Dangerous Addiction

After doing this so many times, I think one of the best approaches is to simply ask, “What could go wrong?” Other things being equal, a growing population and increasing productivity will naturally produce a growing economy. But of course other things aren’t equal, and examining the deviations is a good way to reveal what might slow or reverse growth.

As I said in my 2018 forecast and again last week, I think a Federal Reserve policy mistake is our top risk. That’s less a “forecast” and more a recognition of reality, since the mistake is already happening. The Fed is raising rates and reversing its quantitative easing at the same time. They should be doing one or the other, not both. I think the global balance sheet reduction is especially harmful. I think/hope Jerome Powell will realize this in early 2019. If he doesn’t, or the rest of the FOMC disagrees with him, the year could get very rocky, very quickly.

Let’s look at a few things that crossed my inbox in the last month and see if I can piece them together.

I’ve been tough on the Fed but I may actually be understating the danger. My friend Chris Whalen described the problem last week. After noting work by economist Zoltan Pozsar, who said QE-created bank reserves aren’t “excess,” Chris wrote (with my bolding):

The obvious points to take from Pozsar’s work are two: First, the FOMC cannot withdraw the liquidity provided to the US financial system via QE without causing the system to implode. Chairman Jerome Powell needs to publicly state that the Bernanke-Yellen inflation in asset prices will entirely reverse as the FOMC tries to reduce “excess reserves” to pre-crisis levels. Regardless of whether the FOMC raises the Fed funds target rate or not, continuing to shrink bank reserves via QT implies a significant reduction in prices for stocks and real estate.

Second and more important, Powell needs to inform Congress that so long as the Treasury intends to run trillion-dollar-plus annual deficits, the Fed’s balance sheet must grow rather than shrink. To have the FOMC try to follow a narrative set in place half a century ago when fiscal deficits were minuscule is obviously impossible given the Treasury’s borrowing needs. This implies that the FOMC must embrace an explicit policy of inflation that is at odds with the legal mandate enshrined in Humphrey-Hawkins.