When Chair Powell last Friday shocked traders when he said that, contrary to what he had said just two weeks prior during the December FOMC press conference, the Fed could be "patient", rate hikes could, in fact "pause", and the Fed's balance sheet reduction is not in fact on "autopilot", the Powell Put finally emerged for the first time, and the result has been a torrid rally ever since.
It also prompted an avalanche of accusations that Powell folded like a cheap suit, held hostage by traders who pushed stocks low enough to i) test where the Powell Put strike price is and ii) force the Fed to halt its rate hikes, something it has now effectively done.
And yet, being held hostage, or captive, by the market is nothing new to Powell; in fact, it was way back when in March 2013, ahead of the Fed's taper announcement, that the Fed chair first realized that it was not the Fed that controls the market, but rather - after years of ZIRP and QE - the Fed had become a hostage of the market's every whim.
What follows is one of Powell's recurring warnings about the size of the Fed's growing balance sheet, in which he not only argued about the potential for massive book losses when rates pike (and associate political risks), and that the lack of clarity around when the Fed would stop its asset purchases was itself a financial stability risk, but explicitly stating what Powell himself would experience nearly 6 years later: that the Fed is now a puppet to the market.
With inflation under control, I have the same two main concerns as others. The first is that our policies will push the markets too hard, and that the result will be an unexpectedly sharp increase in rates as normalization approaches and damage to the real economy. I see that risk as manageable for now but increasing materially with the size of the balance sheet.
I also see it as principally a risk of market dynamics and not one that is easily captured by our model. The second major cost, again, is that of the realization of losses, low remittances, and depleted capital. And I want to say that I think this scenario captures my concern. It’s in one of the many memos.
We buy another $500 billion, which gets us to $1 trillion starting on January 1, 2014. Rates are 100 basis points higher. The first part of that is a near certainty at this point, it seems to me, at least in the market’s expectation. The second is quite plausible. That gives us five years of zero remittances, $300 billion in losses, and we sprout a deferred asset of $63 billion in 2019. I’m very uncomfortable with that for the political risk reasons that have been elaborated.
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I have one final point, which is to ask, what is the plan if the economy does not cooperate? We are at $4 trillion in expectation now. That is where the balance sheet stops in expectation now. If we have two bad employment reports, the markets are going to move that number way out. We’re headed for $5 trillion, as others have mentioned. And the idea that President Kocherlakota said and Governor Duke echoed— that we ’re now a captive of the market — is somewhat chilling to me. I think we need to regain control of this, or we will be moving out on that if the economy doesn’t cooperate. There’s some material part of the probability distribution that is not covered by a plan, in my view. The way to get at it is to increase flexibility, starting now, around the plan for the existing prongs: the costs and the risks, and what constitutes a substantial improvement. I think both of those need to be communicated better to the public in a way that increases our flexibility to do something, because if the economy doesn’t cooperate, I don’t know what we do. The problem has been, and is, the open-endedness of the plan. And I would say , in closing, that the risks may be manageable at $4 trillion, but at $5 trillion , you’re in a different league. There has to be convexity in this.
And so, almost six years after Powell first defined precisely how the Fed is now a captive of the market in March 2013, Fed Chair Powell just got to experience it first hand.