«There’s not much the Fed can do to address a liquidity crisis»

Danielle DiMartino Booth, CEO of Quill Intelligence and former analyst at the Federal Reserve Bank of Dallas, talks with «Finanz und Wirtschaft» about the current problems of monetary policy.

Danielle DiMartino Booth is a vocal critic of the Federal Reserve. The former analyst at the Federal Reserve Bank of Dallas condemns the devotion of the unelected academics to their theoretical models. In her book «Fed Up» she writes about arrogance and tunnel vision that drive core policies of the Fed and explains why the central bank is bad for America.

Ms. DiMartino Booth, why is the Federal Reserve bad for America?
Because of its intellectual dishonesty. The Fed noticed around 2009 that if they had had a more reliable and realistic inflation gauge on which to set policy, they would have seen the crisis coming. But despite that recognition, they chose to do nothing about it.

Are there more realistic inflation gauges?
Several Federal Reserve Districts have come up with alternative gauges. The underlying inflation gauge from the New York Fed for example also includes asset price inflation. And it runs about one percentage point higher than what the Fed measure is – they prefer the core Personal Consumption Expenditures Price Index, the core PCE.

How would monetary policy look like with a more realistic inflation gauge?
Monetary policy would be much different. The Fed would not have been able to maintain a monetary policy as easy as it has done over the last couple of years. Central bankers are hiding behind the core PCE being at 1,6%. They’re saying that this gives them cover to not normalize interest rates. But even the core Consumer Price Index has been north of 2% for 14 months.

What does this mean for current monetary policy?
Former Fed Chair Janet Yellen lead the slowest rate hiking campaign in the history of the Fed. Had she been using a more realistic inflation gauge, she would not have left current Chair Jay Powell with having to play catch-up. He wasn’t able to normalize interest rates, nor to run down the balance sheet as much as he would have been able to otherwise – and had Ben Bernanke not insisted on the 2% inflation target.

What is the reason behind the inflation target of 2%?
Alan Greenspan and Paul Volcker said that the best inflation rate as far as households and businesses are concerned is 0%. There is nothing that is damaging to a household about inflation being non-existent. As Greenspan and Volcker both pointed out: If you have 2% inflation steadily for 50 years, the value of the dollar in your wallet is diminished. Inflation is corrosive as a factor of time.

What about the risk of falling into deflation?
A deflation in wages, as we saw during the Great Depression, is the worst-case scenario. But Japan has served as a modern-day reminder that households are not going to be injured by very very low levels of inflation. In a disinflationary environment with a decent level of growth, you’re not running that risk. You’re still going to have job creation and economic growth. But you’re not going to have the pressure of rising prices on households. Housing makes up 33% of the average US household budget, and housing inflation has gone through the roof in recent years. Not that it’s captured correctly in the metric that the Fed uses.

So, why is the Fed aiming for 2%?
When Stanley Fisher was vice chair, he asked the same question during his first Federal Reserve meeting. He said, why do you insist on using this antiquated broken method? One of the staffers raised his hand and said if we didn’t use it, then the models would not work.

Why has the Fed become more dovish recently?
Credit market volatility picked up appreciably last year as we moved from 2,1 trillion $ of global Quantitative Easing for the full year 2017 to zero in December. This drained liquidity from the system on a global basis. In December, we had had no junk bond issuance in the US for a record period of 41 days. There were outflows from bond funds and spreads started to widen.

So the reason for the Fed being more dovish wasn’t the stock market?
Not as much as it has to do with how problematic and difficult it would be to address a seizing up in bond market liquidity with monetary policy, given that we have got nearly 250 trillion $ of debt worldwide. The fact that Powell completely changed his approach and started sounding like he was channeling a combination of Janet Yellen and ECB President Mario Draghi implies, that there’s not much the Fed can do to address a liquidity crisis.

How liquid is the bond market now?
Some weeks ago the issuance in the junk bond market dried up for an entire week. After that, Powell had his Draghi moment at the Chicago Fed conference, saying the Fed would do whatever it takes to sustain the economic expansion.

What do you expect at the Fed meeting on June 19th?
I expect the Fed to lower its expectations for economic growth and the labor market and prepare the financial markets for the possibility of a rate cut if conditions were to deteriorate. Powell will lay the groundwork for having as much flexibility as the Fed needs to cut rates. It’s quite clear that it is a global coordinated effort, given the communiques out of European Central Bank and the bank of Japan where we’re starting to hear about rate cuts from these two institutions.

What is the state of the US economy?
The US economy is definitely slowing. The CEO confidence is at the lowest level since the last quarter of 2016.

Is there a recession imminent?
It could just be a matter of either we are already in recession or it is coming very soon.

But stock markets trade near record highs.
The market is expecting the Fed to be very aggressive in launching a rate cut campaign. Powell and others have given speeches recently that appear to advocate negative interest rates, as is the case in Europe and in Japan, and also more Quantitative Easing. A lot of the optimism in stock markets is based upon investors’ perceptions that if the Fed pumps enough liquidity into the system, that will allow for stock markets to never correct.

So Powell will save the stock market.
That’s the reigning theory. Jay Powell will save the day. We have never seen an episode in US history when we technically are in a recession and when earnings decline quarter after quarter but we don’t see a negative impact in the stock market. But try telling that to the stock market.

How will monetary policy look like in a couple of years?
I have no idea. We are falling further down into the rabbit hole of unconventional monetary policy.

Is there any way to get out?
I don’t know. There is so much debt. They have created debt in order to resolve an over-indebtedness problem. So it’s the policy makers themselves that have made the situation that much worse. Think about insurance companies and public pension plans throughout Europe and Japan. How do you sustain yourself when interest rates are negative?

What can the Central Banks do?
There are no easy choices to be made. If you’re Draghi’s replacement, what do you do? Do you just say, okay let Italy go, it’s only the third largest sovereign debt market in the world. Central Bankers have made their choices much more difficult by insisting on never normalizing. It was well-known in the US in 2008 that there was a liquidity problem that was seizing the market, not the cost of credit. The Fed didn’t even have to go below 2% in 2008 because what was plaguing the financial system was a lack of liquidity. Those problems were resolved with the facilities that were created by the New York Fed. The problems were not resolved by taking interest rates to 0%. The price of money at times of financial market disruption is irrelevant.