In what qualifies as a huge understatement, the September 13th FOMC day did not play out as we expected. We overestimated the rational capacity (and perhaps the intellectual honesty) of Fed Chairman Ben Bernanke, and underestimated his fear of the Tea Party.
From an odds perspective, we thought the Federal Reserve had very good reason to show restraint at the September meeting.
By restraint meaning ‘delivery of the minimum’ while still satisfying expectations for stimulus, i.e. reasonably accommodating action coupled with pointedly neutral language (or something to that effect).
Call it the ‘neutral accomodative’ stance. Going into the meeting, we pegged the odds of neutral accomodative at something like 70 percent, with 20 percent chance of “nothing done” and a pause until the December meeting. The chances of a full-blown “super dove” outcome were seen as statistically non-trivial, but very low.
Why take that probabilistic mix? Let’s recap the analysis elements, as they appeared before the announcement occurred.
In considering how dovish to be, these are (roughly) the risk factors the Fed faced:
- risk of the appearance of political partisanship prior to a major election
- risk of inciting a frenzied reaction (acceleration of speculative bullishness) that might cause markets to overheat, creating more danger later
- risk of using up psychological ammo prior to fresh crisis (Greece for example)
- risk of leaving nothing for December if the economy slows between here and there
In comparison to the above, consider the advantages the Fed would have had, had they deliberately crafted a more ‘accommodative but neutral’ message:
~ A mildly disappointed, but still mostly appeased market, would have presented less danger of overheating.
~ There would have been more tactical and psychological ammunition ‘left in reserve,’ with the possibility of pointed reference that it could be used at the December meeting.
~ An ‘accommodative yet neutral’ stance would have nicely threaded the political partisanship needle, giving short term assistance to the economy but waiting for bigger juice until after the November election.
~ Given the overbought state of equities and oversold state of the dollar even before the meeting occurred, a modest mean reversion in both (equities down, dollar up) would have provided a more stable market profile, with the Fed able to jawbone or policy-walk equities back up / push the dollar back down if mean reverting corrective action grew out of hand.
~ Given the state of sharp internal division within the Fed (doves vs hawks), an accommodative but neutral stance also would have walked the line between these groups.
~ A more measured stance would have reflected a vote of confidence from the Fed in respect to the US economy’s slow healing, versus over-aggressive actions containing a whiff of panic.
The accumulated evidence, in other words, clearly favored restraint – at least some restraint – of a nature that would give the Fed more ‘Reserve’ (no pun intended) at a time when markets were probably about as favorably disposed as possible to a little medium disappointment without imploding.
That’s the logic. And yet, ‘neutral accomodative’ ain’t what we got. Instead we got “ludicrous speed,” as confirmed by the following language:
The FOMC also said it would probably hold the federal funds rate near zero “at least through mid-2015.” Since January, the Fed had said the rate was likely to stay low at least through late 2014. The Fed said “a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”
…“This is definitely a significant shift in FOMC policy,” said Julia Coronado, chief economist for North America at BNP Paribas in New York and a former Fed economist. “This is a very aggressive commitment to success on its mandates.”
Bernanke said the open-ended purchases would continue until the labor market improved significantly. “We’re not going to rush to begin to tighten policy,” he said. “We’re going to give it some time to make sure that the economy is well established.”
Instead we got the lower probability 10 percent scenario: Bernanke firing the big cannon, and making markets go insane. We can see just how insane by observing the parabolic action in the euro (EURUSD), which clearly denotes a big surprise in terms of the Fed not just “coming through” on QE3, but being a hell of a lot more accomodative than expected.
Which begs a curious question: Why would the Fed do that?
When such a rational course of action was available, why would they use up their psychological ammo before December… risk bitter charges of partisanship… alienate the internal hawks… Leave themselves flat-footed in the event of new crisis… and, last but not least, run the risk of pushing an already extended equities-up / dollar-down “risk on” trend to frenzied collapse-prone levels?
From a game theory perspective, such a decision making process suggests the Fed is dumb. But we do not believe that.
Corrupt? Yes. Beholden to special interests and financial insiders whose well being is elevated above all? Certainly.
But dumb? No.
This leaves one last possibility: The Fed has decided it wants to see President Obama re-elected… and wants to help engineer that outcome at all costs.
The Fed may have further decided that President Obama’s reelection is so important, it is worth risking all manner of bad optics to make it happen (by juicing the economy prior to November as much as it possibly can).
Of course, Bernanke went out of his way to specifically deny this possibility, stating that “We have tried very hard to be non-partisan and apolitical… We make our decisions entirely on the state of the economy.” But of course he would say that, wouldn’t he? It is a classic vein of politician and CEO speak. When a leader says ‘X is not a concern,” you know damn well it’s a large concern…
Too tinfoil hat, you say? Consider this recent Reuters report, “At Jackson Hole, a growing fear for Fed independence:”
Increasing political encroachment on the Federal Reserve, particularly from the Republican Party, could threaten the central bank’s hard-won independence and undermine confidence in the nearly 100-year old institution.
That was the pervasive sentiment among economists gathered at the Fed’s annual monetary policy symposium in Jackson Hole, Wyoming. Against the dramatic backdrop of the Grand Teton mountain, many said a closely-contested presidential race has turned the monetary authority into a political football.
“I do fear for it a bit if the election comes out that way, especially if some of the more radical voices, that happen to be Republican voices nowadays, get reelected,” said Alan Blinder, Princeton economics professor and a former Fed vice chairman, adding that historically opposition to the U.S. central bank had come predominately from the left.
“There’s a lot of hostility,” said Blinder, who was appointed to the Fed by former president Bill Clinton.
The Federal Reserve rightly fears the Tea Party – to whom VP candidate Ryan is somewhat beholden to – and the ‘hard money conservative’ wing of the Republican party in general.
Let us now conduct a political analysis. This is about as pleasant as gutting a trout, but it is necessary to put the pieces together. So here goes.
We do not remember the origin of the saying (thinking it might be Barry Ritholtz), but we generally agree with the notion that “Democrats are the party of no ideas, while Republicans are the party of bad ideas.”
As John Mauldin has keenly observed, the Democrats, having no idea how to help the economy, have passively signed on to a monetary policy form of “trickle down economics” – by way of endorsing the “socialism for the rich, boost paper assets, push them out on the risk curve” tactics of the Federal Reserve – that is more grossly unfair to the poor than Reagonomics ever dreamed of being.
As a side note on this, the sight of Michelle Obama waxing eloquent about her and the President’s working poor class roots warranted such deep cynicism one hardly knew whether to laugh or cry. Health insurance tweaks aside, the Wall Street driven corporatist Obama presidency , with all its leniency towards savings-destroying, cost-of-living increasing actions, has been one of the worst for poor people ever. Some food for thought:
- The End of the Middle Class Century
- Household income sinks to 1995 level
- Producer Prices Post Biggest Gain in 3 Years
With all the above said, the Federal Reserve would prefer to cast its lot with the Democrats because, being the party of no ideas, their “go with the flow” solution involves handing over economic responsibility, and power, to the Fed.
Such is further underscored by leading super Keynesians like Paul Krugman, to whom virtually all stimulus is good stimulus. As if the point were not underscored enough, Krugman apparently thinks even the latest water cannon blast was “not enough.” Dear Paul Krugman, you are certifiably nuts.
The Republicans, on the other hand, being the party of “bad” ideas – and also the party of hard money – see an alternative way to save the economy, via the blanket lowering of taxes.
From the Federal Reserve’s point of view, the soundness of Republican tax-obsessed ideology is irrelevant. The key threat is that, via Tea Party views specifically and Republican views in general, lower taxation is seen by Repubs as a preferable saving grace option versus leaving the reins of monetary power in the hands of a corrupt Fed.
We are not attempting to pick a side here. We are certainly not favoring the lowering of taxes as an economic cure-all, any more than we favor dumb stimulus. Neither Democrats nor Republicans have our endorsement (so if you are a partisan hack for either side, PLEASE spare us). “A pox on both houses” is our political motto, and bumper sticker affiliations (e.g. “proud to be a [fill in the blank]”) are for simpletons in our view.
As macro-oriented traders of all liquid asset classes, we are interested in trying to figure out why the Fed did what it did, especially in light of the fact that the Fed surprised us.
Referencing basic game theory once again: If you have determined someone to be your enemy beyond a shadow of a doubt, and if that enemy is posing an active threat, it may make sense to strike as hard as you can, while you can, before losing the chance.
The Tea Party, and the hard money ideology of Republicans in general, is a genuine threat to the Federal Reserve’s independence – or at least is perceived as such – via the possibility of legislative change under Republican control.
Some may say this threat is far fetched, but it is the most serious threat to the Fed that exists… and for Bernanke, his legacy as chairman within the Fed’s hallowed halls is surely just as important, if not far more important, as his broader reputation in the outside world.
For Bernanke to be the chairman who lost the Fed’s independence on his watch, would be an absolute legacy disaster. And so, just as risk of death supersedes risk of non-serious injury, this legacy risk trumps all else.
For the Fed in relation to FOMC day prior to a key presidential election, the proper strategic course of action thus becomes dominated by this single huge variable, outweighing all the other (very strong) reasons why a pre-election “accommodative neutral” stance would have made sense.
With potentially everything to lose from an institutional legacy perspective at the hands of a hard money, anti-Fed, lower-taxes-not-stimulus Republican administration, the Fed judged all the attendant risks worth it in order to ensure the best chance of an Obama reelection possible.
This realization is deeply troubling, of course, because in order to protect its own backside, the Fed has made a grossly unwise decision in respect to the health and stability of the actual economy.
Again, it seems crazy for the Fed to do what it did on Thursday, and we know these men and women not stupid. (Many other things, but not that.)
But when you consider the internal calculus, it all makes sense…
Even from a delayed costs perspective, if it all comes crashing down worse later on as a result of the Fed’s move, odds are good the do-nothing Fed supportive Dems will have been re-elected by then (via economic juice headed into November) – the core of Bernanke’s legacy (protecting the institution) thus preserved.
We did not like Ben Bernanke before. We now like him even less. We fear that, when the Fed-fueled bottle rocket has gone down in stagflationary flames, many more investors who now cheer the Fed will come around to our view. Because, like it or not, the Fed could actually be setting us up for a deflation outcome of major size and scope… more on that in a future episode.