Janet Yellen’s game of Jenga

Jenga tower

Jenga Tower (Photo by Guma89)

Janet Yellen has a plan. The plan is to exit the ultra-loose policy of the Federal Reserve, and to do so very slowly and very carefully. And by slowly I mean very slowly.

2013, the last year of the Bernanke reign and the sixth year post subprime, was the central bank’s most generous if measured by level of interest rates and the expansion of the girth of its balance sheet: Fed Funds remained at 0.25 percent throughout the year, and through quantitative easing the monetary base grew by another $1,000 billion. Such largesse even beat the emergency stimulus in the wake of Lehman. According to Yellen’s plan, the Fed will add another $400-plus billion via QE this year – this is only slightly less than what the Fed did in 2011 but more than 2009 and 2010 combined – and another six months later, if all goes to plan, the first rate hike may occur. That would take us to the summer of 2015 and to the eighth anniversary of the subprime meltdown. But even then, Yellen & Co. are at pains to stress, will the rise in interest rates be very, very slow indeed.

It is clear that the Fed is walking on eggshells. One explanation may be that the ‘real economy’ is so weak that it can only be released from the Fed’s nursing ward in a carefully paced process. The US economy must slowly learn to walk again without the Fed’s monetary crutches.

However, I suspect that another explanation is more fitting. The Fed is not really managing the economy, it is managing the financial sector. Yellen knows that six years of zero interest rates and various rounds of QE have led to an immensely bloated and potentially vastly distorted financial system. The Fed has no choice but to remove its market-distorting über-stimulus with the utmost care. Rather than guiding the ‘real’ economy’s glacial recovery, the Fed is slowly weaning a swollen financial system off its monetary morphine. The big risk in this is not so much a suddenly much weaker economy but the emergence of withdrawal syndromes in the financial sector.

Steady as she goes.

In 2013 the US economy grew by 2.6 percent. Recent forecasts by the Fed are for 2.9 percent growth in 2014, and 3.1% in 2015. At the end of 2013, the unemployment rate stood at 6.7 percent. At the end of ‘taper’ the Fed expects it to stand at 6.2 percent, and when rates should finally start going up, at 5.7%.

A) None of this looks like an economic emergency to me. B) Yes, ongoing improvement in the economy is expected but nothing that is offensively flamboyant is expected either. But the 2013 numbers appear to have required the biggest stimulus in Fed history, the 2015 numbers require rate hikes.

Of course, you may object, the numbers only look so smooth and Goldilockish because the Fed is so skilful in employing its interventionist arsenal, and knowing exactly when and how to withdraw it. Maybe so. The Fed has certainly built the expected success of its policies into its forecast. But still, I for one believe the Fed’s policy is mainly geared towards steering an unruly financial sector fattened by years of super easy money, and it hopes it can do so without pushing the economy off its recovery path.

Look what free money can buy you!

The wider financial community knows that equities are only trading where they are (that is, at record highs) because of the Fed. Corporate bonds are only trading where they are because of the Fed. High-yield bonds, bank loans, and real estate are trading where they are because of the Fed. For years the prime reason for buying these assets has been that they were supported by the Fed’s ultra-easy policy. Fed ‘stimulus’ has been the prime mover of every market and the common denominator of all price advances. Fed policy – and by extension, central bank policy in general – has been the main, if not the only, topic on trading floors. Investors must now be telling themselves that these assets can keep trading at elevated levels and even advance further without support from Yellen & Co., that now the ‘real’ economy will take over supporting them (that would be that calmly cruising entity described by the numbers above). The hope must be that the old relationships emerge again, meaning that policy boosts the real economy, which in turn lifts financial assets, so that assets can keep rising with just some decent growth in their sails, and even once the Fed has packed up and gone home. The question is, is that a realistic prospect?

The “Bernanke” doctrine

The whole idea runs somewhat counter to the “Bernanke doctrine”, which states that the Fed really focuses on financial assets, that it boosts those first, and that this in turn lifts the economy. The Wall Street tail wags the Main Street dog. Former Fed chairman Ben Bernanke explained this clearly to the American public in his famous Washington Post editorial in 2010. Asset prices are thus a tool for policymakers to get economic results. They are to be astutely manipulated so that the economy can perform better. Have you forgotten? “…lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”

For more than 5 years, investors have (more or less) happily played that game. “Don’t fight the Fed” was the convenient and slightly dim-witted motto. Being “long and leveraged” was again the winning maxim for risk-takers, just as it was in 1997 or 2006. But what can the financial system accomplish without the big Sugar Daddy of the Eccles Building? The investor community is now split between those who continue to ride, slightly nervously, the wave of still easy money and still rising prices and falling risk premiums, those who believe that this should go on a tad longer, and those who have already trimmed the hedges – naturally too early. Both must feel very uneasy.

And Yellen must feel uneasy too. She wants out but knows that the financial sector may throw a hissy fit. Of course, in an ideal world she should ignore it, even at the risk of reverberations for the ‘real’ economy. But after many years of bad parenting, the financial system is like a spoiled teenager who knows his rich parents will ultimately get the checkbook out rather than see their kid endure any real trouble. That is the reason why Yellen is moving so slowly and carefully, and not the so-called ‘real’ economy, which seems to be doing its own thing in the meantime. The whole affair is like a financial game of “Jenga”, where Yellen is slowly removing pieces from the wooden tower that is the overstretched financial system. This will not be a smooth process. There will be wobbles. There may even be collapses. Then the checkbook will come out again. Ultimately, Ms Yellen will not see her plan through.

 

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