As the Federal Reserve meets today to decide how to communicate its messaging on future rate hikes and balance sheet reduction, financial stability will play a key role. Yesterday, I wrote about the Bank of International Settlements new warnings on financial stability. And just this morning, I read a piece from Goldman Sachs Asset Management EMEA division head Andrew Wilson, warning that the risk of overheating was real. So let’s put some framing around this issue and ask how the Fed reacts as the data come in down the line.
In the past decade on Credit Writedowns, I have had a lot of good commentary from different writers on financial stability. And most of it is based around Hyman Minsky’s Financial Instability Hypothesis. As someone who used to work in debt capital markets and do financial models for private equity investing and corporate finance for mergers and acquisition, I find the Minsky analysis a huge benefit in thinking about the macroeconomy that standard macro modelling techniques don’t incorporate. So I want to use this as the prism through which to look at the Fed’s reaction function to predict future yield curve flattening and the resulting economic impact.
Long cycles end with higher risk
First, here’s what Minsky’s hypothesis is all about. Let’s use excerpts from Randall Wray’s 2012 piece to make the case here. You can read the full piece here. And I will summarize in layman’s terms afterwards; but here’s what I want you to take away with my own highlights added in bold:
In his publications in the 1950s through the mid 1960s, Minsky gradually developed his analysis of the cycles. First, he argued that institutions, and in particular financial institutions, matter. This was a reaction against the growing dominance of a particular version of Keynesian economics best represented in the ISLM model. Although Minsky had studied with Alvin Hansen at Harvard, he preferred the institutional detail of Henry Simons at Chicago. The overly simplistic approach to macroeconomics buried finance behind the LM curve; further, because the ISLM analysis only concerned the unique point of equilibrium, it could say nothing about the dynamics of a real world economy. For these reasons, Minsky was more interested in the multiplier-accelerator model that allowed for the possibility of explosive growth…
…he examined financial innovation, arguing that normal profit seeking by financial institutions continually subverted attempts by the authorities to constrain money supply growth. This is one of the main reasons why he rejected the LM curve’s presumption of a fixed money supply. Indeed, central bank restraint would induce innovations to ensure that it could never follow a growth rate rule, such as that propagated for decades by Milton Friedman. These innovations would also stretch liquidity in ways that would make the system more vulnerable to disruption. If the central bank intervened as lender of last resort, it would validate the innovation, ensuring it would persist… profit-seeking innovations would gradually render the institutional constraints less binding. Financial crises would become more frequent and more severe, testing the ability of the authorities to prevent “it” from happening again. The apparent stability would promote instability.
With his 1975 book, …Minsky distinguishes between a price system for current output and one for asset prices. Current output prices can be taken as determined by “cost plus mark-up”, set at a level that will generate profits…
There is a second price system, that for assets that can be held through time; except for money (the most liquid asset), these assets are expected to generate a stream of income and possibly capital gains…The important point is that the prospective income stream cannot be known with certainty, thus is subject to subjective expectations…. Minsky argued that the amount one is willing to pay depends on the amount of external finance required—greater borrowing exposes the buyer to higher risk of insolvency. This is why “borrower’s risk” must also be incorporated into demand prices.
Investment can proceed only if the demand price exceeds supply price of capital assets. Because these prices include margins of safety, they are affected by expectations concerning unknowable outcomes. In a recovery from a severe downturn, margins are large as expectations are muted; over time, if an expansion exceeds pessimistic projections these margins prove to be larger than necessary. Thus, margins will be reduced to the degree that projects are generally successful. Here we can insert Minsky’s famous distinction among financing profiles: hedge (prospective income flows cover interest and principle); speculative (near-term income flows will cover only interest); and Ponzi (near-term receipts are insufficient to cover interest payments so that debt increases). Over the course of an expansion, these financial stances evolve from largely hedge to include ever rising proportions of speculative and even Ponzi positions.
Translation: Institutions matter. You can’t look at an economy without considering the structure of its financial arrangements because – contrary to the thinking that an economy is always in or trying to get back to some equilibrium – it’s really a messy world out there. Once you look at financial institutions in particular, you see that they are important in that they use debt and credit to bolster current output, sometimes by very large amounts.
But we also have to realize that their ‘price system’ is inherently more unstable and uncertain than the “cost plus mark-up” system of current output. And this, by definition, creates an inherent instability. How? The longer a cycle goes on, the more leveraged financiers feel cheated, as if they are constantly leaving money on the table; the margin for error they incorporate into their debt models simply proves time and again too large. And so they reduce that margin for error in order to reduce the money they leave on the table for debt investors.
Let me put this in corporate finance terms: as the cycle lengthens, projected levels of enterprise value to earnings before interest, tax, depreciation and amortization [EBITDA] increase, and so too do debt to EBITDA calculations, which serve as the margins for error in leveraged financial models. Right now, private equity firms are paying 10.7x earnings [EBITDA] for middle market companies. In my day as a leveraged finance associate 20 years ago, if that number was half as big it would have been considered high. So that gives you a perspective.
Now let’s remember that what makes this the most dangerous point in the cycle is that, as the margin for error is decreasing, monetary policy is tightening, increasing downside risk. Investors with 3-5 year investment exit time horizons are hoping that the cycle lasts through at least 2020 or 2022 because if they are caught in an investment for which they paid almost 11 times earnings when the cycle comes to an end, the losses will be enormous.
In the wider economy, the IMF has noted that more and more companies in the US are so-called “Zombies”, where interest coverage ratios are low. The Bank for International Settlements estimates that the zombie share of firms has doubled to 10% of US companies, with a combined market capitalization of $2.3 trillion.
Hyman Minsky models this at a macro level by looking at the percentage of investments like this that have safe investment error margins versus ones where prospective income flows only cover interest and principle and ones where near-term receipts don’t even cover interest payments, Ponzi investments. And his basic insight is that long cycles have a higher percentage of speculative and Ponzi investments because leveraged investors have reduced their margin of error for default to take advantage of the business cycle’s financial stability. This means that longer cycles end with greater risk of financial instability and financial crisis, a potential reason the so-called Great Moderation ended in the Great Financial Crisis.
The Fed’s reaction function says hike rates
So what about the Fed? We are at a key point in the cycle since Janet Yellen is passing on the reins to Jay Powell in overseeing monetary policy in the US. Ostensibly, Powell is well-positioned to understand Minskyian risk since he worked in private equity for many years and was a partner at The Carlyle Group before joining the Fed. But Powell is just one person. And the Fed is an institution steeped in tradition. We can’t know ahead of time whether Jay Powell will or won’t move the Fed to think more about financial stability.
What we do know is this.
First, the Fed has two goals – the oft-reported dual mandate of price stability and maximum sustainable employment. And it is the Federal Reserve’s Federal Open Market Committee (FOMC) that meets today which sets U.S. monetary policy to translate “these broad concepts into specific longer run goals and strategies.” That’s how the Chicago Fed puts it.
Second, the Fed has said 2% is price stability and this represents its longer-term objective for inflation. But on employment, by definition, the term ‘maximum sustainable unemployment’ suggests some sort of trade-off with inflation. If the maximum sustainable employment level were 100% then we would say the Fed’s mandate is full employment. But we don’t say that. And Fed officials explicitly say that “a very, very low unemployment rate” is a bad thing that invites rate hikes. Think of this as Fed-engineered unemployment in order to prevent inflation from taking off. And the Fed especially targets wage growth because it sees wage growth as wage ‘inflation’ as an employer would — thinking this presages a rise in the price of goods and services in the “cost plus mark-up” world of current output.
So given that the baseline level of unemployment is now 4.1%, I believe most Fed policy makers believe we are at the maximum sustainable employment level or even below it. And while inflation is below the 2% target, the Fed’s belief that “cost plus mark-up” style inflation will rise when we reach that level dictates tighter policy. In fact, I believe the Fed is now fine with instituting double-barrelled tightening where it raises rates and reduces its balance sheet at the same time. Last summer the swoon in oil prices put the Fed off from double-barrelled tightening. But now, all asset markets are rising simultaneously. And that gives the Fed cover for tightening via the balance sheet and interest rate channels at the same time.
Back in June, I noticed that the incoming Fed Chair Jay Powell was the Fed Governor who was tasked with giving the signal that Quantitative Tightening was going to happen. And at that time I wrote that “since we already see both inflation below target and market indications of tightening financial conditions via the flat yield curve, I believe the Fed will be forced to pause at some point. It will not be able to deliver on its forecast of rate hikes. That is bullish for Treasuries.” There I meant long-term Treasuries of course (vis-a-vis short-term treasuries). The Fed did pause, and the yield curve has flattened an additional 36 basis points since I wrote that.
But what happens during a double-barrelled tightening? Financial conditions are no longer tightening. So I believe the Fed will now pull both levers at the same time. During the initial part of 2018, I think we can still eke out a 3%ish growth level and so perhaps the curve steepens a tad. But in the middle of 2018, I believe growth will slow as the Fed’s rate hike train takes effect with a lag. And so we will see the curve flatten again. By the time we get to June and July, I expect three rate hikes to have occurred and for the curve to be nearly flat, meaning at least another 36 basis points down from present levels.
Financial stability is the Fed’s third mandate
But what about financial stability?
US regulators have been concerned about lax lending for a long while now. They have pointed the finger at leveraged lending, subprime auto, and commercial real estate. I think you could also talk about student loans here as well. These concerns on financial stability are more fundamental than even the Fed’s dual mandate.
If you look at the Federal Reserve Act, it starts with financial stability because the Fed was formed in 1913 to ensure financial stability. Here’s how the Fed puts it:
The Federal Reserve Act of 1913 established the Federal Reserve System as the central bank of the United States to provide the nation with a safer, more flexible, and more stable monetary and financial system. The law sets out the purposes, structure, and functions of the System as well as outlines aspects of its operations and accountability. Congress has the power to amend the Federal Reserve Act, which it has done several times over the years. The complete act, as amended, is provided here by section.
The monetary policy objectives outlined after that was only established by Congress in 1977. So the Fed sees its role to “provide the nation with a safer, more flexible, and more stable monetary and financial system”, established at the outset as more fundamental to its role than even its monetary policy objectives established just 40 years ago.
To me, that means the Fed has a third mandate, if you will. It means that financial stability is always a fundamental issue that the Fed is addressing with monetary policy. With Jay Powell, the question is whether he steers the Fed to address financial stability via macroprudential tools as the BIS suggests or whether he uses rate policy more actively.
Let me address that this way: My sense is that the Trump Administration is working actively to reduce regulation in a way that will increase financial instability concerns at the Fed. Look at what’s happening at the Consumer Financial Protection Bureau or at the Department of Transportation or at the Office of the Comptroller of the Currency. All of the regulatory moves the Trump Administration is making move in the direction of fewer regulations and less regulatory oversight on a wide range of issues. In terms of the financial system, this will mean that the Fed cannot count on macroprudential tools to do the heavy lifting of ensuring financial stability. Only to the degree that the Fed reaches into the financial system directly, mandating tighter regulatory control in its role as regulator, could we expect the Fed to use macroprudential tools. But people like Dan Tarullo who favour this approach are gone.
I believe the preponderance of evidence indicates that the Fed will have to use rate policy to address financial stability concerns. And if they do, this could mean more rate hikes than currently anticipated by financial markets.
So as we await the Fed’s decision today on rate hikes and balance sheet reduction, the message I want to send is that the Fed is likely to be more hawkish in 2018 than expected, unless the economy decelerates appreciably. What this means is that the yield curve will flatten toward the middle of the year. With a flat yield curve reducing the attractiveness of banks’ core maturity transformation function, credit growth will slow before the additional Fed rate hikes from now until mid-2018 have had a chance to be felt in the financial system.
At the same time, if you look at the situation through a Minsky instability prism, we are at a more vulnerable point in time than currently recognized by financial markets. I believe the risk here is that the Fed doesn’t appreciate these variables and goes headlong into its 2018 rate hike campaign, confident it can pull back before the yield curve inverts. Since policy acts with a lag, all the Fed needs is to continue double-barrelled tightening when we are even close to inversion, say 25-50 basis points; and the markets would do the inversion.
The upside here is that we’ve been here before with the shale oil investment bust. And the Fed listened to the signal that markets were sending. Moreover, Jay Powell knows how leveraged financiers operate and may be attuned to these financial stability issues. And so as Yellen gves her swan song press conference today, I will be thinking more about Powell and what signals he will give once the new year begins.