The Fed’s Calculus
We have been watching the Fed professionally since 1982, when the weekly release of Money Supply was the thing. This is not meant to imply that being older than the hills gives us special insight into when the Fed will hike rates – a lack of insight we accept not necessarily because we are slow learners, but rather because the Fed is a living organism with changing mandates and incentives adopted for changing economic and market conditions.
For example, according to the Fed’s website:
"The Federal Reserve System and public- and private-sector analysts have long monitored the growth of the money supply because of the effects that money supply growth is believed to have on real economic activity and on the price level. Over time, the Fed has tried to achieve its macroeconomic goals of price stability, sustainable economic growth, and high employment in part by influencing the size of the money supply. In the past few decades, however, the relationship between growth in the money supply and the performance of the U.S. economy has become much weaker, and emphasis on the money supply as a guide to monetary policy has waned."
And so, as the Fed notes, US monetary aggregates have been relegated to the bank bench of economic data. The reason behind this – the overwhelming emphasis on fractionallyreserved bank and fully-reserved shadow bank credit that eventually usurped the importance of the money stock over the last few decades (and made possible by twenty years of easy credit conditions overseen by the Fed) - is not discussed on the Fed’s website. Perception is everything in contemporary economics and the Fed is the center of perception; the medium has become the message.
This is not gratuitous Fed bashing, but rather an observation directed at where the esteemed institution sits in the global economy and how it positions itself in the narrative. Though it must pose as an erstwhile body of best-in-class econometric modelers and policy wonks applying its findings to optimize sustainable economic demand; the Fed is, in reality, an erstwhile cabal of respected theoretical extrapolators jerry-rigging credit rates to fit a public narrative it also creates.
The truth is more this: the Fed no longer reacts to the waxing and waning of animal spirit-led demand. In the current monetary regime it exists to create and maintain animal spirits with a secular policy centered on ever-expanding credit, but it is very aware that admitting it’s centrality would defeat its purpose.
If there is any benefit to torturing one’s self by Fed watching for thirty-odd years, it is the knowledge that its credit and communication policies are as circular as the monetary system it oversees.
A New Narrative
The Fed did not raise its target for Fed Funds yesterday and suggested recent global economic weakness and implied potential US dollar strength were the main reasons. According to Chair Yellen: “A lot of our focus has been on risks around China, but not just China – emerging markets more generally and how they may spill over to the US.”
We have two main observations that suggest a meaningful shift in Fed oversight and communications.
First, by waiting and citing global economic weakness, the Fed effectively took responsibility over the exchange rate of the US Dollar - oversight traditionally managed by the Treasury Department.
One does not have to go back to the eighties to know that US Dollar policy has historically been the specific domain of the US government. Ms. Yellen’s willingness to disregard any mention of “a strong-dollar policy” made famous by Robert Rubin’s Treasury implies: 1) a fundamental shift in control over the economic policy narrative put forth by the United States, and 2) the US wants to send a message to foreign monetary authorities that it will let the US dollar weaken…for now.
It seems economic authorities and commercial operators in China and everywhere else now need only watch and listen to the Fed to understand US policy towards the Dollar and now know that the US will support their efforts to stabilize their economies. (More on this in later reports.)
Our second observation is that Ms. Yellen’s comments yesterday make clear that the Fed is implicitly judging the health of the US economy by incorporating global factors that may directly or indirectly affect its formal domestic macroeconomic mandates of price stability, sustainable economic growth, and high employment.
This had to happen eventually. US dollars are not only the domestic currency Americans use to consume, invest (and ostensibly save); they are also the world’s most dominant reserve currency used in trade and the one in which significant global debt is denominated. Ms. Yellen’s tacit admission that the USD is a consideration in the Fed’s decision to maintain zero-bound US rates a little longer does not necessarily suggest that the Fed does not believe the US economy, per se, could not absorb a rate hike.
Taken together – unilateral authority over US dollar policy, an implied acknowledgment that the global economy could not yet withstand a stronger US dollar (but don’t mess with us!), and the US economy would suffer as a result – is the likely calculus behind last week’s Fed rate decisions.
The implication for investors in the US and everywhere else is, to paraphrase the famous line credited to President Nixon after the 1971 USD/gold default, we are all Fed watchers now. Regardless of focus, there has never been a better time to include macroeconomic analysis in one’s investment process.