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  • Writer's pictureGerard Kavanagh

Only half the story

Today we will kick off with a John Mauldin weekly missive outtake, this one regards ex-Fed board member Tom Hoenig, and while it gave credence to my near 30 years of bemoaning central bankers and the idiocy (laziness) of their policies, that is not the point of today's blog commentary. Anyway, read on Macduff (!): "I was thrilled to have Tom Hoenig at SIC. Over 20 years (1991–2011) as president of the Kansas City Federal Reserve Bank, he sat on the Fed’s policy committee and saw the decisions happen. And he wasn’t thrilled with some of them. Most of this was during the Alan Greenspan era. The initial mistakes seemed innocent. The Fed became more accommodating to markets in the Mexican peso crisis, then later with Asian and Russian debt crises. These were indeed bad situations. The Fed had to respond, which it did, preventing the markets from imploding. Wall Street hailed Greenspan as a genius. But then bankers and investors came to think the Fed could manage its way out of any crisis. This was the genesis of the overconfidence Bill White talked about, and other central banks had it, too. Hoenig saw early on the Fed was really just bailing out hedge funds. Later, he saw them announcing policies with open-ended, “for a considerable period” commitments. This came to be called the “Greenspan Put.” I think we all kind of knew what was happening, but it’s still startling to hear this inside description. Fed officials knew full well their policies were creating asset inflation—higher stock and real estate valuations, etc. They thought that was fine as long as it didn’t become broader price inflation. Which it wasn’t, at least according to the Fed’s benchmarks. (Anyone trying to rent an apartment or pay for healthcare saw plenty of inflation in those years.) This went from bad to worse in 2007 as Ben Bernanke became Fed chair. A small group—not the entire FOMC—came up with the “Bernanke Doctrine” of zero rates and large-scale asset purchases. This was well before the Bear Stearns and Lehman Brothers failures. We all know what happened next. You can argue the Fed did what it had to, but Hoenig saw it doing far more. As he had predicted years earlier, these policies that were so easy to introduce proved very hard to end. He said so, dissenting as the lone “no” vote at several FOMC meetings. Here he is, describing what sounds like a very tough year in 2010.

“I know we still had high unemployment, but it was coming down, and yet we have to do another quantitative easing. I said, ‘That doesn’t make sense. You’re going to further inflate asset value, further make it difficult to normalize your balance sheet, further have the economy adjust from an equilibrium other than zero,’ which is very unstable almost by definition. And yet, I was clearly outvoted every time 11 to 1. “And so that was part of the disappointment in terms of the policy that, for me, seemed pretty clear in terms of we needed to remove this excess stimulus carefully, slowly, while we had the time. But instead, it was, 'Yes, we got to go full guns because we want unemployment down to 3% overnight.’ Well, that’s wishful thinking in the best of circumstances.” In one sense, this is water under the bridge, but it’s also important. It means Federal Reserve leaders knew what they were doing as they propped up the markets. They had a chance to change course and didn’t take it. This launched a decade of low rates and slow GDP growth but strong market performance. The Fed choked, and it led directly to the financialization and stifled competition that contribute to today’s price inflation. Hoenig thinks there is a very real chance the Fed will soon make that same mistake again. “Will the Fed stay the course? Will the Fed even keep rates where they are? Let’s say they’re 2% by summer and they’re taking out the $95 billion a month, and the market begins to have a real anxiety attack. Will the Fed stay the course? “And I don’t mean keep raising rates. Would they even keep them at the same level? Would they not reverse their quantitative tightening to quantitative easing? That’s the question I think will be really important and will determine a lot for the future. I fear that they will get cold feet and back away, and if they don’t, I also am very concerned that we will have a recession. “And, once that unemployment rate starts to rise and the market starts, will the Fed be able to stay the course? If they think they’re under a lot of pressure now, I think two months from now, it’s going to be really difficult for them, and I don’t know that they won’t back down. If you look at their past performance, their past actions of the last several months and years, actually, you would be skeptical that they would not reverse policy.” This is my fear as well. We saw a similar situation in 2018. I was critical at the time of the Fed doing what I called a “two-variable experiment.” The Fed was tightening, markets didn’t like it, and Powell gave in. He “crawdadded,” as I called it back then. He will soon be tempted to do the same again. I don’t have the words to explain how risky this is. As Bill White said, a behind-the-curve Fed will mean lower real interest rates. That is how inflation gets out of control and currencies crash. For that to happen in the global reserve currency and the world’s largest economy would be indescribably catastrophic. I have that same criticism today. They should just raise rates and maybe let the mortgages roll off the balance sheet, but not both. If something breaks, what do you blame? Do you cut rates and do more QE in an attempt to fix what broke? What if you just need to do one? The way they are conducting monetary policy is far too risky in this environment. They should simply be raising rates about 50 basis points at every meeting until inflation begins dropping toward 3%. I’m just not that bothered by the balance sheet. The balance sheet got very large in the 1930s, and the Fed did nothing, and we just grew out of it. I suspect the same thing could be done today."

This to me is missing half the story, in fact, 3/4's of the story. The subject not mentioned, the bulk of the iceberg lurking below the waves, the pack of elephants in the room is debt - global debt - it's unfathomably IMMENSE. Raise rates into that backdrop, and you blow the entire financial system/economy to pieces - think 2008 was unpleasant, that was a cakewalk compared to where we are now (and there is no China or nearly enough dirty money out there to restart the system if it face plants this time). To raise rates even fractionally more (let alone 50bps per meeting) is to bring that danger to the fore right quick, to invite armageddon. This brings us back to the idiocy of central banks (as Mr. Hoenig has clearly highlighted above). The single greatest threat is that central bankers will believe their own bs and as Powell is championing Volcker go gently into that "good night". While we have empirical proof, care of Mr. Hoenig, that central bankers are ivory tower muppets and do believe their own dogma (bs). We believe, this time, central bankers are in fact (and back to Dylan Thomas) raging against the dying of the light. They have successfully jawboned (for what else can you do once you have painted yourself into a corner) the markets (bond + equities + crypto) to do their bidding and take the excessive edge off - rates if they are going higher are going so in a very minimalistic manner. There are signs and common sense that inflation is rolling over - moving to meet a higher base (and thus a lower growth rate). As John Mauldin wrote at the end of his missive (the one highlighting Tom Hoenig among others) is as follows: "We may be between a rock and a hard place, but we still have a path forward. There are lots of opportunities.” We agree, we think the path forward, as we have been experiencing and discussing, is that inflation is embedded, and financial repression which has been the ongoing situation is the way authorities have chosen to deflate the debt bubble they have caused. We also see the pendulum swinging from free to command economics as govts seize financial independence from central bankers by directed (and guaranteed) bank lending, reshoring supply chains (deglobalisation) continued ill-conceived greening of energy policies, etc. Equities will trump bonds, and value will trump growth, but inflation, repression (capital and yield controls), and dwindling free markets mean easy money is gone.

The risks are legion, and this will not be an especially fun 10-20 years (esp for elderly savers), but there are real and tangible opportunities. This is an investment regime change, the secular change we have discussed ad nauseam.

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