Mester On Financial Stability

When I refer to financial stability, I mean a financial system that is resilient to shocks. That is, one in which banks and nonbank financial institutions not only remain solvent but also continue to lend to creditworthy businesses and households during a significant economic downturn, and one in which financial markets continue to intermediate in an orderly fashion during periods of stress.” Cleveland Fed President Loretta Mester, June 22, 2021

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I read with keen interest Mester’s presentation, “Financial Stability and Monetary Policy in a Low-Interest-Rate Environment.” With rates locked a zero and the Fed’s balance sheet inflating $4.332 TN, or 115%, in 93 weeks to surpass $8.1 TN, there is no more pressing issue than the interplay of monetary policy and Financial Stability.

From one perspective, the March 2020 crisis showcased a financial system resilient to shocks. A well-capitalized banking system continued to lend, while there was little concern for financial institution solvency. Meanwhile, financial markets clearly did not “continue to intermediate in an orderly fashion.” When I refer to Financial Stability, for starters I mean a financial system that does not require monumental liquidity injections and bailouts that clearly come with dangerous unintended consequences. Speculative Bubbles are reflective of financial instability.

June 24 – New York Times (Jeanna Smialek): “As Federal Reserve Chair Jerome H. Powell and Treasury Secretary Steven Mnuchin scrambled to save faltering markets at the start of the pandemic last year, America’s top economic officials were in near-constant contact with a Wall Street executive whose firm stood to benefit financially from the rescue. Laurence D. Fink, the chief executive of BlackRock, the world’s largest asset manager, was in frequent touch with Mr. Mnuchin and Mr. Powell in the days before and after many of the Fed’s emergency rescue programs were announced in late March. Emails… along with public releases, underscore the extent to which Mr. Fink planned alongside the government for parts of a financial rescue that his firm referred to in one message as ‘the project’ that he and the Fed were ‘working on together.’”

Curiously, Mester’s discussion of the March 2020 instability episode fails to mention the dislocation that unfolded throughout the ETF complex. “ETF” or “exchanged-traded funds” cannot be found in her paper. “Bubble” not included. Nor was there a mention of the Fed’s hasty decision to purchase corporate debt and fixed-income ETF shares. Mester specifically addressed that “$125 billion flowed out of prime money market funds in March 2020.” Yet not a peep regarding the run on ETF shares, which risked a full-fledged collapse across the equities and fixed-income markets.

Mester: “The pandemic also revealed some structural issues in the U.S. Treasury market, one of the most important and most liquid markets in the global financial system. In March 2020, amid great uncertainty about the emerging global pandemic, many investors sought to move into cash and began liquidating their positions, even their positions in U.S. Treasuries, which are usually viewed as safe-haven assets. Pressure to sell was widespread and overwhelmed the dealers who play a central role in this market by intermediating between buyers and sellers. Stresses rose to a level that necessitated aggressive actions by the Fed, including purchasing large volumes of Treasury securities and agency mortgage-backed securities and conducting operations in the repo market.”

Again, the omissions are noteworthy: No mention of hedge funds, leveraged speculation or the derivatives industry. The most crucial market in the world was in complete disarray, revealing acute financial instability. What were the root causes? What role did monetary policy play? And what is the Fed doing to address market structural shortcomings? Mester: “While these actions were able to re-establish smooth functioning in the Treasury market, they did not address the underlying structural issues that propagated the stresses.”

I do credit Mester for stating the obvious: “I would like to see financial stability considerations explicitly incorporated into the monetary policy framework, with an acknowledgment that nonconventional monetary policy has the potential to increase the risks to financial stability…”

Mester: “Given the limits on cyclical macroprudential tools in the U.S., focus is better placed on improving the resiliency of the financial system’s structure across the business and financial cycles.” “My second recommendation recognizes that much of our regulatory, supervisory, and macroprudential apparatus is focused on banks, yet financial activity is increasingly moving outside of the banking system.”

After the role the “shadow” non-banks played in the 2008 crisis, the lack of Fed focus is inexcusable.

Mester: “[Money market fund] outflows forced the funds to redeem their commercial paper holdings, thereby creating more stress in short-term funding markets. These runs were severe enough to require the Fed to intervene with emergency facilities. Reforms to the structure of these funds to reduce the risk of runs are now being considered by U.S. regulators.”

Arguably, the risk of a systemically destabilizing run is today greater for the ETF complex than with money market funds. Again, there's no mention of exchanged-traded funds. Apparently, no “reforms to the structure of these funds to reduce the risk of runs” are being contemplated.

The sordid process unfolded over the past few decades. These days, debt doesn’t matter, and deficits don’t matter. QE to the tune of $120 billion a month in the face of a booming economy and bubbling securities and housing markets is accepted as enlightened policy. Zero rates – and near-zero returns for savers – are perfectly acceptable. Stocks always go up. The Fed is prepared with its liquidity backstop to rescue the marketplace in the event of any trouble. QE is a proven commodity – no longer unconventional.

There is a monumental flaw in contemporary central banking doctrine, one not debated and seemingly not even recognized: it is perilous for central banks to manipulate the securities markets as their chief mechanism for managing financial conditions.

Traditionally, central banks adjusted short-term funding markets to, on the margin, either encourage or discourage bank lending. The banking system for generations was the key instrument for regulating system lending conditions and Credit availability, along with the overall monetary backdrop.

The Fed’s focus began to shift during the prolonged Greenspan era. Especially in response to early-nineties banking system impairment (post-eighties Bubbles), the Greenspan Fed started using “activist” monetary policy to achieve specific market outcomes. It orchestrated a steep yield curve to recapitalize the banking system. It employed lower interest-rates to bolster bond prices and, as such, market demand for Credit instruments. This loosening of financial conditions worked to promote bond issuance and, as such, Credit growth. The “Maestro” learned to wield incredible market power with small rate adjustments or, more often, with mere comments.

I found it confounding at the time that such a momentous change in monetary policy doctrine evolved without as much as a debate. The new regime proved a godsend for the leveraged speculating community. Speculative leverage ballooned, creating fragilities and repeated crises. This required ever-grander market bailouts. Each crisis backdrop afforded the Fed the opportunity to take another incremental “activist” leap. Of course, the markets beckoned for as much – and who would argue against Fed intervention with the markets and economy in distress? One of these days, our central bank will be held accountable.

The Fed was essentially pegging low interest rates, nurturing asset inflation and (with the help of the GSEs) backstopping marketplace liquidity. As one would expect, this stoked risk-taking and leveraging. It also momentously impacted the derivatives marketplace.

The new Fed policy regime allowed the derivatives complex to operate under the assumption of liquid and continuous markets, despite the reality of a long history of markets suffering recurring bouts of illiquidity and discontinuity. Basically, the Fed’s regime fundamentally altered pricing for market risk “insurance.” Think in terms of selling flood insurance with the Federal Reserve right there to safeguard against torrential rainfall. The availability of cheap market protection promoted risk-taking and leveraging, fundamentally altering market behavior and structure.

The upshot was a historic Bubble that burst in 2008 – providing a golden opportunity for the Fed to add QE to its expanding arsenal. It’s no exaggeration saying, “the world will never be the same.” At that point, the Fed was wedded to market intervention and manipulation to maintain the ultra-loose financial conditions necessary to hold Bubble collapse at bay. Not only did the Bernanke Fed expand Federal Reserve Credit by $1.0 TN, but the reflation strategy focused on coercing savers into the risk markets. While there was some protest within the economic community, consumer price inflation was at the time viewed as the major risk. It was not the time to fret prospective market excess and the inflation of historic Bubbles.

I warned of a “Moneyness of Risk Assets” dynamic, where activist Fed policymaking was distorting the perception of price and liquidity risks (equities and corporate Credit, in particular). Just as Greenspan was a godsend to the leveraged speculation community and derivatives players, Bernanke’s policy regime was tailor-made for the newest innovation in financial speculation: exchange-traded funds.

The Fed had one last chance to rein in the Bubble. It announced its non-conventional policy “exit” plan in 2011, with expectation to pare back some of its unprecedented balance sheet expansion. But instead of exiting, the Fed again doubled asset holdings over three years to $4.5 TN. And the policy evolution went beyond adding massive amounts of liquidity in a non-crisis environment. With essentially no fanfare, Bernanke sank deeper into activist policy quicksand in 2013: “If financial conditions were to tighten to the extent that they jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that.”

Dr. Bernanke was essentially telegraphing the Fed would not tolerate the consequences of weak securities markets – let alone a correction or bear market. It was monumental. The Fed was no longer only backstopping the markets against crisis dynamics. Our central bank wanted loose financial conditions, and it was ready and willing to do "whatever it takes" to ensure inflating markets. Fed mandates could only be accomplished through robust securities markets. At that point, the Fed was managing financial conditions in name only. It directly orchestrated booming markets to accomplish its economic objectives.

It’s all been fairly predictable since then: escalating speculative excess, over-leveraging, Bubble Dynamics, and recurring market instability. And each bout of market turmoil ensured only more outlandish Fed market intervention: Powell’s “pivot,” the 2019 “insurance” stimulus in the face of booming stock markets and unemployment at multi-decade lows, and then the Monetary Fiasco unleashed in March 2020. The Fed’s balance sheet has about doubled in 15 months, while our central bank ventured into buying corporate bonds and ETFs. Importantly, it thoroughly convinced the marketplace that “whatever it takes” can be literally interpreted when it comes to sustaining Bubble markets. Manias were spawned in precarious “Terminal Phase Excess.”

Now what do they do? The Fed and global central bank community have inflated myriad historic Bubbles. They’ve irreparably distorted market prices and function. The upshot is momentous risk distortions throughout – with particular emphasis on unprecedented leveraged speculation, the derivatives complex and the ETF industry. The money market funds should be the least of the Fed’s concerns.

Goodhart’s (British economist Charles Goodhart) Law is germane: “When a measure becomes a target, it ceases to be a good measure.” The Fed’s overarching objective must be to ensure monetary stability. To focus on managing financial conditions through securities markets interventions is to propagate monetary instability. It only nurtures price distortions, speculative leverage, asset inflation, Bubbles, resource misallocation, and financial and economic instability. Moreover, such a policy course will favor a segment of the population and economy. It will spur inequality and put the Fed’s institutional credibility in jeopardy.

I appreciate Loretta Mester’s attention to the critical issue of Financial Stability. Unfortunately, these types of discussions are moot if they exclude the Fed’s now longstanding role in promoting market distortions and Bubbles. Speculative finance is inherently destabilizing. It is self-reinforcing on the upside and highly disruptive on the downside. Fed policy has evolved to the point of essentially guaranteeing loose financial conditions and, as such, promoting speculative finance and overheated Bubble markets. This flawed policy regime is anathema to Financial Stability.

Disclosure: Doug Noland is not a financial advisor nor is he providing investment services. This blog does not provide investment advice and Doug Noland's comments are an expression of opinion ...

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