The Credit Strategist Blog
We witnessed the most colossal blunder in monetary policymaking history over the last 12 years as the Fed maintained crisis-era policies long after the Great Financial Crisis ended. Now the Fed is left with little choice but to accelerate a damaging and disruptive withdrawal from years of unnecessary, untested and unwise negative real interest rates and debt monetization that it hoped against hope would be far less painful. But those hopes were never realistic just as its views on virtually every important economic issue were misguided. The Fed conducted policy based on fundamental misunderstandings of the real economy, undue reliance on flawed economic statistics and theories, and in arrogant dismissal of warnings that they were fomenting inflation, wealth inequality and financial instability. Instead, they were more worried about upsetting stock market investors and bailing out massive hedge funds on occasions when the latter became dangerously overleveraged trying to line their pockets with highly leveraged speculative trades akin to picking up pennies in front of steamrollers. This consistently asymmetrical policy regime left the economy grossly overleveraged and markets structurally fragile (and we increasingly see the latter effects materialize as more firms and funds collapse in the weeks and months ahead as rising rates pull them under).
The Fed’s partners-in-crime were the politicians who not only cheered them on but joined in the party with excessive fiscal spending, as well as the financially illiterate mainstream media that did absolutely nothing to educate the public about the risks. Historians will look back on the 2008-2021 period as a catastrophic series of policy errors that undermined the economic and political hegemony of the United States.
The Fed’s 75 basis point hike in the Federal Funds rate yesterday was about all it could do without totally spooking the market or blatantly admitting its errors. But the hike was effectively announced on Monday in a leak to The Wall Street Journal and the message was received loud and clear. The Fed waited too long for inflation to break out from the prison-house of phony statistics in which it was trapped because of institutional weakness that takes the form of fear of the stock market (which is really fear of politicians that want stocks to go up to please their short-term focused constituents). Donald Trump was the most blatant of the Fed’s paymasters when he publicly pressured the Fed for ridiculously low rates, but he was hardly the first to overstep the bounds of propriety and wisdom (remember Lyndon Johnson beating on William McChesney Martin years ago). People are supposed to get smarter and learn from our mistakes but human nature keeps dragging us back to acting on our worst instincts. As a result, we are facing another 150-250 basis points of interest rate hikes over the next 6-9 months that will still leave real interest rates in negative territory while pressuring equity prices further downward.
The question now is not the depth of the coming recession; for the sake of future prosperity, a severe recession would purge more excesses from the system and perhaps make a sufficient impression on policymakers to lead them to make better decisions in the future. And a severe fall in asset values might at least temporarily purge the markets of some speculation and teach important lessons about the risks of zero cost money and leaving our fate in the hands of economics professors who have no clue how the real world operates. There is a potential upside to this mess if our collective intelligence can be applied constructively to addressing the errors whose difficult consequences we are now feeling.
In the July issue of The Credit Strategist, I will be analyzing in detail the impact on credit markets of what the Fed has done so far. Credit markets are experiencing their worst losses in modern history - Treasuries, investment grade and high yield bonds, leverage loans, etc. Equities have a ways to go to get to that point but are likely to catch up if the Fed does what it has to.