauder got loose. The economy scrambled into hiding. And the market took a terrible fright. Powell got the stock market up and going again. Yet it requires more artificial support than ever. And the economy has only partly emerged from its bunker. Will zero rates entice it out?
Are Rates Actually Low? Nominal rates are at zero, it is true. But does that mean interest rates are truly at zero? Not when you consider real interest rates. Jim Rickards: "As for rates being “low,” they’re not. It’s true that nominal interest rates (the kind you see on screens and TV) are near all-time lows. But real interest rates (nominal rates minus inflation) are quite high by historical standards. Real rates have to go much lower to help growth. With inflation dropping, that means nominal rates have to go deeply negative in order to get real rates low enough to help. That is, even at zero, the economy cannot withstand higher interest rates. In this telling, they must in fact sink far into negative territory to push the economy far into positive territory."
Thus the Federal Reserve cannot increase interest rates for years and years. Nor can it saw into its balance sheet without sawing through Wall Street. But if a $4 trillion balance sheet was a “magnet for trouble over time,” what about a $7 trillion balance sheet?"
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