The Fed’s positive feedback loop

The Fed responds to the market, and the market responds to the Fed, until both are so attuned to each other that neither does anything. Today’s much-anticipated release of minutes from the January Federal Open Market Committee meeting revealed that the Federal Reserve would do… nothing.

On Tuesday and Wednesday morning prior to the release of the minutes, the US stock market did… nothing. And after the release of the minutes, the US stock market did… nothing.

To be specific, the Federal Reserve plans to do nothing to the overnight rate and nothing to its balance sheet. As an emergency measure following the Great Financial Crisis, the Fed bought $4 trillion of Treasury and mortgage-backed securities, by way of quantitative easing. Early in 2018 the Fed began to reduce its securities holdings by the smallest of increments, and market panic set in.

In December, Fed Chairman Jerome Powell declared that he would continue to reduce the Fed balance sheet, and a very great panic set in. Thereupon, the Federal turned its tail and fled, like Brave Sir Robin in Monty Python’s “Holy Grail” story.

As the minutes report, “Almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year.” And the Fed said it would be “patient” about raising the federal funds rate, which means that it won’t do anything at all. The interest-rate market presently anticipates no rate increases in 2019 and a small rate cut in 2020.

The Fed’s Phillips Curve model states that low unemployment means higher wages and thus higher inflation, which in turn requires tighter money. But forward-looking views of inflation expectations suggest that the big risk is not inflation but rather deflation.

Employment has grown, to be sure, but the quality of employment has downshifted to less secure and less remunerated sectors, as I observed in yesterday’s column. Important sectors of the asset market, for example real estate, show price sogginess because prospective buyers and renters can’t afford the higher prices. The willingness of consumers to spend is questionable, and the ability of all but the best-rated borrowers to obtain credit is limited.

Something scary happened last year as oil prices fell. Once the oil price settled into a trading range in the mid-$50s for West Texas Intermediate, expected inflation as embodied in Treasury yields fell sharply, from 1.9% during the next five years to 1.7% during the next five years. (So-called breakeven inflation is the difference between the yield of inflation-indexed US Treasuries and ordinary Treasuries, i.e., the inflation rate at which both will return the same amount).

When a little nudge from the oil prices causes inflation expectations to fall off a cliff, that can’t be good. The Fed thinks that inflation should run at about 2% – a strange idea, considering that the price level will quintuple over the average lifetime of an American at that inflation rate.

Just as scary is the fact that US equity markets tracked inflation expectations tick for tick since last September. Deflation is bad for stocks; it lowers the pricing power of corporations and reduces profits (inflation is also bad if it runs out of control). As the S&P 500 fell at the end of 2018, expected inflation fell in tandem. Inflation expectations have revived a bit as the stock market bounced back in January, but remain on a lower track.

These numbers tell the Federal Reserve that large parts of the US economy are ready to retrench the moment that liquidity becomes less abundant. It wasn’t only the stock market that crashed in December. The market for below-investment-grade credit shut down entirely. Total issuance of high-yield bonds fell to less than $1 billion, something that hasn’t happened since the data series began in 1996. Not only did investors pull back, but consumers evidently pulled back as well, as retail sales had their biggest monthly decline in December 2018 since the great crash in 2009.

The dead calm in the US equities market yesterday and today suggests strongly that the Fed has done all it can to revive the equity market. Color me skeptical about the Wall Street consensus view that profits will pick up late in 2019 after a first-quarter trough. I continue to like good-quality income assets more than equities.

Any attempt on the part of the Federal Reserve to siphon air out of the bubble threatens to pop the bubble.