Does the Fed Keep Spiking the Punch?

This Wednesday, March 17^th, we will learn about the Federal Reserve’s approach to the color green.  Although the color is of course associated with that date’s St. Patrick’s Day holiday, it is also the color of American money.  Financial markets will be on edge that afternoon, as investors seek clarity about the path of future monetary policy during the Fed’s statement, “dot plot” and comments by Chairman Powell during his ensuing press conference.  The world’s investors will have their eyes fixed upon him.

Chairman of the Federal Reserve was once an uneventful job.  From 1951 through 1970, the Federal Reserve’s Board of Governors was chaired by William McChesney Martin, Jr.  He was a creature of the Establishment.  His father helped write the Federal Reserve Act in 1913 before serving as a Fed governor and the head of the St. Louis Federal Reserve Bank.  If anyone was ever born to head the Fed, it was the younger Mr. Martin. 

Despite his nearly two-decade tenure at the head of the nation’s Central Bank, Martin is best known for a 1955 quip.  At an address before the New York Group of the Investment Bankers Association of America, he said “The Federal Reserve, as one writer put it… is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”  Poor guy.  He is remembered mainly for one quote, but it turns out he was actually paraphrasing someone else.  Mr. Martin was indeed primarily a hard money central banker, who institutionalized much of the Fed’s decision making and zealously guarded its independence.  If any Fed Chair seems to epitomize a bygone era, it was Bill Martin.

With four different people in the role over the past 20 years (Greenspan, Bernanke, Yellen, Powell) it is hard to imagine any Federal Reserve Chair remaining in that position for that long.  It is even harder to imagine a hard-money Federal Reserve.  We need to go back several decades to recall one.  Alan Greenspan, the first of those four mentioned earlier, also held the role for just under 20 years.  He came into the job with inflation-fighting credentials, and was known to have previously advocated for the gold standard prior to assuming his role at the Fed.  Yet if he was a hard-money banker, circumstances forced him to abandon that stance almost immediately.   The stock market Crash of 1987 occurred just two months after Greenspan was confirmed as Chair, and he famously responded by implementing highly accommodative monetary policies to avoid a stock market crisis becoming a broader threat to economic stability. 

Those 1987 actions were indeed a watershed.  They provided a playbook for other central bankers to use during times of crisis.  They were a precedent for those seen a year ago, when the Federal Reserve, and later the Federal government, responded with alacrity and vast stimuli in response to the burgeoning Covid-19 crisis. 

Yet one could argue that the Fed’s willingness to provide liquidity during the crises that have ensued since 1987 have gotten markets addicted to easy money from the world’s central banks.  The Greenspan era saw at least two other booms and busts that were initiated by easy money and doused by subsequent tightening cycles.  The late ‘90s tech boom reflected the technological advancements brought by the internet, but the final phase of the bubble was abetted by extraordinarily accommodate monetary policies that were instituted ahead of Y2K fears.  When those fears proved to be largely illusory, the monetary policy tightened, and the tech bubble eventually popped in 2000.  Later that decade, a new round of easy money spurred a housing crisis that led to a major recession.  By that point, Alan Greenspan had been replaced by Ben Bernanke.  In a thought experiment, he had once proposed the idea of dropping money from helicopters to initiate spending.  “Helicopter Ben” was extraordinarily accommodative during the depths of the crisis, which also saw a round of fiscal stimulus. 

Since the depths of the 2008 crisis, markets have seemingly depended even more upon monetary accommodation.  Janet Yellen took office not long after the “Taper Tantrum” of 2013 and saw during that event and others just how sensitive investors were to even a perception that monetary conditions could tighten.  She is now Treasury Secretary, with a key role in guiding the Administration’s economic policies, while her successor, who clearly absorbed those accommodative lessons now guides economic policies.

That brings us to Wednesday’s Fed meeting.  Bond traders are clearly fearful that the most recent round of fiscal stimulus, arriving amidst continued monetary stimulus and as the nation appears to be shedding its year-long daze, could bring inflation to goods and services.  Markets haven’t minded inflation in financial assets, though one can argue that we are starting to see worrisome inflationary signs in commodity prices and alternative assets.  The 10-year notes now yield 1.60%, a historically low number but high by recent standards.  This reflects bond investors’ rising inflationary expectations.  Mr. Powell has done little to assuage those fears during recent comments where he reaffirmed the Fed’s need to stay accommodative until inflation is consistently above 2% and the economy reaches full employment. 

Investors are in a bind.  They like monetary accommodation but are now beginning to worry that is going too far, and that the Fed’s determination to keep liquidity measures in place could have unanticipated side effects of the inflationary variety.  In effect, they are in the opposite position of the one described by Mr. Martin in 1955.  In 2021, the Federal Reserve may be not only leaving the punch bowl on the table, they may be the ones spiking the punch to keep the party going even after the guests are already intoxicated.  Investors will be looking for signals when the last call might be expected.