Has Bernanke/Powell’s fear of 1929 put us on the same track? Part 3 of 5.

Part 3 of 5.

This post is the third 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. If you missed Part 2, tap here.

In this third instalment, it’s time to look at the great crash of October 1929.

Even the 1929 Federal Advisory Council (FAC) wanted to normalise rates earlier!

Let’s stay in the present for a few moments. As you know, Jerome Powell has told everyone not to worry about asset prices, or QE Infinity and that the 2020 Fed is not even thinking about thinking about increasing interest rates. He can’t hear any bubbles pop, so apparently there are no asset bubbles.

Now let’s rewind to last week’s instalment. In it, I provided you with evidence directly out of the Fed’s 1929 Annual Report showing how worried the Federal Reserve Board was about the unrelenting build up of speculative credit.

You will recall that by 1928/29 the Fed had to resort to ordering an increase in interest rates from 3% to 5% to fight inflation.

While very late in the day, this move was aimed at cooling down the unsupportable run-up in asset prices.

Even the 1929 Federal Advisory Council, or FAC for short (which is the 12 member council made up from each of the Federal Reserve banks and which advises the Board on a quarterly basis) felt asset prices to be a critical part of the Fed’s mandate.

Although the FAC said it wanted to use any other method available to it before increasing interest rates; by early 1929 it had concluded that the only way to stop the runaway speculative credit train was for the Fed to overrule the obstructive (dovish) banks and direct the system to permit a further increase in interest rates.

The Fed’s 1929 Annual Report again provides evidence that the Fed (ex-obstructionist western banks) knew it had the responsibility to normalise interest rates.

The 1929 Annual Report of the Federal Reserve includes the following notes in relation to the thoughts and position of the FAC.

FEBRUARY 15, 1929
On February 15, 1929, the Federal Advisory Council adopted the following resolution:
The council believes that every effort should be made to correct the present situation in the speculative markets before resorting to an advance in rates. The council in reviewing present conditions finds that in spite of the cooperation of member banks the measures so far adopted have not been effective in correcting the present situation of the money market. The council, therefore, recommends that the Federal Reserve Board permit the Federal reserve banks to raise their rediscount rates immediately and maintain a rate consistent with the cost of commercial credit.

And then in May 1929, this:

MAY 21, 1929
Recommendation.
—The Federal Advisory Council has reviewed carefully the credit situation. It continues to agree with the view of the Federal Reserve Board expressed in its statement of February 5, 1929, that "an excessive amount of the country's credit has been absorbed in speculative security loans." The policy pursued by the Federal Reserve Board has had a beneficial effect, due largely to the loyal cooperation of the banks of the country. The efforts in this direction should be continued. The council notes, however, that while the total amount of Federal reserve credit being used has been reduced, "the amount of the country's credit absorbed in speculative security loans" has not been substantially lowered.
Therefore, the council recommends to the Federal Reserve Board that it now grant permission to raise the rediscount rates to 6 per cent to those Federal reserve banks requesting it, thus bringing the rediscount rates into closer relation with generally prevailing commercial money rates. The council believes that improvement in financial conditions and a consequent reduction of the rate structure will thereby be brought about more quickly, thus best safeguarding commerce, industry, and agriculture.

Wham - 6% - double the prior year.

In contrast, a slow but sure introduction of higher interest rates could have been used earlier to cool down asset inflation in 1925 or ‘26, had the Federal Reserve system possessed a centralised decision making regime at the time.

Still, with wholesale and retail consumers alike drunk on the high life that comes with low interest rates and free and easy credit, its easy to see why the market mechanism had no chance for a smooth recalibration in 1929. Sound familiar?

But we did have a centralised mechanism in 2015 at the time Fed chair Janet Yellen was busy normalising interest rates and the balance sheet. So, what went wrong?

The Trump Tantrum. Fed Chair Yellen was forced out and replaced with Trump nominee, Jerome Powell.

He followed Yellen’s lead for awhile, but a year later and under intense pressure from his benefactor, he backflipped and interest rates were again managed down and the share market levelled up for its pre-COVID monster rally.

At the time, this is what I said in my blog, The Fed just issued an open invitation:

“Succumbing to pressure from the President, Wall Street, the Euro-Sino growth dislocation from the US, and a lack of internal data as a result of the U.S. Government shutdown, Fed Chair Powell broke his silence on the balance sheet run-off by saying:

“The committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accomodative policy that can be achieved solely by reducing the federal funds rate.”

So, either the auto-piloted balance sheet run-off is probably a little more provocative than just ‘watching paint dry’ as prior Fed Chair Yellen used to say; or the Fed has decided to buckle to the growing pressures mentioned above.

Regardless of the reasons and the inevitable nuancing by global commentators, the ‘normalisation problem’ is being swept under the carpet and the market went on a tear last night as a result of this capitulation.”

Normalisation has been a missed opportunity in both time periods, albeit for different reasons.

And while it’s yet to play out one way or another in our timeline, if we go back to the 6% shock in May 1929, within 4 months of that final straw the stockbroker party (and I’m thinking of the 1920’s version of a white Lamborghini stacked after a night out on killer ludes) would finally be over.

And then the decade that roared was all over.

The stock market peaked in early September 1929, following years of post-war exuberance associated with industrialisation.

On 28 October 1929, Black Monday, the stock market corrected down around 13% after smaller rumblings on the previous Thursday.

The next day on Black Tuesday, a roughly similar leg down occurred.

More bumps came, some big and some small.

Boom, crash, no opera.

The recovery rally (which in our timeline we have so far been experiencing for 7 months) began in mid-November 1929 and peaked in April 1930. People were pretty hopeful during that 5-6 month period.

But it was short-lived, with the Dow Jones grinding lower over the next two years until it bottomed out in mid-1932, having lost nearly 90% of its value since September 1929.

That’s what a double dip crash looks like.

At this point let me just say that I don’t think the risk of a repeat is currently factored into today’s equities markets, and even bond yields have been firming.

On one hand, the Fed has said it has everyone’s back and the market seems to have already priced in the next round of welfare (the market calls it stimulus - lol). And if that’s true the Treasury will do its thing and the Fed will buy another few trillion of bonds (taking the balance sheet to somewhere around $10 trillion), spray bond sellers with oodles of liquidity, and force down yields even lower. I think this is what most people are expecting.

On the other hand and despite QE Infinity in the U.S., Europe and Japan (noting that QE could not have worked in 1929 due to the return to the gold standard after WWI money printing) there is still a risk today of a secondary and impactful correction which does not appear to be priced in - despite welfare fiscal.

The recovery took 22 years.

The share market’s September (1929) level would not again be reached until 1954, some 22 years after the low in mid-1932.

Extraordinary. And not unlike today, many families of 1929 had built most of their wealth in the secondary markets (stocks, bonds, etc).

The collapse of secondary markets created insolvency events for many of them (particularly for those who lost their jobs and had leverage/debt) and stoked the extremely long, slow and deflationary nature of the Great Depression.

Early normalisation may have reduced the severity and length of the event, if not prevented it, but we will never know.

There are many families today that remember Great Depression stories told by their parents and grandparents. It’s these people (and others) who are not borrowing at present, regardless of how low interest rates have sunk and how much Powell shouts at banks to lend, lend, lend.

But there is a grave danger associated with QE Infinity. The Fed has tried to reverse it, and can’t. Increases in interest rates this late in the cycle would upend markets due to the great lakes of debt that have not yet been drained, and create mass insolvencies.

Add to that Guarantee Infinity and Liquidity Infinity and it is difficult to see how the 2020 Fed can get out of its money printed corner.

Hell, it’s not even thinking about thinking about increasing interest rates, because it just can’t - and although it’s on the same ‘we’ve left it too late’ train track, previous Fed Chair Ben Bernanke who came before Janet Yellen said the Fed would ‘not do it again’. But we’ll cover that next week.

In the next and fourth instalment: Ben Bernanke, his extraordinary comments of 2002, the crystallisation of those comments in the melt down of 2008/2009, and his role as the architect of modern QE Infinity.

Until then, keep it on the rails.

Mike.