It is my professional opinion that the Federal Reserve overtightened in December 2018. That rate hike was not necessary and was reversed last week, but the combination of a shrinking Fed balance sheet and a rate hike amid heightened trade tensions last December was clearly not warranted.
The shrinking Fed balance sheet equals the removal of electronic dollars from the financial system that can only be accessed by financial institutions. In that regard, the meaning of fed funds rate hikes and cuts has now been completely altered under QE and QT.
The Federal Reserve is like a stick-shift driver who just got behind the wheel of an automatic-transmission vehicle. If they wanted to – and I am not suggesting they really want to – they could accelerate the runoff rate of the balance sheet, in effect accelerating the removal of electronic dollars from the financial system and cut the fed funds rate, and the net result would be a monetary tightening.
That would be like hitting the gas pedal and the brakes at the same time. The engine is revving but the car is shaking. (Most people who learned how to drive on a stick shift and later drove a car with an automatic transmission learned to hit the gas and accelerator with different feet, as stick shift drivers use both feet).
A note to President Trump: If the Federal Reserve wanted to crash the economy and the stock market, they could do that at any time. Again, I am not suggesting they want that, but they control the payments system, so they can slow down the whole economic shebang and the whole kit and caboodle will come down. While I doubt that they will ever use such powers in a nefarious way, does the President really want to antagonize the guy who is holding such awesome powers in his hands? It seems unwise to me.
It is true that it is legal that the Federal Reserve chairman can be removed “for cause.” Using the Fed Chairman’s powers in nefarious ways would be a clear definition of cause. But the fact remains that there may be convoluted activities not well understood by the President and the financial community that may push back against President Trump and his Twitter account, and there is nothing Trump can do about it.
Last year was a volatile year, as there was epic friction between fiscal and monetary policy. A tax cut, which is in effect fiscal stimulus, clashed with monetary tightening via fed funds rate hikes and removal of electronic dollars from the system via balance sheet shrinkage. The previous time we had so many sparks flying between the Federal Reserve and the White House was when Paul Volcker was Chairman under President Ronald Reagan. Granted, there was no Twitter back then and I sincerely doubt if there were Twitter Ronald Reagan would have used it in the innovative ways that The Donald is finding.
Still, Paul Volcker did deliver a monstrous Fed tightening in the early 1980s, causing a bad recession and then a more benign monetary tightening in the mid-1980s, causing a soft landing without a recession.
While Paul Volcker served as Fed Chairman eight years (August 6, 1979 to August 11, 1987), he was not very popular with the business community and the White House, yet today he is regarded as one of the greatest Fed Chairmen of all time for breaking the back of out-of-control inflation. I think The Donald craves the kind of reverence reserved for Ronald Reagan, but for that he would have to get that Chinese trade deal consummated and get the nukes out of North Korea – both of which are yet to be accomplished.
It’s Still Too Early to Call a Recession
I know the trade situation is bad, and not getting better. A real trade war, with much higher tariffs, will slow the flow of global trade, which can cause a global recession. No Fed rate cuts can push back against a sharp decline in the flow of goods and services. Monetary policy can do a lot, but it cannot do miracles.
When banks stopped dealing with each other in 2008, global trade collapsed. They have not done that this time around, yet, but tariffs have slowed global trade and more tariffs will slow trade even more. I think that the president prides himself in being able to pick the magic moment when tariff escalations will still be reversible, even though I don’t believe that there is a clearly defined line in the sand. The “point of no return” is more like a gray area that is constantly moving.
While both the 10-year Treasury and the 2-year note have declined precipitously, the 10-year Treasury note yield never dipped below the 2-year note, so the classic measure of yield curve inversion (the 2-10 spread) is still in positive territory (see chart below).
If there is a trade deal – and that is a very big if – this message from the bond market could be like the infamous 1995 “soft landing,” when the yield curve marginally inverted, yet the economy kept on expanding for another five years.
It is true that we have a record economic expansion that has lasted longer than 10 years, but the first three to four years of this expansion were so weak that the present expansion can be probably be elongated by another three to four years. Plus, the digital economy has changed so much in the last 20 years that the “Amazon effect” is being discussed in FOMC meetings. Is there any wonder why we don’t have surging inflation as the global economy is weak and those “next-day Prime deliveries” arrive even on Sunday?
Equities Contributor: Ivan Martchev
Source: Equities News