Multi-decade shift in paradigm?

The November 2 statement by the Federal Reserve was engaging, but we think the crowd missed the most important cue that could have repercussions for the next decade and effect losses and so litigation.


The main focus of reporters and the market was on the 'hawkish' or 'dovish' tone, or aka the 'pivot' to a less hawkish tone. However, when combined with the clues from other central banks and supranationals a new trend seems to be emerging, and we try to unwrap it here. This shift is possibly so material, that it will shape the economic landscape for at least the next decade.



Image by Mark Jennings-Bates from Pixabay


First for the prosaic


The written statement was read as 'dovish', and markets rallied on its publication (before the Powell speech). That was short lived as Chairman Powell, during his speech and Q&A, quickly made it clear that the Fed was far from done. For those who don't listen to a lot of Fed statements, the Q&A is always the most salacious bit.


Powell reiterated during Q&A that past statements that their primary focus was about 'structural inflation' (the idea that consumer behaviours anticipate price rises and further feed the inflation cycle by buying in advance and shunning cash), however, noted that inflation expectations had turned lower, and so they were slightly more sanguine about this essential issue.


Speculation that Powell was more hawkish in his speech after observing the market reaction to the written statement indicate some combination of the following: (a) there is a divide within the committee that drafted the statement (with some dovish voices influencing the statement) (b) that Powell wanted to ensure the market got the right interpretation (most likely) or (c) that the Fed is concerned about the equity market signalling euphoria and are trying to control equity markets (not something we believe).


Now for the juicy detail


During the opening remarks Powell said the following (with our emphasis).


"My colleagues and I are strongly committed to bringing inflation back down to our two percent goal we have both the tools [comment: an important clue that the Fed is thinking differently now as it has more tools post GFC then in the prior century] that we need and the resolve [a reference to a track record of central banks failing to finish the job, because they only had one tool - rate cuts] it will take to restore price stability on behalf of American families and businesses."


"Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy [sound money lets savers and investors make rational decisions, and it does not favour asset owners over those with cash]."


"Without price stability the economy does not work for anyone [this is important - this feeds into a reasonable view that central banks failure in the past to fight inflation has skewed economies toward asset owners]. In particular without price stability we will not achieve a sustained period of strong labor market conditions that benefit all today [sound money lets people focus on productive activity, rather than speculation and asset accumulation]."


Then in the Q&A, Powell elaborated on this view point in response to a question from Michael McKee from Bloomberg who wanted to know if the Fed still believed there was 'risk of hiking too little'. Powell responded that since that statement was made, 375bp had already been hiked, but that the statement stood. And then he said something interesting.


"But if we over tighten, then we have the ability with our tools, which are powerful, as we showed at the beginning of the of the pandemic episode. We can support economic activity strongly if that happens if that's necessary." For us, this was an interesting comment. And we have clues about this new framework from elsewhere too.


A changing agenda


Policymakers are grappling with a number of systemic reforms to deal with challenges we are facing. Those that make the headlines are about climate change and sustainability. By contrast economics and monetary policy seems rather dull. However, as one may expect, changes to how we manipulate money can have rather material effects.


We became conscious of this shift first when reading Jim Rickards, 'Road to Ruin'. Perhaps a variation on Hayek's 'Road to Serfdom' but here Rickards published many of the changes we had seen post the GFC in 2008. In Basel III and IV, central banks adopted new powers - or 'tools' as Powell refers to them. Their remit broadened from simply manipulating interest rates to the capacity for direct intervention in markets and institutions - by historical standards, this is a close to economic omnipotence as one can get. Rickards attributes this to malign plans to control the economy, in line with the libertarian view that with these great powers, politicians will be unable to help themselves from meddling in free markets, often with corrupt intent. Historically, that is how it has played out, but this time we also have extraordinary degrees of transparency and accountability through the internet and other modern tools.


Once you understand that central banks have changed post GFC, the next question is what do those changes mean. And we witnessed signs of this new world order in the UK recently.


During the 'mini-budget' (led by leveraged pension funds) crisis in the UK, the Bank of England too seemed remarkably hawkish. It intervened quickly and effectively, but a month later we have hiked 75bp (this week), and the unwinding of QE carried on. So despite facing a huge crisis, the BoE was confident it had the 'tools' to deal with the situation and return financial stability, and returned to its 'hawkish' position shortly after a brief intervention. In its statements it too noted it had 'powerful tools' to address any challenges.


The IMF's statement chided the Truss government for unrolling a policy that would have devalued the pound (deliberately), imported more inflation (and competitiveness?), as it would exacerbate 'inequality'. That the IMF is concerned about 'inequality' is equally interesting. It suggests that policy makers are conscious of the social divide in many developed economies that is feeding into more polarised politics.


What does this mean for the economy?


So in short, a crash can happen, businesses can fail, but the Fed has the tools to help ordinary people. To fully understand this you need to revisit the idea of being 'too big to fail'. In major crisis over the past five decades (and perhaps longer), the Fed has had to use its only tool, the blunt instrument of rate cuts, to prevent a recession or worse, a depression. In a depression politics goes awry, and the risk of the extremes of politics rises. And so the Fed cuts rates, but this habit has introduced 'moral hazard'. Legitimate libertarian concerns that the system is corrupt, fed into many of the populist movements of the past decade. This is the idea that we do not have true capitalism, but rather 'crony capitalism', where asset holders are repeatedly bailed out by the central bank or government. Essentially, profits are privatised and losses are socialised.


We believe we are witnessing the emergence of a new type of central bank. From a historical perspective that is understandable. Policymakers have long been known to use crisis as opportunities for reform. The Federal Reserve was set up in 1913 in response to the 1907 Knickerbocker crash. Major changes followed the 1929 crash, and in another period of tumult, the 70s, we saw major changes too (from financialisation under Kennedy, leaving the gold standard and the Basel series (I to now IV).


After the Great Financial Crisis of 2008, central bank powers expanded from merely being the guardians of the value of the currency (by hiking and cutting interest rates) to economic stability. To enforce that second part of that mandate, central banks have be anointed with remarkable, in economic terms, near omnipotent, powers. Their intent is to use those new powers for 'good', by retaining sound money, and rescuing parts of the economy, if needed, with their 'powerful tools'.


The result is that companies that have been built on continually rising asset prices and leverage are now in the eye of the policy storm. Whether you are a property developer or a leveraged buy-out fund, your businesses relied on cheap debt and buoyant asset prices.


In fact after three decades, economic activity based upon cheap debt is likely pervasive across the global economy.


What are the implications for litigators?


In the past, most mid-land cycle (based on the theory that land cycles drive the most major type of crash) crashes were minor affairs. Specific asset classes facing challenges, but over all the system was buoyed by this principle of easy money. The 'Greenspan put' was the most cliche reference, but it has existed in various forms for 50 years.


We have now a turning point, where central banks are saying the party is over. Easy money is perverting the economic system, increasing inequality and through politics, threatening the historically successful (at least in terms of economics and progress) neoliberal consensus best described by Francis Fukuyama in the 'End of History'.


If policymakers are to be believed, the era of cheap debt is over. The economy is going to need to restructure and in that process there will be a lot of businesses caught by surprise.

This is one of those historical turning points, and countries, businesses and individuals are rarely prepared. The winners of the next decade will recognise this and pivot to take advantage.


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References:


Fed November 2 Speech

https://www.youtube.com/watch?v=CUx1RNvZ8z0

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