High Priests of Finance

I don't want to care about the Federal Reserve.

When I started learning about investing, I learned that I am a value investor by disposition. After reading the usual handbooks on the subject, I set about dutifully applying what I had learned and was puzzled why almost none of it worked. The circuitous, albeit enjoyable, tour through the finance media world took me on a sightseeing tour through many of the issues of macroeconomics. I want to be a value investor but I’m forced to spend most of my time thinking about macro. To be clear, I enjoy thinking about this stuff. I find the puzzle endlessly interesting but someday, I hope I can go back to spending most of my time looking for value.

FOMC in session

F.or O.ur M.arket C.onfusion

Every so often, the entire market watches as the high priests of finance make pronouncements and scours over their every word looking for tiny changes to the narrative that might impact their investing worldview. A shift in a word here or a different colored tie there could cause huge moves in markets. We used to care about the thickness of Greenspan’s briefcase. Sometimes, central bankers even embrace the symbolism.

This week, Jerome Powell took to the podium to pronounce on the decisions arrived at during his meeting with the bishops at his Temple of Eccles. The denotative message was fairly consistent with what he has been saying during this entire hiking cycle which began in March of 2022: data dependence, dual mandate, etc. But the connotative message and the unsaid, along with a few shifts of phrase, were what markets and journalists keyed in on. Yes, rates will be higher for longer but the policy interest rate is "at or near its peak for this tightening cycle." The roar from the crowd was instantaneous and deafening. If we’re done for this hiking cycle, then the bias for future rates is down. The market took this happy forward guidance and did the needful. Interest rates all along the yield curve were driven dramatically downward.

In monetary policy, there are a lot of mistakes but no accidents. The pattern over the last forty years is that they will keep pressing their runbook until something breaks. After the breakage, they leap into action to preserve the financial system, usually by reversing the policy they held into the breakage. The unintended side effects of this response plant the seeds of the next cycle. Repeat. James Grant puts it more poetically: the Fed plays the roles of both arsonist and fireman.

The Fed held their policy rate low for more than a decade after the Great Financial Crisis and this did not result in monetary or consumer inflation, although we did have inflation in financial assets. They have been on this hiking cycle for barely more than a year and are already declaring mission accomplished despite the widespread belief that shifts in policy act with "long and variable lags." If low rates didn’t cause inflation why should we believe that this abrupt change to higher rates has quelled it, especially in so short a time? Is it possible that inflation has come back down for other reasons, irrespective of interest rates? During the press conference, Michael McKee asked a great question.

Mr. Chairman, you were, by your own admission, behind the curve in starting to raise rates to fight inflation and you said earlier again the full effects of our tightening cycle have not yet been felt. How will you decide when to cut rates and how will you ensure you’re not behind the curve there?

This is where Powell spiked the football while doing a jaunty dance, metaphorically speaking. He spoke to the dual mandate of price stability and full employment being in "better balance" and said the need to press hard on the policy rate has subsided. McKee followed up with another great question.

When you begin the cutting cycle, will it be essentially run the same way you do it now with raising rates where you basically do trial and error, cut and see what happens or will you tie it to some particular measure of progress?

Sick burn. Well played, Mr. McKee. Powell’s response was to admit they haven’t thought that far ahead. Yikes.

Mission Accomplished?

The Fed got lucky with inflation. It has come down but it has done so for a lot of reasons that have nothing to do with their policy rate. Declaring victory reveals something about their hand which they keep close to their vests: they’re worried. They understand that they are losing control of the bond market and fear that if they continue to press, a la Volcker, that they’ll break something. So they declare victory when victory is far from certain and ride into the new year on a high note. It’s all a fiction. Inflation is likely to return in a second wave, bigger than the first. Their policy tools aren’t going to be able to address the second wave any better than they were able to address the first. They have to convince the market of their fiction in order to keep the game going. Powell isn’t Paul Volcker. He’s John Law.

The Visible Hand

All government intervention is stimulus; some of it is just dressed up to look like regulation. The question is who receives the stimulus. The years of historically low interest rates were stimulus for financial assets. The past year and a half of rising rates were stimulus for people with access to liquidity. This rate reversal is stimulus for people who traffic in sovereign debt.

The Arrow of Time

There is essentially no more important financial metric than time. Compounding interest, the time value of money, and discounting future cash flows all revolve around time. Interest rates put a price on time. Should we really live in a world where the most important price is set by a cadre of political appointees? Or is it possible to let interest rates be determined by the supply and demand dynamics around the actual people whose time is being priced? What if the Fed left interest rates alone? Or better yet, what if the Fed didn’t exist because they weren’t needed? Their dual mandate is: stable prices, which they seem unable to effectively control: and full employment, which they have no business being involved with. What if we let employers deal with full employment and the rest of the world price their own time?

Further Reading

If you read one book on this subject, make it Liaquat Ahamed’s "Lords of Finance." If you want to continue further, check out G. Edward Griffin’s "The Creature from Jekyll Island." The history of the Fed is sordid and their track record, doubly so. We got along without it before 1913. Prior to the establishment of the Fed, periods of inflation were followed by relatively symmetrical periods of deflation, which resulted in a long run average which plausibly resembled stable prices.

Oh, and no one had to tune in on a beautiful Wednesday afternoon to listen to and parse the pronouncements of monetary high priests in order to try to understand markets and plan for the future.