A Fed Governor speaks honestly to us about the costs and risks of our monetary policy

Larry Kummer, Editor

12 years ago

Summary: Fed officials see as tools their ability to manage our confidence and expectations. This means a constant policy of exaggeration and distortion in their speeches, as truth and plain-speaking are secondary considerations. But there are exceptions. Perhaps the most famous is Bernanke’s 2002 “the U.S. government has a technology called a printing press” speech. This week as another, an even more impressive and rare example of honesty by a high government official. He warns us that the extreme monetary policy of today has costs, and might prove difficult to unwind. Let’s pay attention to his words.

Note: We tend to get our news and insights through intermediaries, who inevitably filter and distort the content. On the FM website we try to avoid this, instead giving excerpts with links to the full text. Governor Fisher — like the IPCC, and the famous leaders of our past — speaks to us, and needs no interpreters.

Beer Goggles, Monetary Camels, the Eye of the Needle and the First Law of Holes
With Reference to Peter Boockvar, the Book of Matthew, Sherlock Holmes, ‘The Wolf of Wall Street’ & Denis Healey

Richard Fisher, President of the Federal Reserve Bank of Dallas
Remarks before the National Association of Corporate Directors
14 January 2014

Excerpt #1: Beer Goggles …

Two comments I recently read have been buzzing around my mind as I think about the many issues that will condition my actions as a voter.

The first was by Peter Boockvar, who is among the plethora of analysts offering different viewpoints that I regularly read to get a sense of how we are being viewed in the marketplace. Here is a rather pungent quote from a note he sent out on Jan. 2:

“… QE [quantitative easing] puts beer goggles on investors by creating a line of sight where everything looks good …”

For those of you unfamiliar with the term “beer goggles,” the Urban Dictionary defines it as “the effect that alcohol … has in rendering a person who one would ordinarily regard as unattractive as … alluring.” This audience might substitute “wine” or “martini” or “margarita” for “beer” to make it more age-appropriate, but the effect is the same: Things often look better when one is under the influence of free-flowing liquidity. This is one reason why William McChesney Martin, the longest-serving Fed chairman in our institution’s 100-year history, famously said that the Fed’s job is to take away the punchbowl just as the party gets going. {1955 speech}

Peter Boockvar is Chief Market Analyst of The Lindsey Group (bio here). Here is an early statement of his “beer goggles” theory.

Excerpt #2: Free and Abundant Money Changes Perspective, the first explicit mention I’ve seen by a Fed official of QE’s possible ill effects.

But I have found myself making arguments similar to his and to those of other skeptics at recent FOMC meetings, pointing to some developments that signal we have made for an intoxicating brew as we have continued pouring liquidity down the economy’s throat.

Among them:

Share buybacks financed by debt issuance that after tax treatment and inflation incur minimal, and in some cases negative, cost; this has a most pleasant effect on earnings per share apart from top-line revenue growth.

Dividend payouts financed by cheap debt that bolster share prices.

The “bull/bear spread” for equities now being higher than in October 2007.

Stock market metrics such as price-to-sales ratios and market capitalization as a percentage of gross domestic product at eye-popping levels not seen since the dot-com boom of the late 1990s.

Margin debt that is pushing up against all-time records {data here, graph here}.

In the bond market, investment-grade yield spreads over “risk free” government bonds becoming abnormally tight.

“Covenant lite” lending becoming robust and the spread between CCC credit and investment-grade credit or the risk-free rate historically narrow. I will note here that I am all for helping businesses get back on their feet so that they can expand employment and America’s prosperity: This is the root desire of the FOMC. But I worry when “junk” companies that should borrow at a premium reflecting their risk of failure are able to borrow (or have their shares priced) at rates that defy the odds of that risk.

… And then there are the knock-on effects of all of the above. Market operators are once again spending money freely outside of their day jobs. An example: For almost 40 years, I have spent a not insignificant portion of my savings collecting rare, first-edition books. Like any patient investor in any market, I have learned through several market cycles that you buy when nobody wants something and sell when everyone clamors for more.

During the financial debacle of 2007 – 2009, I was able to buy for a song volumes I have long coveted (including a mint-condition first printing from 1841 of Mackay’s Memoirs of Extraordinary Popular Delusions, which every one of you should read and re-read, certainly if you are contemplating seeing the movie The Wolf of Wall Street). Today, I could not afford them. First editions, like paintings, sculptures, fine wines, Bugattis and homes in Highland Park or River Oaks, have become the by-product of what I am sure Bill Martin would consider a party well underway.

I want to make clear that I am not among those who think we are presently in a “bubble” mode for stocks or bonds or most other assets.

Excerpt #3: How Large Is the Camel? How narrow the eye of the needle?

Let’s turn to the camel, by which I mean the size of the Fed’s balance sheet. …

Here is the rub. We have accomplished the last $2 trillion of balance-sheet expansion by purchasing unprecedented amounts of longer-maturity assets: As of January 8, 2014, 75% of Federal Reserve-held loans and securities had remaining maturities in excess of 5 years.

The brow begins to furrow. To be sure, Treasury and MBS markets are liquid markets. But the old market operator in me is conscious that we hold nearly 40% of outstanding eligible MBS and of Treasuries with more than 5 years to maturity. Selling that concentrated an amount of even the most presumably liquid assets would be a heck of lot more complicated than accumulating it.

Currently, this is not an issue. But as the economy grows, the massive amount of money sitting on the sidelines will be activated; the “velocity” of money will accelerate. If it does so too quickly, we might create inflation or financial market instability or both.

The 12 Federal Reserve Banks house the excess reserves of the depository institutions of America: If loan demand fails to grow at the same rate as banks accumulate reserves due to our hyperaccommodative monetary policy, the resultant excess reserves are deposited with us at a rate of return of 25 basis points (1/4 of 1% per annum).

Here is some math confronting policymakers: Excess reserves are currently 65% of the monetary base and rising. The only other time excess reserves as a percentage of the base have come anywhere close to this level was at the close of the 1930s, when the ratio hit 41%. We are in uncharted territory.

… In the parlance of central banking, the “exit” challenge we now face is somewhat daunting: How do we pass a camel fattened by trillions of dollars of longer-term, less-liquid purchases through the eye of the needle of getting back to a “normalized” balance sheet so as to keep inflation under wraps and yet provide the right amount of monetary impetus for the economy to keep growing and expanding?

For more about the danger Fisher warns of: