Driving a car in reverse is much more difficult than driving it forward. You need to look behind you or constantly check the rear-view mirror (or camera) and try to flip the images you’re seeing.
Driving monetary policy in reverse is even more difficult. It’s more like driving while blindfolded, as no one can predict what will happen next, or what impact your decision will have on the economy and on markets.
This is especially true today, as the Federal Reserve Board has never before had to tighten monetary policy after taking interest rates down to nearly zero percent (zero interest rate policy or ZIRP) while more than quadrupling its bond portfolio.
The Courage to Act?
Current Chair Jerome Powell didn’t create the situation he’s in. That was former Chair Ben Bernanke, who engineered the purchase of trillions of dollars’ worth of bonds, then immodestly suggested that doing so saved the economy.
His book, The Courage to Act: A Memoir of a Crisis and Its Aftermath, generally garnered media praise, but didn’t exactly lead bestseller lists. Personally, we’re waiting for the movie version, even though Peter Sellers is no longer around to play the lead. Maybe Bernanke will play himself, since he claims to have “the courage to act.”
Regardless, the “aftermath” of the financial crisis is still with us — and now it’s Powell’s thankless job to ensure that it doesn’t lead to an all-new crisis.
Difficulty of a Soft Landing
Engineering a “soft landing” (i.e., bringing interest rates to a perceived “normal” level without significantly disrupting the economy or the stock market) is difficult under the best of circumstances. But Powell and other board members are trying to increase interest rates to whatever level normal is, while keeping unemployment low and stabilizing inflation at 2% a year. And they’re also tasked with unloading most of the $4.5 trillion in bonds in the Fed’s portfolio.
The difficulty is magnified, because whatever the economy is doing isn’t always self-evident and the economic impact of the Fed’s decisions isn’t realized until months after it happens.
Powell predecessor Janet Yellen was able to avoid economic calamity by doing and saying almost nothing during her tenure. Fed policy statements were repeated practically word for word from one Fed meeting to the next, leaving financial media to interpret the meaning behind even the tiniest word changes in each new policy statement.
This do nothing/say nothing approach appeared to be a deliberate strategy, as any wrong action or even wrong wording could cause the market to crash like a pile of Jenga blocks.
Yet doing nothing can have consequences, too. Powell came on at a time when the Fed had to take action. With tax reform and deregulation driving higher economic growth, the Fed has been gradually raising interest rates.
By bringing rates up just 0.25% at a time, the Fed managed to raise the federal-funds rate eight times in three years without spooking investors. But markets swooned in December when the Fed announced its ninth rate increase, and stocks experienced their worst week since 2008 just before Christmas.
The increase took place in spite of pressure from President Trump to temporarily halt increases and public statements by some experts suggesting that it was time to pause the rate hikes. As a result, the rate increase appears to have had a greater impact on the stock market than it otherwise might have had.
Of course, there were other factors, too — especially automated trading — but many blamed the Fed for December’s market swoon.
Impact of Portfolio Reduction
Some have also blamed the Fed’s attempt to reduce its portfolio of bonds for recent market volatility.
It’s a logical conclusion. If the Fed’s bond purchases pushed the stock market ever higher, even as the economy sputtered along, wouldn’t reversing the process have the opposite impact?
The Fed has been reducing its portfolio by allowing Treasury and mortgage securities to mature without replacing them. But it’s doing so very gradually. Up to $50 billion worth of bonds are allowed to expire each month, although only about $40 billion in bonds have been allowed to expire in recent months.
It may not seem that reducing the portfolio at this rate would have much of an impact, but it all depends on investor psychology. And, after all, this level of bond buying has never taken place before, so who’s to say what impact reversing it would have?
In our next post, we’ll review recent Fed actions and their market impact.