The Conclusion to: Has Bernanke/Powell’s fear of 1929 put us on the same track?

Yes, it has, but destination unknown.

Same track, but this time we’re in a steam train powered by rocket fuel on a long and arduous journey to who knows where - because the 2020 Fed just keeps on increasing its balance sheet and manipulating down interest rates, in an attempt to avoid the perils of 1929.

In doing so, the 2020 Fed has enabled rampant asset inflation, encouraged massive debt levels, and created high levels of debt default risk through its ongoing programs of quantitative easing, or QE Infinity.

Unless another technique is found to inject stimulus into Main Street, not Wall Street, and normalise the Fed’s $7.1 trillion balance sheet and zero interest rates before they go too negative, it appears we will accelerate in speed to who knows where.

This is the final instalment in our central banking series.

Let’s recap on the last 4 instalments in this series.

Back in the day, this is how the Fed was thinking, as seen through the lens of the 1929 Annual Report of the Federal Reserve System.

“It [the Federal reserve] 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. 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.”

Today, Federal reserve credit has again been sustainably diverted into channels of speculative security credit.

In fact, how to deal with this still represents the most difficult and urgent problem confronting the Federal reserve system - after 91 years!

In April 1929, asset prices hit levels that were too high to ignore. In a last ditch attempt by the Fed Board to reign in the egregious diversion of Fed funds into speculative credit supported by many of the 12 central banks, interest rates were increased to 6%, effectively a doubling of the cost of money since the year before.

After four months of snap freeze cooling, the stock market crashed.

On 28 October 1929, Black Monday, the stock market corrected down ~13% after smaller rumblings on the previous Thursday. On the Tuesday, a roughly similar leg down occurred.

The recovery rally started in November 1929 and peaked in April 1930. But things went south quickly with the Dow finally bottoming out in mid-1932, having lost nearly 90% of its value since Black Monday. The pre-September 1929 level would not again be reached until 1954, 20 years later.

While the 1929 Fed’s uncoordinated actions (not necessarily the final hawkish actions in 1929 which were too late) contributed to the timing of the Great Contraction/Depression, it’s acknowledgement of the bubble was certainly in stark contrast to the Bernanke/Powell position of not even attempting to normalise interest rates and the Fed’s sky scraping balance sheet.

In 2002, ex-Fed Chair Ben Bernanke apologised on behalf of the Fed by saying that the Fed would never do that again (i.e., increase interest rates and cause a depression) and this explains his actions in 2008 and 2009 when he kickstarted modern quantitative easing (QE) to manipulate down interest rates and provide the economy with ample credit to stimulate investment and spending.

It worked during the GFC because that was a cyclical crash brought on by a collapse of the sub-prime market and roughly two dozen banks in the U.S. which were exposed, and that either went bankrupt or had to be bailed out.

Some would argue the bubbles should have been popped there and then.

This time it’s different because COVID literally stopped the real economy – after nearly two years of trade wars, tariffs, the amazon effect, and almost zero inflation.

It was the final rip of the band-aid and now we can see the sore. A second wave of shutdowns right around now will not help.

Neither Chair Bernanke (as promised) or Chair Yellen (try as she did) or Chair Powell (who is unable or unwilling to consider asset inflation to be a bubble) were able to return the balance sheet and interest rates to normal, prior to COVID.

The Fed is still trying to stimulate growth and inflation, since the GFC, but this period is now categorised by disinflation, and deflation in some parts.

And it’s not too dissimilar to the conditions of the 20s and 30s. That is, the decade before the Great Depression was categorised by price disinflation followed by a decade of deflation between 1930 and 1939, with some very bad years between 1930 to 1933.

In fact, inflation only went positive as a result of the massive annual increases in U.S. GDP, before and after the U.S. joined WWII.

I’m pretty sure we don’t want to go there again.

So, at present, balance sheets are heavy, interest rates and money velocity are almost non-existent and we are in a period of price disinflation and rampant asset inflation. If Fed support continues, so does the train journey to who knows where. If withdrawn, 1929.

You know which way the Fed will go.

Is monetary policy the silver bullet to cure the real economy?

No, in fact it’s more like the full moon that brings werewolves and vampire squids out to trade the secondary market, while the real economy sleeps.

As we have seen, nothing long lasting can be achieved solely by reducing or increasing the fed funds rate via QE or quantitative tightening (QT).

But this is what Jerome Powell had suggested in January 2019 when signalling the end to the Yellen balance sheet run-off. At the time he said:

“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.”

Chair Powell is now finding out that rate reductions alone are insufficient, but he probably already knew that.

Rate targeting needs to work in tandem with something else, i.e., real economy fiscal spending in growth projects. That’s because if asset prices go up in spite of deteriorating economic and/or company specific fundamentals (i.e., decreasing earnings), they will become unsupportable as they are now.

On top of that, what’s the point of zero interest rates created by bond purchasing when banks won’t lend, and impaired households don’t have the cash flow to service their loans, and for every dollar of new debt there is probably only 10c to 15c of GDP being produced?

In other words, at times when there is no economic growth, job losses and a fragile economy, the only reason to keep rates low is because if you don’t there would be far too many debt defaults. So the Fed keeps the infinity train in fuel.

Regrettably, growth fiscal is yet to come and can only really bite if markets are no longer in lockdown.

Next year’s fiscal is likely to still be welfare fiscal to pay for the fiscal that’s currently missing, and that will be reflected in a massive budget deficit.

At the moment, people are saving and not borrowing. Smaller businesses are not being supported by credit markets (which favour very large companies). Banks are not lending what they could be and have trillions of dry powder stacked at the Fed even though all base level requirements have been removed.

Many retirees are not spending because their investment assets are not yielding, or they are scared to go out.

So, if banks are not on-lending and if people are saving and hoarding - QE is money down the drain.

The legacy is: rampant and unbridled asset inflation, and debt creation.

Should the Fed and other central banks be worried about rampant secondary market asset inflation?

Yes, and the 1929 Fed was, but its resolve to force a resolution amongst the 12 banks came a little too late.

The 2020 Fed is either unable or unwilling to acknowledge it. Interestingly, Philip Lowe of the RBA has acknowledged asset inflation. His problem is that he needs to lower rates, otherwise the AUD rises too high against the USD (which it is still doing now) and our commodity exports become less competitive.

And the problem around the time of the GFC was that President Obama was prepared to support a massive bailout and decided to not prosecute collapsed bank CEOs. Tim Geithner was able to persuade him to give them a free pass, and for Ben Bernanke and Hank Poulson to execute a $450 billion bail out package to protect banks and corporations that were ‘too big to fail.’

Had this not occurred, banks and other corporations would have been left to fail, and thereafter, the Fed’s balance sheet might have looked very different.

Over the next few years more and more free and easy credit was again (like during the Roaring Twenties) diverted into speculative secondary market securities and buy-backs.

Bernanke chose this way because of his focus on the damage done by the 1929 rate hikes, not the ‘too late’ aspect of those hikes.

Janet Yellen on the other hand developed a different opinion by 2015. Chair Yellen felt enough was enough and that a hawkish approach in terms of normalising rates and the balance sheet was required to regulate market behaviour, and most importantly, to rebuild the stock of dry powder that could be used in the event of another crisis. Yes, Janet Yellen actually used those words.

In other words, drain the punchbowl and take away secondary market rocket fuel to recalibrate wall street with high street. Yes!

But, no. That rocket fuel now includes a US$7.1 trillion balance sheet; the Trump tax cuts; a promise to keep interest rates at zero until at least 2023; trillions of bank funds still on deposit with the Fed even though all base level requirements have been removed; and a velocity of money of under 1x – sending clear evidence that QE Infinity has failed and savings and hoarding has taken over while we ride the infinity train to who knows where.

On top of that, Guarantee Infinity encourages traders, speculators and investors that are still in the markets, to continue with a risk-on strategy because the Fed will provide an open ended stop loss. Until it doesn’t.

It’s not one bubble, it’s several bubbles.

The missing technique is not monetary.

In 1929 the Fed said:

“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.”

Given QE was only successful in kicking the 2009 can down the road to 2020, and given we now have 0% interest rates and a velocity of money of under zero, QE Infinity has failed.

So too has the monetary transmission mechanism, which we know as the fractional banking system.

And for the moment, the only thing keeping the zombie bubble afloat is Guarantee Infinity – that is Powell’s pandemic promise to buy government and corporate bonds and other risk assets, should the issuers default or fail. That keeps large investors, institutions and corporates in the secondary markets.

Potentially, there are only three ‘techniques’ that can avoid mass insolvencies when the balance sheet is this large, and money no longer has any velocity.

They are: to keep printing; fiscal spending; and direct chimney drops of helicopter money.

The first is the current solution. The infinity train to who knows where.

The second is to fix the economy, and get real economy growth happening in the primary market. Backfill as much as the secondary market as possible and let market forces decide the relevant clearing prices for each asset class.

But the fiscal wheel is in the Government’s wheelhouse and it rusted over some time ago. And, apart from fixing it, what is needed is an amendment to the Banking Act which requires a fiscal or helicopter money sidecar to be approved by Congress, before the Fed is empowered to cross a certain QE threshold. But that won’t happen or help now. Plus we still have COVID.

The third is Helicopter money as it is targeted welfare that bypasses the slow and clunky bond market. It should also bypass the employer market and go straight to households, but it does not always do that (e.g., JobKeeper in Australia).

Fiscal spending (predominantly from taxes as opposed to bond issuance) and selective helicopter money (potentially delivered via central bank digital currencies) may be an effective sidecar for a less accommodative monetary policy, if doled out in the right proportions, and if done early enough.

But when the monetary policy transfer mechanism breaks down, i.e., zero or negative interest rates and a velocity of money with zero maturity of below 1, you know we are forty years too late.

Too much can be devastating, despite the teachings of MMT, because of the ‘debt spiral’.

With other key central banks at or below zero, all that is left is the hope of massive fiscal spending, chimney money and growth policies across key economies to stimulate demand.

In the U.S., we need to wait to see what a so-called fiscal stimulus package might look like, given the U.S. election timetable with the run-offs.

In the medium term and if COVID goes for another year, the risk is the towering global debt load. In other words, COVID just ripped the band-aid off quicker than many had expected and there is now a real risk of a debt spiral unless the infinity train continues its journey to who knows where.

Why? Because the over printing and priming of liquidity has created too much debt for the world to repay at this point.

In typical circumstances low intertest rates are not a big problem, other than for savers. But when there is too much debt and a lack of cash flow to service that debt such that a very small increase in the interest rate can cause an avalanche of insolvencies, you have a problem.

It creates a debt spiral that works like this. You drop interest rates, so households and business are incentivised to borrow. They borrow. If they can’t repay it, they need to refinance. To refinance, they need collateral or a strong enough balance sheet, but the more debt and servicing there is the worse off the balance sheet is. If they can’t repay because the economy isn’t doing so well, the central banks intervene and print more money to avoid defaults.

Then there’s a pandemic or similar and helicopter money is dropped down chimneys. If governments are running deficits, that money needs to be funded. So, treasuries issue bonds. With more bonds, there is more debt created and more bond buying by central banks to keep interest rates down and avoid defaults.

The spiral continues in a downwards direction with more debt being stacked up. Even if there is a refinance and extension, that debt still exists.

That’s why there’s more debt than there was at the time of the GFC, and it’s there for all to see - unless there is a forgiveness or a debt jubilee. But with the fall of globalisation and the rise of trade barriers, tariffs and nationalism, it is difficult to see a pan-global debt forgiveness.

Powell’s spiral started in the punchbowl, just like in 1929.

So based on Powell’s view and Bernanke’s view about interest rates and asset inflation, we have the largest Fed balance sheet ever at $7.1 trillion and going up next year.

All other centrals have followed.

Rates are pretty much zero everywhere apart from a few countries which are negative. Global debt is over $350 trillion and needs to be serviced (with global debt to GDP around 400%). A 1% increase in the global interest rate would means a $3.5 trillion increase in annual servicing, roughly equating to 5% of GDP.

Corporations have borrowed large. Those which did not need the pandemic loans have been borrowing large in the open market and have not been barred from buy-backs (also forcing share prices up regardless of earnings).

Employees that have jobs and those who have been collecting welfare have been buying assets on the secondary market and fuelling asset prices.

Meanwhile, Powell wants an overshoot of consumer inflation, and has announced an average inflation target of 2%. Regrettably, annual consumer price inflation has only hit 2% twice, since the GFC.

So far, inflation remains in assets and not prices, and that means he will be waiting for quite some time.

And so, the infinity train is forced to continue along the track in order to avoid a debt spiral, debt deflation and insolvencies.

What are 2020 central bankers missing?

I believe that Jerome Powell has failed to recognise inflation in all of its forms can influence price stability.

Price inflation has been low because of China production, the rise of amazon and the disinflationary effects of cloud hosted retail marketplaces, demographic pressures with retiring baby boomers, and other intertwined elements. For the time being inflation has jumped into assets – and because Powell doesn’t believe asset inflation should be in his wheelhouse, he is ignoring it.

For all of these reasons consumer inflation has been low – but this is not a reason to have kept rates low.

Recalibrating rates and weaning markets of cheap and zero cost debt (and deflating rising asset prices) would have been a better way to end the post-GFC emergency period. But the punchbowl was left out, and it is human nature to borrow more and take on more risk, and even for big businesses to use cheap debt to fund buy-backs.

It is not very responsible of central banks to encourage this, particularly as global debt stands at ~$350 trillion, and it will need to be refinanced because it won’t be able to be repaid as more new debt is stacked up. This was acknowledged in 1929.

So, to avoid foreclosures and insolvency events, the central banking systems will create even more new money to avoid debt spiral insolvency.

A slight conundrum, mon ami?

Some concluding thoughts.

Chairs Bernanke and Powell may have missed the real lesson from 1929 – act and recalibrate earlier!

They may have also missed the reasons for insipid inflation today, i.e., the range of factors covered in previous sections that have led to the jumping of inflation from consumer prices to asset prices.

But it’s still inflation, and inflation in all of its forms can influence price stability, which is one of the Fed’s dual mandates.

QE Infinity + Guarantee Infinity lead to massive asset inflation and higher levels of debt, which increases debt default risk. And this impairs the balance sheets of households, as much as consumer price inflation impairs the purchasing power of households. Same negative impacts from different types of inflation. Hello?

So, if you agree with that, you should also agree that price inflation and asset inflation should both be taken into account by the Fed and that the average inflation targeting of 2% is an ineffective and misleading trigger level to start thinking about thinking about raising interest rates.

Simply put, asset inflation should be in the Fed’s wheelhouse like it was in 1929 and prompt monetary tightening, earlier in the cycle.

The 1929 Fed did acknowledge asset inflation, but its mistake was waiting too long to reign it in. This Fed won’t even acknowledge asset inflation as sitting in its wheelhouse.

And if it can’t stop the infinity train, there will be more asset inflation and at some point a blowback into consumer prices. As a result, we should plan for a long and drawn out ride to who knows where.

But there is hope. It might take some time and it might be derailed by a Republican Senate, but if Joe Biden is inaugurated and if Janet Yellen is confirmed as Treasurer, there may be light at the end of the train tunnel. That team might be able to come up with a technique of mixing chimney money and fiscal growth spending, with a much less active Fed that in time might be able to tap on the brakes of monetary policy.

What remains to be seen now, is whether world governments and central banks have the wherewithal and political will to throw the railroad switch onto a different track to stimulate jobs, wages and spending - and to avoid the debt spiral.

We’ll just have to wait and see.

What this means for Australia.

On a brighter note, our gold reserve endowment will stand us in good stead as more money is printed and debased; putting a floor under the gold price and underpinning a gold boom - and for support products/services as well.

Australian interest rates will likely follow the rest of the world down. If not, the differential will express itself in a much higher AUD, which will be particularly bad for exports.

But Australia is no economic island. It will likely be pulled further into a China versus the rest of the world paradigm, and our Prime Minister’s response will be instructive.

China’s aspirations in all of its forms will also be instructive, and the level of demand for Australian iron ore and other exports will be key factors in our fortunes. So too will be how we embrace technology.

But most of all, the Reserve Bank of Australia will be faced with a growing unease around its own QE program. Many will be watching to see what damage the RBA might be forced to do to the Australian economy if other countries go below the zero interest rate line.

Will it follow other centrals below the plimsoll, or will it try to remain above and risk a stronger AUD?

In the meantime, Australian businesses should be assessing the probabilities of open versus shut international borders in 2021, and considering strategies to boost their competitiveness in their addressable (or new) markets under each of those scenarios.

I hope you’ve enjoyed this five part series, and thanks for your continued reading.

Best wishes, Mike.

All text other than for quotes from the Federal Reserve Annual Report of 1929 are copyright, NextLevelCorporate.