• The Fed has received much popular criticism for raising the fed funds rate again in December, as Fed leaders resisted pressure to act in support of equity markets
  • While markets are focused heavily on Fed interest rate policy, a greater unknown is the impact of quantitative tightening on market performance
  • Treasury Secretary Mnuchin’s questionable reassurance of bank liquidity roiled markets on Christmas Eve

It was the worst December for U.S. stocks since the Great Depression, and the outlook for global risk markets remains grim heading into 2019. A great deal of blame for the recent carnage has been placed on the Federal Reserve, particularly from President Trump. If anything, the Fed has been operating under standard central bank procedure according to its dual mandate to this point, but financial markets have become too accustomed to an unofficial third mandate popularized by Fed Chair Jerome Powell’s three predecessors (Greenspan, Bernanke, and Yellen). Too often, these predecessors would make supportive statements or policy decisions in an apparent effort to boost asset valuations during periods of heightened market volatility. These actions were initially dubbed the “Greenspan put” in the 1990s, and hence, the assumption of a third mandate. In 2011, Fed Chair Ben Bernanke boasted in his belief that Fed asset purchases “have contributed to a stronger stock market, just as they did in March of 2009” following the initial round of quantitative easing. Under Janet Yellen’s leadership, the Fed was also reluctant to raise rates until late in her term.

The problem with this “third mandate” is that it increases financial instability risks, as evidenced by the dot-com and housing bubbles of the 2000s. Fed Chair Powell seems to understand this dilemma, and his determination to continue with policy tightening in the face of volatile risk markets is commendable from this perspective. Business cycles must come to an end, and the current expansion is close to becoming the longest in history (and already well above average in terms of duration), as shown in Exhibit 1. Powell is not inexperienced whatsoever as it relates to financial markets and expected reactions. He has been an investment banker, hedge fund manager, and held numerous posts within the Treasury Department. It would seem that he is trying to the lead the Fed down a prudent path given its assessment of current economic output and completely independent of market volatility and outside criticism, particularly from the executive branch. This should be a welcomed event from the many who have criticized previous Fed administrations of fueling asset bubbles. Will Fed tightening ultimately be followed by an economic recession? If yes, it would be consistent will almost all other Fed tightening cycles, but the severity of a recession can be amplified by the bursting of major asset bubbles, which most market participants fail to see until it’s too late. This is precisely why those who have criticized the Fed for contributing to past bubbles should be applauding Powell for not wavering in the face of these pressures.

All that said, the lesser discussed policy action currently in process by the Fed is balance sheet reduction, perhaps better named “quantitative tightening.” The Fed has raised the fed funds rate many times in past cycles as a monetary tightening tool, but it has never engaged in quantitative tightening as it is currently doing. Further, it has certainly never engaged in both actions at the same time. As such, how does the Fed really know the impact of each when conducting both at the same time? It would be reasonable to propose that quantitative tightening is the greater culprit with regards to financial market volatility than rate hikes, but one couldn’t say so with certainty with both variables concurrently in play. If one were to criticize the Fed, it would be on this issue, and Fed leaders may choose to pause rate hikes in 2019 while continuing with balance sheet reduction. If so, we may better understand the costs of quantitative tightening.

A Curious Reassurance
It was the worst Christmas Eve in history for U.S. stocks, and the primary catalyst of the turmoil on that day was completely avoidable. On Sunday, December 23, while on vacation in Cabo, Treasury Secretary Steve Mnuchin tweeted an official memo describing phone calls he had made that day to the CEOs of the nation’s six largest banks. In the memo, Mnuchin said the bank leaders confirmed “that they have ample liquidity available for lending to consumer, business markets, and all other market operations.” Wait, what did he say? Did the Treasury Secretary just bring up a question that the markets weren’t even worried about at a time of heightened volatility? In the wake of Dodd Frank and Basel III, banks are more capitalized than ever, and big U.S. banks are also operating under more stringent liquidity requirements relative to the pre-crisis era. No one in the markets was worrying about a liquidity crunch in the U.S. banking system until Mnuchin brought it up, and at this point, everyone now wonders whether they should be worried.

This was, in effect, creating a panic out of thin air, and there were many satirical responses to Mnuchin’s decision in the hours that followed. Yes, bank stocks have suffered in recent weeks/months, but anyone remotely connected to financial markets understands that it’s not because of liquidity concerns. A senior Treasury official attempted to calm markets on Christmas Eve, telling CNBC that Mnuchin’s calls to bank executives were not about liquidity concerns but were instead meant to be a “check-in” on Fed Chair Jerome Powell, the government shutdown, trade, and the markets. Regarding the Fed Chair, Mnuchin was reportedly reassuring the banks that President Trump is not going to fire Powell, an action that would likely create more market turmoil.

Economic Data Trend
While not as dramatic a decline as market sentiment, the domestic data trend has slowed in recent months, particularly relative to expectations. The Citigroup Economic Surprise Index, which tracks the actual data trend relative to expectations, held in negative territory for much of the second half of 2018 (currently -23.8). That said, U.S. PMI data for both manufacturing and services sectors remain in expansion territory, as illustrated in Exhibit 2. A reading above 50 indicates expansion in activity, and vice versa for a reading below 50. Also, unemployment continues to hold at multi-decade lows, and recent wage growth data has trended higher. However, growth data from China and Europe has notably slowed in recent months, sparking general market concerns that the U.S. will eventually follow…


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