Flying Blind With the Fed

Perhaps the most unsettling comment to come out of U.S. Federal Reserve Chairman Jerome Powell’s news conference this week was his admission that he and other experts overseeing the economy are confronting “something that we haven’t faced before.”

“The thing is,” Powell said, “there isn’t a lot of experience in responding to global trade tensions.” His approach: “We’re learning by doing.” 

That was a euphemistic way of pointing out that U.S. President Donald Trump—joined now by British Prime Minister Boris Johnson, who has sent the British pound plummeting with his threat of a no-deal Brexit by Oct. 31—are wreaking a new kind of havoc with the international economy. Growth and investment are slowing due in large part to the uncertainty those leaders have sown. And even as a possible recession looms, the Fed and other central banks will have fewer tools to combat it since rates are already so low.

That statement wasn’t what market players focused on most—traders were mainly interested in whether Wednesday’s interest rate cut would be a one-off or would touch off a new series of reductions. But Powell’s many hedges and uncertainties following the quarter-point cut set markets roiling. Bond traders bet Thursday that he’d be forced to cut further, despite his hawkish hints otherwise. Trump, meanwhile, doubled down: He blasted the Fed chief for not cutting enough—“As usual, Powell let us down,” Trump tweeted—and then exacerbated tensions with China further by announcing new tariffs, sending the Dow plunging by 280 points. 

If things do start to go south, what could turn a possible financial crisis into a catastrophe is the huge overhang of debt—corporate, credit card, student, auto, and other kinds of debt—and the weakness of banks worldwide to deal with potential default. Americans tend not to think about this because their top banks remain strong for the present. The same can’t be said of European banks, starting with the deeply troubled Deutsche Bank, or those in China.

“In the European Union, the banking system is hanging on by its fingernails,” said Michael Greenberger, a former division director of the U.S. Commodity Futures Trading Commission. Greenberger, an expert in derivatives, also fears that major banks are playing their old games with derivatives by creating complex debt products and then avoiding Dodd-Frank restrictions by putting them on the books of non-bank-guaranteed affiliates and shadow banks abroad. 

“Deutsche Bank is a zombie. It will soon have to be rescued by Germany, the economy of which is very troubled,” said Greenberger, who now teaches securities law at the University of Maryland. “But that single rescue could very well trigger enough panic that other teetering EU banks collapse, e.g., Italian banks,” he said. “A string of failures and rescues—if there are rescues—will begin to trigger worldwide tightening of credit in an environment where short term credit is needed to sustain long-term outstanding loans.” 

Greenberger added: “The economic consequences of even a mild recession will increase defaults on student loans, credit card debt, auto loans, and outstanding corporate loans to fund stock buybacks.” Powell himself has sought to ameliorate fears of mounting corporate debt by dismissing comparisons to 2008. But back in May he did it with such faint damnation that he only deepened those fears, saying meekly: “The parallels to the mortgage boom that led to the global financial crisis are not fully convincing.”

Since 2010, the assets of the so-called shadow banks, or nonbank lenders that deal in often-risky debt, have soared to $52 trillion, a 75 percent increase over what they were at the end of the last crisis, based on data from the Financial Stability Board reported by CNBC.

Powell alluded to this global threat Wednesday when he appeared to consider the health of the U.S. economy almost an afterthought—even though that is the Fed’s central mandate. “We will be monitoring the evolution of trade uncertainty, of global growth, and of low inflation—and we will also of course be watching the performance of the U.S. economy,” he said. 

All this comes at a time when those who managed the last great crisis back in 2008 are worried that their policymaking successors don’t have the same tools they did, since individual banks can’t be rescued under the new regulations. 

“We are not sure people remember everything they need to remember,” former Treasury Secretary Henry Paulson told an audience last month as the Trump administration and Republicans in Congress continued to dismantle parts of the Dodd-Frank financial regulation law passed in 2010. Meanwhile, under Trump, Republicans continue to discard even the pretense of Tea Party-inspired fiscal discipline in favor of blowing out the budget, raising spending by $320 billion; total U.S. debt is now nearly 105 percent of GDP, its highest level in decades. Some experts believe another giant bank bailout, only a decade after the last one, would be politically impossible.

And while the overall economy is growing, it has been clearly slowing since the middle of last year, as Powell acknowledged Wednesday. Hence uncertainty and mixed signals rule the day. While the stock market is still rising on the whole, the bond market is signaling recession, and Powell himself faces a divided Fed board. Interest rates, already so low, aren’t what is holding back investment—trade uncertainty is—and no one thinks a mere quarter-point cut is going to spur more investment. But as Powell himself said, the Fed can’t inject itself into trade issues; it can only try to ameliorate their effects, apparently. 

In other words, Powell is admitting that he’s pretty much in the dark—flying the economy through a soupy fog based on antiquated instrument training and an outdated map. To make things worse, many markets around the world now think that the Fed chairman, like the Republican Party, is succumbing to Trump’s bullying, costing U.S. economic authorities even more credibility when the crisis comes.

It’s probably too soon to panic, many experts say. “The reason for the [Fed] move is the global manufacturing recession that hit at the end of last year,” said Liaquat Ahamed, a former bond trader and author of the Pulitzer Prize-winning book Lords of Finance. “But the U.S. consumer is still going strong … which gives us 1.5 to 2 percent growth, not weak enough to be of concern but enough to stop further tightening. As for the debt overhang, it by itself is not going to cause a recession. But it will mean any recession that does come will create some sort of upheaval in the credit markets.” 

Nor would this be the first time the Fed was feeling its way gingerly forward into new economic realities. Some market observers like Ahamed compared the current Fed approach to that of the mid-1990s, when then-Chairman Alan Greenspan carefully tweaked interest rates down as the economy slowed in order to prolong the “Great Moderation,” as that long expansion was called. The problem is the longer an expansion goes on, the more complacency sets in, as it did with reckless mortgage lending at the tail end of the Greenspan era, leading to the financial engineering insanity of the mid-2000s.

And complacency is what makes a “Minsky moment” possible. Named for Hyman Minsky, the late economist, the hypothesis is that the longer a boom lasts, the less market players come to consider failure a possibility. Cautious borrowing, lending, and investment give way to recklessness and speculative euphoria and at a certain point—or Minsky moment—the inevitable correction begins: The most speculative investments crash, loans are called in, asset values plunge, and the downward spiral feeds on itself.

That’s what happened in 2008. Today, a very different kind of complacency is setting in: the belief that the current environment of low interest rates, little or no inflation, and ever mounting debt can go on forever. Ten years ago, the ultimate lesson of what may go down as the worst financial catastrophe in history—worse even than the stock market crash of 1929 that precipitated the Great Depression—was that finance had become so complex and the banks that practiced it had grown so big that even the CEOs who ran these firms no longer understood what their traders were doing.

As the Fed chairman has just admitted to the world, no one can quite fit together the pieces today either.