Authored by Guy Haselmann of Scotiabank,
FED – Encouraging the Melt-Up Trade, While Regulating Bubbles Away
The Fed moved ‘all-in’ in 2008/09 when it pushed rates to zero and embarked on QE. Since the Fed basically used its final chips via this action, it became trapped playing ‘this hand’ until the bitter end. The stakes are enormous and grow over time. The only way the Fed can ‘win’ is – as Yellen said today – “to do everything possible to promote a very strong recovery”. Tapering too soon could be calamitous toward this objective. Yet, the longer it continues, the more the risks aggregate. However, Yellen seemed to calmly indicate today that any unintended consequences or dangers to financial stability are worth the risk.
There is an inability, and lack of good options, for providing any additional monetary or fiscal accommodation, should the economy weaken or should a global crisis arise. This is what makes the Fed’s current policy experiment such a high-stakes experiment. Here is why policy-makers are in such a predicament:
Every economic or business cycle decline over the past three decades has been met with the same response: monetary or fiscal stimulus. Policy makers have been quick to offer accommodation, but they have been slow to withdraw the stimulus which is always politically more difficult.
Fiscal accommodation over the years has resulted in large deficits and debt which are now leading to contentious discussion about how to reel them in.
Monetary authorities have stair-stepped the Fed Funds Rate down, but eventually hit zero and ran out of room.
Effectively, both stimulatory mechanisms are broken.
Yellen had to field several questions about potential market bubbles, but she deflected them aggressively saying that she did not believe that “bubble-like conditions” existed. Whether she believes that or not, it would have been counter-productive for her to admit it. She mentioned that should bubbles begin to form, the Fed has the regulatory tools to control them. She can’t possibly believe this (or can she); but regardless, she must try to convince the market that the Fed is monitoring them and can contain them.
Basically, she has given the market the green light to “melt-up”. The only question is how much higher will the Fed’s ‘gift’ drive prices? She indicated the Fed has no choice but to continue with this policy until it succeeds (or will it ultimately fail?).
As perverse as this seems, Yellen likely ensured that an equity market crash (someday) is inevitable. Yellen’s failure to acknowledge any signs of bubble-like conditions encourages more risk-taking and speculation. Therefore, this fact, combined with her hints of a continuation of policy, should lead to a bubble; if one hasn’t been created already. And, all bubbles eventually pop.
Alternatively, it is possible that Fed policy fails and economic growth begins to slip. In this scenario, a significant re-pricing (lower) of financial assets would occur.
Since banks are in a much stronger position today than in 2008, the Fed probably has limited concern about a market crash – as long as the banking system remains healthy. The Fed probably doubts a crash could be as bad as 2008, and it know it know possesses a slew of liquidity facilities (established in 2008) which could be implemented quickly if necessary.
“The question isn’t who is going to let me; it’s who is going to stop me.” – Ayn Rand