Has Bernanke/Powell’s fear of 1929 put us on the same track? Part 2 of 5.

Part 2 of 5.

This post is the second of a five part series which looks at the actions of the 1929 and 2020 Federal Reserve Boards in an attempt to find out whether the low cost money punchbowl is again likely to be left out for too long, like it was in 1929.

If you missed Part 1, tap here.

In this second installment, it’s time to look at how each Fed Board felt about speculative credit and asset inflation.

The 1929 Fed felt speculative credit was bad and would end in forced interest rate hikes.

Unlike today, the nexus between low interest rates and asset inflation (bubbles) in the secondary market was not only acknowledged, but feared by the 1929 Board.

In fact, the 1929 Annual Report of the Fed clearly shows that the Board felt it had a duty to restrain the use of Federal Reserve credit facilities to stop the growth of speculative credit, lest it (the Fed) be forced into ordering higher interest rates to the detriment of the economic expansion.

Here you go, straight out of the Fed’s 1929 Annual Report.

"The Federal Reserve Board neither assumes the right nor has it any disposition to set itself up as an arbiter of security speculation or values. It is, however, its business to see to it that the Federal reserve banks function as effectively as conditions will permit. When it finds that conditions are arising which obstruct Federal reserve banks in the effective discharge of their function of so managing the credit facilities of the Federal reserve system as to accommodate commerce and business, it is its duty to inquire into them and to take such measures as may be deemed suitable and effective in the circumstances to correct them; which, in the immediate situation, means to restrain the use, either directly or indirectly, of Federal reserve credit facilities in aid of the growth of speculative credit. In this connection, the Federal Reserve Board, under date of February 2, addressed a letter to the Federal reserve banks, which contains a fuller statement of its position:
" ‘The firming tendencies of the money market which have been in evidence since the beginning of the year—contrary to the usual trend at this season—make it incumbent upon the Federal reserve banks to give constant and close attention to the situation in order that no influence adverse to the trade and industry of the country shall be exercised by the trend of money conditions, beyond what may develop as inevitable.
" 'The extraordinary absorption of funds in speculative security loans which has characterized the credit movement during the past year or more, in the judgment of the Federal Reserve Board, deserves particular attention lest it become a decisive factor working toward a still further firming of money rates to the prejudice of the country's commercial interests.
" 'The resources of the Federal reserve system are ample for meeting the growth, of the country's commercial needs for credit, provided they are competently administered and protected against seepage into uses not contemplated by the Federal reserve act.
"'The Federal reserve act does not, in the opinion of the Federal Reserve Board, contemplate the use of the resources of the Federal reserve banks for the creation or extension of speculative credit. A member bank is not within its reasonable claims for rediscount facilities at its Federal reserve bank when it borrows either for the purpose of making speculative loans or for the purpose of maintaining speculative loans.

But the last paragraph is crystal clear.

"'The board has no disposition to assume authority to interfere with the loan practices of member banks so long as they do not involve the Federal reserve banks. It has, however, a grave responsibility whenever there is evidence that member banks are maintaining speculative security loans with the aid of Federal reserve credit. When such is the case the Federal reserve bank becomes either a contributing or a sustaining factor in the current volume of speculative security credit. This is not in harmony with the intent of the Federal reserve act nor is it conducive to the wholesome operation of the banking and credit system of the country.'"

Despite the pandemic, today’s Fed is guaranteeing loans for some companies that are beyond speculative, i.e., they were already dead before the pandemic. Those zombies, plus the mass issuance of corporate bonds as a result of unprecedented liquidity from the Fed and Treasury might indicate that the 2020 Fed has not learned all it should have from the past. That is, when to stop and recalibrate the expectations of borrowers and investors.

The Annual Report goes on as follows:

It is not for the Federal Reserve Board to estimate the general expediency or the larger public consequences of its intervention by "direct pressure" in the complex situation existing at the time the above statement was called forth. It may be remarked, however, that the course adopted by the board resulted in a substantial conservation of the credit resources of the banking system of the country, and particularly of the Federal reserve banks, for essential needs which arose later in the year.

And then this….

The protection of Federal reserve credit against diversion into channels of speculation constitutes the most difficult and urgent problem confronting the Federal reserve system in its effort to work out a technique of credit control that shall bring to the country such steadiness of credit conditions and such maintenance of economic stability as may be expected to result from competent administration of the resources of the system.

A massive admission by the 1929 cohort. I’m thinking that this is still the biggest problem the Federal reserve system faces. It remains an unsolved problem even though modern monetary theorists argue that money printing is good, money printing works. Maybe a totally new system is required?

In the meantime (back in 1929) - direct pressure was the go!

Whatever method, or combination of methods of securing these results may eventually win the sanction alike of successful practice and of public opinion, the recent outstanding experience of the Federal reserve system in demonstrating the practicability of "direct pressure" has clarified the problem and advanced its solution.
Although the Federal reserve system did not resort to advances in discount rates, it continued throughout the first quarter, in addition to pursuing the policy of direct pressure, to exert its influence toward firmer money conditions.

The Annual Report also records what was happening with interest rates.

The reserve banks' buying rates for bills were advanced in the early months of the year from 4% to 5% per cent on short maturities, a rate higher than the 5 per cent rate on discounts, with the consequence that funds arising from a considerable inflow of gold from abroad in the early months of the year were utilized for the liquidation of the system's acceptance holdings, rather than of discounts for member banks. After the first three weeks in January, at the end of the seasonal return flow of currency, discounts began to rise rapidly, and this growth was further accelerated by sales of United States securities out of the system's portfolio. In the spring discount rates at the four western reserve banks, which had held their rates at 4% per cent, were raised to the 5 per cent level prevailing at the other reserve banks.
Federal Reserve Annual Report, 1929.

So, there it is, the discount rate was already higher than 5%. And, for the western banks which had been refusing to lift rates, their 3% became 4% and by January had also succumbed to pressure, agreeing to a whopping 5%.

At the same time, securities were sold, putting more upwards pressure on interest rates, and although not mentioned this would have drained liquidity from the secondary market. Double ouch!

How would you deal with a 2 percentage point increase in your borrowing rate, i.e., 3% to 5% with chances of it going to 6%?

What if there was a pandemic or similar event at the time like a Spanish Flu, and you lost your job?

These were rushed, large interest rate hikes in the late stages of the roaring 20’s.

But there was one more passion killing moment to come before the speeding locomotive ran out of track - and I’ll cover that one next week.

Contrasting the two Feds so far.

The ‘hawkish’ role that the decentralised 1929 Federal Reserve system played back in the day was fundamentally different to the role Jerome Powell’s 2020 Fed has adopted. In 1929 they appear to have been correct in their intent to normalise, but it appears they got the timing badly wrong.

Instead of slowly but surely draining the train of its space shuttle fuel and going back to coal, and slowly normalising the balance sheet (as Janet Yellen rightly attempted to do in our current time period), they erred.

In direct contrast to the 1929 Fed’s late cycle actions, Jerome Powell’s Fed has piled on the rocket fuel by doing the following:

Encouraged the use of speculative credit.
Reduced bank base level reserves with the Fed to zero in an attempt to get banks lending more in the face of uncertain corporate cash flows.
Squirted unprecedented levels of liquidity into the system (QE Infinity).
Guaranteed the purchase of government and corporate bonds to the extent those issuer’s fail (Guarantee Infinity).
Denied that there is a secondary market asset bubble.
Supported the tearing down of the Volcker Rule.
Gave the market guidance that he will let the economy overshoot 2% inflation (without even having hit 2% in the first place).
Said that his Fed is ‘not even thinking about thinking about’ interest rate normalisation.

The 2020 Fed Board (and previous Chairman Ben Bernanke) interpreted the late cycle interest rate hikes of 1929 as bad medicine. But its was good medicine, just delivered far too late in the day, in too tight a time frame. In contrast, the 2020 Fed is betting it all on Liquidity Infinity. And how it stops the train without wrecking it is a good question.

Or, perhaps it lets it run further until it totally de-bases the reserve currency (negative interest rates means that money is actually worth nothing to negative) and most other countries continue to follow suit to protect capital flows and exports. Is this why Powell is happy to embrace central bank digital currencies?

But when the 1929 Fed finally worked out that liquidity alone was not going to work, it was just too late. Is today’s Fed in the same train? In an attempt to not repeat the mistakes of the past, is the 2020 Fed at risk of doing just that?

In the next installment: What happened when the 1929 Fed left the punchbowl out for too long - the disaster of September/October 1929.

Until then, smile, it already happened……

Mike.