June 7, 2016

“My name is The Market and I am still a Fedaholic.”

You don’t break your drug addiction by driving around and around the rehab center drinking a bottle of whiskey and popping pills.

Similarly, you don’t break an addiction to easy money by constantly stalling any interest rate rises and failing to make any reduction in the monetary base.

However much the Fed would like you to believe that it has put the markets on the road to easy money rehab, the fact is that the Fed is scared of what will happen to financial markets and the real economy if it actually sends the markets to easy money rehab and forces them to stay there.

As argued in a post earlier this year, “The Markets Go to Rehab”, the markets have become addicted to a dangerous cocktail of “easy money” drugs. While the markets have enjoyed an easy money binge over the past ten years, breaking the habit will be a very unpleasant experience. Moreover, if the Fed doesn’t wean the markets off the easy money drug, then the long-term economic consequences will be dire.

Back in the first quarter of this year, it looked as though the Fed might actually try to cut off the drugs. There was a genuine expectation of a series of rate rises over the course of 2016, even if those rate rises were engineered by the disingenuous policy instrument that is “interest on reserves”.

However, as we near the half way mark for the year, it seems increasingly clear that the Fed has no appetite for genuine “normalization” of monetary policy.

Consider the evidence so far. We are now six months into this current cycle of tightening monetary policy. How many times has the Fed raised interest rates in this cycle? Once.

In six months, we have only seen one 0.25% interest rate increase by the Fed. In previous tightening cycles, one would have reasonably expected three or four increase in the short-term interest rate by now.

To repeat, we have seen only one rate rise in six months. It begs the question: is the Fed serious about tightening monetary policy? Or does the Fed just want to pretend that it is tightening policy?

To be fair, short-term interest rates are not the only way we can measure Fed activity. The other key monetary policy setting that we need to consider is the size of the monetary base.

Over the past eight years, the monetary base of the United States has quintupled. This rate of growth in the monetary base is far in excess of the historical norm. Any genuine attempt to tighten monetary policy settings in the United States must include a significant reduction (30-50%) in the size of the monetary base.

How is the Fed doing on this second benchmark? Not so well.

As you can see from the chart above, the Fed has barely touched the monetary base. Indeed, the US monetary base continues to hover at dangerously elevated levels.

The lack of Fed action on both interest rates and the monetary base raises a couple of question. Is the Fed genuinely attempting to tighten monetary policy, or is the Fed merely pretending to tighten to monetary policy? And why would the Fed pretend to tighten monetary policy?

The Great Pretender

Why is the Fed trying to be seen to take action while its takes no action?

We can break this question into two parts. First, why doesn’t the Fed want to tighten monetary policy? Second, why does the Fed want the world to believe that it will tighten monetary policy in the near future?

The first part is easy to answer. The markets are addicted to easy money: take away the easy money and the party is over.

Nowhere is this relationship better illustrated than a chart of the US monetary base plotted against the S&P 500.

While Fed officials may have trouble with some concepts, we know that all the members of the FOMC can understand charts and correlation. We can be fairly certain that the extraordinary correlation between the US monetary base and the global equity markets has not escaped their attention.

Now ask yourself: if you were a Fed official today, would you want to the one that pushes for a reduction in the monetary base? Do you want to be the Fed official that goes down in history as the one who crashed the stock market? Probably not…

While one can understand why the Fed doesn’t want to tighten monetary policy, the more important question is why does the Fed want to appear to be tightening monetary policy? This is an important because the answer to this question highlights the vulnerability of the Fed and the tremendous risks associated with current monetary policy settings.

The view of The Money Enigma is that while the Fed doesn’t actually want to tighten monetary policy, it must keep threatening to tighten monetary policy in order to retain its credibility and, ultimately, to protect the value of the US Dollar. If the Fed doesn’t continue to jawbone the markets regarding imminent rate hikes, then the US Dollar might collapse and the rate of inflation will soar.

One can think of it in terms of our previous analogy.

The markets know that they are addicted to drugs (easy money), an addiction that has been enabled by the Fed over many years. However, the markets believe that this is just a temporary problem, i.e. they can break the habit at some point.

As long as the Fed keeps promising to send the markets to rehab but doesn’t actually send them, then the markets can continue to believe that the addiction is just a short-term problem that will be fixed one day.

However, if the day comes where either (a) the Fed genuinely cuts of the drugs, or (b) stops promising cut off the drugs because the markets are “beyond hope”, then the markets will realize that their addiction problem is in fact a permanent one.

It’s one thing to be an addict who believes you can be redeemed: it’s another to be an addict that knows that all hope is lost.

If the markets begin to realize that the aggressive monetary policy settings of the past ten years are to become a more permanent feature of the economic landscape, then the value of the fiat money issued by the United States could drop sharply. Why? Well, in simple terms, fiat money only has value because it represents a claim against the future output of society. More specifically, it represents a proportional claim against future output, i.e. the more money that is created, the less value it has. [See “Theory of Money” section for a in-depth discussion of this concept.]

Over the past ten years, the Fed has been able to dramatically expand the monetary base with little consequence on the value of money. It has been able to do this because the markets believed that this expansion was a short-term phenomenon. However, if the markets suddenly realize that the expansion of the monetary base is a long-term phenomenon required to support the markets easy money addiction, then the value of money will quickly erode and prices, as expressed in money terms, will surge higher.

In conclusion, the Fed is taking the long road to rehab. It doesn’t want to check the markets into easy money rehab, but it must appear to be doing so. Ultimately, the Fed is playing a dangerous confidence game, and one it is sure to lose.