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Why The Fed Is Wrong, Again
These days everyone is a macro trading expert. Literally every crypto and meme stock fiend on FinTwit has now developed their own proprietary rates vs. S&P levels toolkit and is Twitsplaining it to the rest of us all day long.
Well, we can look you in the eye and say (1) we aren’t macro trading experts and so (2) you won’t see any hastily cobbled-together charts or tables here. We do however have a guest author, Yimin Xu, who actually does know what he is talking about on Fed matters, so if it’s data and actionable insight you’re looking for, check out Decoding The Fed.
We can also look you dead in the eye and say, the Fed has this whole rate-rise thing flat wrong, and it’s because all the decisionmakers there are on drugs.
Allow us to explain.
They Saved Every One Of Us
In 2008, Western Capitalism actually was under threat. Not from the Bolsheviks of old, not even from China, but from contradictions within itself. Yes, Marx did say this would happen. No, he was not correct on the outcome. Because he didn’t know about Money Printer Go Brrrr.
Equity market participants remember the 2008/9 Great Financial Crisis as an equity event, when stocks hit the deck and stayed down. But that was a consequence of what actually happened - it was just a surface observation, not the guts of the matter. The guts of the matter is that capitalism almost broke because trust between counterparties evaporated. And that trust evaporated because:
A lot of people had obtained liar loans and could not in fact afford to service the mortgages they had taken out.
Originators of these liar loans had sold them on to investment banks who structured them into baskets of securities wherein a bucket of poor quality loans with a few AAA sprinkles on top suddenly got rated investment grade (way to go, ratings agencies!).
Investment banks then sold these mortgage-backed securities on to credit investors, who at least in theory thought they were buying investment grade products. (We are willing to bet that most of them knew that junk with pixie dust on top does not a Treasury bond make).
Credit investors then insured themselves using many things but including complex derivatives structured and sold OTC (ie. not traded on an exchange but held between distinct counterparties).
Little collateral was held in support of these derivatives or indeed at all.
This was the latent fuel for the fire. The spark came when borrowers struggled to keep up with the payments on their liar loans (shock!) and default rates started to rise and jingle mail became a thing. And the catalyst, the accelerant that turned a gentle smoulder into a full on firestorm was that one of the investment banks at the heart of the system, Lehman Bros, well, the CEO there had played it all Master of the Universe once too often and it turned out that when your common or garden MOTU on his uppers needs a favor, they don’t have too many actual friends in town. So Lehman blew and that scorched the rest of the system. It turned out that (1) the loans weren’t in fact investment grade (shock!!) and (2) the insurance wasn’t worth the paper it was written on. Well, actually, (2), nobody knew what a lot of the insurance was worth, because a lot of it was in illiquid OTC form and as time went by you couldn’t be sure (a) who the counterparty to your OTC trade was and (b) if they were solvent but you most certainly could be sure that there wasn’t any collateral worth having because, you know, collateral was SO, like, 1980s dude.
Trust in the financial system evaporated. For a short while, commercial paper more or less stopped trading. This is credity-lookin stuff that provides liquidity for actual companies to do actual stuff with. It’s important. And when it stops trading, companies can’t do stuff and cash stops flowing and then all kinds of bad things happen.
The solution to all this excess leverage was, of course, more leverage. (Best hangover cure? More tequila!). The Fed and the other major central banks stepped in and became the lender of last resort. The ‘Fed Put’ isn’t a thing that keeps your AAPL 0.00 stock moving up - it's a thing that means there is always someone to buy bonds or other forms of securitized credit - always someone you can trust.
Governments issued proprietary tokens in their own name - sorry, not tokens, fiat currency, that’s right, totally different thing - and used those tokens - sorry, US Dollars - to buy bonds and other forms of credit. Thus injecting liquidity and trust back into the system and saving capitalism from, let’s call them, over-optimistic borrowers on Main St and, let’s call them, glass-half-full structured credit desks on Wall St.
They saved every one of us. Saved us from a life on the collective farm, fighting over rotting yams.
And in the meantime generated hubris the likes of which had rarely been seen.
The First Rock Was Free
Can you even imagine the dopamine rush that comes from this kind of thing? Forget your Marvel superheroes. The new X-(Wo)Men were the Chairs of the Big Central Banks. They knew it, we knew it, they knew we knew it, and that showed up in the newfound swagger amongst central bankers formerly thought of as anodyne bureaucrats.
Remember the Intel advert, Our Rock Stars Are Not Like Your Rock Stars?
Well, central bankers became the new rock stars.
Hilarious!
Except, like everyone who knocks it out of the park for the first time, they believed their own publicity. And thought not that this was a one-time event with, in truth, way more complexity than we have laid out above, and with, in truth, less agency by central banks and more self-healing methods within the system itself than the New Kings Of The Wild Frontier cared to believe.
Now, the new flood of dollars / tokens (maybe we could call them Fed Transaction Tokens or FTTs?) increased the money supply massively. And what should have happened was a major step up in inflation, as per the Chicago School’s teaching. But it didn’t. And so the lesson learned was not that there were some other factors at play suppressing prices, but that in fact Not Only Had The Central Bankers Saved The World From Capitalism’s Own Contradictions And Thus Beaten Marxism Forever, they had also Defeated Inflation Forever even in the midst of the Money Printer Going Brrr. Wow! Now these guys moved on from the dopamine equivalent of a low-grade blunt to the kind of high only usually available from mainlining the more refined forms of crack cocaine.
The first rock was free.
And now they began to chase the next hit.
It Wasn’t You, Dummy
As every fule kno, nobody had beaten the print-money-causing-inflation thing. What was going on at the time was that policymakers the world over were engaged in increasing levels of globalization which is to say increasing levels of deflation. Globalization means lower tariff and non-tariff barriers for the trade of goods and labor. Lower tariffs means lower prices. Lower prices means lower inflation. Lower inflation means lower base rates. Displaying the kind of recency bias typically only found in Chad’s Mom’s Basement, central bankers and indeed other arms of governments came to believe that low inflation was here to stay and that let’s call it 2% was a long run achievable target. And the longer inflation stayed low, the more folks thought it would stay low. It did stay low for a long time, but not because of the Fed. It was because globalization.
Don’t Look At That - Look At This!
Now, the 2009-21 era was an awesome time to be rich and a terrible time to be poor (even more terrible than it usually is to be poor). Because the QE era - the Fed Put + low interest rates - was the most egregious transfer of value from labor to capital as has ever taken place. Marx would think the dark satanic mills upon which he based his theory of the inevitable overthrow of the bourgeoisie were kids’ stuff compared to this. If you spent your time allocating capital in this period, you had a ball. You didn’t even need to be any good at it. Just buy SPY 0.00 and go play golf. And tell everyone what a great investor you were (and you would be right!). If you spent your time selling your labor for tokens, sorry not tokens, DOLLARS, ie. working for The Man? Then you had a terrible time, because if you used to be employed making capital goods in the heartlands, well, China was doing that a lot cheaper. And if you used to write software in Redwood Shores, well, India was doing that a lot cheaper. And so on. Fortunately, in a picture-perfect reprise of the Hollywood misdirect expounded by Theodor Adorno and others, you had a BIG TV ON THE WALL to distract you from your plight, and it cost you ALMOST NOTHING EVERY MONTH on the never-never. And when you started to get fed up of the 57-channels-and-nuthin-on situation, and start to think about why your labor wasn't worth much and what you could do about it, you look outside the window and see your BIG OL SHINY TRUCK outside that is also costing you ALMOST NOTHING EVERY MONTH (less, in fact, that it costs to fill the thing up every month). And you went to bed less unhappy than you should have been.
The Second Only Makes You Wonder
This all could have worked out fine for quite some time. The rich getting quietly very much richer at the expense of the poor, and the poor distracted by shiny things in the time-honored way. Marx opined that religion was the opium of the masses. Well, QE was the opium of the masses in the last decade or so. (Oh, also opioids. Opioids were the opium of the masses in the last decade or so. Want to know why? Because when people stopped looking at the shiny things and started to think about the truth of the matter, their limbic brains gave the quick-fire answer of, The truth, son? You can’t handle the truth!. Cue self-medication of all kinds).
But two things came along to spoil the party.
One, a political reaction to the untoward effects of globalization. If you were in the coastal elite / liberal metropolitan elite class, globalization was awesome because your stuff got cheaper, your money made more money, and probably you could get Vietnamese food at 3am even before UberEats was a thing. Or Korean food at 2am. Or cigarettes at 4am. Or in fact absolutely anything you could think of buying at any time you wanted it. And cheaply. Woot! If however you were in the heartlands class, well, none of these benefits applied. Thus the rise of populism. This reared its head in Eastern Europe in the 1990s as the dissolution of the Iron Curtain failed to lead to a Western standard of living for all - mainly because Western Europe saw Eastern Europe as a place where stuff could be made more cheaply using cheaper labor now that there were no tariffs in place … sound familiar? And by the mid 2010s populism was everywhere. At its core a genuine and rational response to the extraction of value from labor by capital, the policies that have arisen from those who have claimed the populist flag aren’t going to do anything to help the labor class, but, at least the capital class aren’t adding capital quite so quickly and so many who vote this way are part-sated. Populism = tariffs = higher prices = inflation. Simple. So the backdrop here is structural inflation from the mid 2010s onwards.
Two, Covid. Or specifically the Fed’s response to Covid. The Fed looked at Covid thus: Aha! We get to reprise our Classic First Album. Lockdowns = people couldn’t earn money = couldn’t pay their rent or mortgage instalments and couldn’t buy stuff = people working in the store couldn’t buy stuff so couldn’t pay their rent = cash flows in the financial system cease = capitalism breaks. Oh, says the Fed, we know this one. Install new toner cartridges, Barbara, make sure the thing is networked up and HIT PRINT BABY!
Again, no doubt that some degree of stimulus was needed; but since household savings were at unprecedented levels in 2021 we can say that probably that wasn’t the intended outcome, and probably the whole Money Printer Goes Brrr thing went on too long.
Not that this troubled the Fed’s image of itself.
Oh dear.
Now having saved the world from itself AGAIN, if you are a central banker you truly think you Pwn The World. You think you have controlling and indeed benign agency over everything.
You have become utterly drunk on the dopamine coursing through your veins and you think you can swat away any ol problem that comes your way.
You have become a hopeless drug addict.
The Drugs Don’t Work, They Just Make You Worse
Self-medication is rarely a great long-term plan, and it turns out that the coke-addict level self-belief of the Fed is about as valid as your regular white-shoe-white-line banker’s. It’s a year now since the rhetoric and reality of rate hikes were put in place by the Fed, with the stated goal of quashing inflation down to their 2% target.
You see inflation anywhere near 2%? Us neither.
You see rich people getting richer? Us neither.
You see poor people getting less poor? Us neither.
The Fed has it wrong.
What they have wrong isn’t that rates should be higher than they were in 2021.
What they have wrong is that inflation isn’t going to 2% no matter what the Fed does with rates, its balance sheet, its Tweeting-By-Proxy (thankyou Nick Timiraos), or anything else. A protectionist world isn’t going to 2% inflation unless global economies are on the floor and bleeding.
A protectionist world looks like the long-run average of inflation and that needs the long-run average of base rates to keep it in check. Inflation at 5% and rates to match, everyone can live with (because they did live with it for decades prior to the Fed Saving The World, Part I, in 2008).
Someone needs to tell the Fed this. Because being hellbent on driving for 2% is like grandpa ditching the Cadillac and buying a classic, race-tuned Honda Fireblade, declining the offer of a helmet, and heading out to Laguna Seca to show the youngsters how a real bike flies. All the while playing the old tunes and pining for the Old Days. It’s not going to end well.
Unfortunately we don’t seem to have anyone in any positions of influence that both understands this point and can persuade the Fed as such and also persuade rich people that 2% is a mirage but they can keep getting richer anyway, and also persuade poor people that the TV isn’t ever going to be as cheap on the monthly BUT maybe they can actually earn more than they used to, and all in all build a coalition of the willing to support the notion that long-run average inflation and long-run average rates might just be OK for us all in the long run.
So, we sit and wait for something to give.
It’s not going to be tariffs. They are here to stay, that’s just how the world is going to be for the next couple decades. Probably needs a major war or other reset for people to remember Economics 101, Tariffs Make Everyone Poorer And More Angry.
It’s not going to be 2%. That is just an addict’s fantasy, the mother-lode rock of which all dreams are filled.
So it has to be the Fed.
Pivot, Interrupted
We don’t see a ‘pivot’ happening. If by ‘pivot’ is meant the Fed going, ah, sorry about that, back to free money after all. At least not at this time. With the superman energy of the addict, the Fed has pounded the table and told us all that it will do EVERYTHING IT TAKES TO GET INFLATION UNDER CONTROL. And that TWO PERCENT IS THE TARGET. So either they have to find a way to twist that narrative to, well, when we said two we meant five, or, a new Chair of the Fed has to be installed who can then toss J-Po under the bus whilst claiming to, er, Save The World From The Fed.
And you know how central bankers Save The World? That’s right. Pass the toner cartridge, Marjorie, and FIRE HER UP!
Cestrian Capital Research, Inc - 29 November 2022.
Folks thanks for a great reaction to this post. It really helps us to grow if you (1) share and (2) 'Like' the post. The former gets our work in front of an audience directly and the latter helps our standing within Substack's marketing algorithm. So, if you read this and enjoy it, please do share it - everywhere! - and 'Like' it. Much appreciated! Alex King - Founder, Cestrian Capital Research, Inc.
Nice work