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Stephen Roach congratulates the US Fed for the courage to commit to normalising interest rate. He says there is simply no other way to break the US economy's 20yr dependence on asset bubbles

Stephen Roach congratulates the US Fed for the courage to commit to normalising interest rate. He says there is simply no other way to break the US economy's 20yr dependence on asset bubbles

By Stephen Roach*

I have not been a fan of the policies of the US Federal Reserve for many years.

Despite great personal fondness for my first employer, and appreciation of all that working there gave me in terms of professional training and intellectual stimulation, the Fed had lost its way.

From bubble to bubble, from crisis to crisis, there were increasingly compelling reasons to question the Fed’s stewardship of the US economy.

That now appears to be changing. Notwithstanding howls of protest from market participants and rumored unconstitutional threats from an unhinged US president, the Fed should be congratulated for its steadfast commitment to policy “normalisation.” It is finally confronting the beast that former Fed Chairman Alan Greenspan unleashed over 30 years ago: the “Greenspan put” that provided asymmetric support to financial markets by easing policy aggressively during periods of market distress while condoning froth during upswings.

Since the October 19, 1987 stock-market crash, investors have learned to count on the Fed’s unfailing support, which was justified as being consistent with what is widely viewed as the anchor of its dual mandate: price stability. With inflation as measured by the Consumer Price Index averaging a mandate-compliant 2.1% in the 20-year period ending in 2017, the Fed was, in effect, liberated to go for growth.

And so it did. But the problem with the growth gambit is that it was built on the quicksand of an increasingly asset-dependent and ultimately bubble- and crisis-prone US economy.

Greenspan, as a market-focused disciple of Ayn Rand, set this trap. Drawing comfort from his tactical successes in addressing the 1987 crash, he upped the ante in the late 1990s, arguing that the dot-com bubble reflected a new paradigm of productivity-led growth in the US. Then, in the early 2000s, he committed a far more serious blunder, insisting that a credit-fueled housing bubble, inflated by “innovative” financial products, posed no threat to the US economy’s fundamentals. As one error compounded the other, the asset-dependent economy took on a life of its own.

As the Fed’s leadership passed to Ben Bernanke in 2006, market-friendly monetary policy entered an even braver new era. The bursting of the Greenspan housing bubble triggered a financial crisis and recession the likes of which had not been seen since the 1930s. As an academic expert on the Great Depression, Bernanke had argued that the Fed was to blame back then. As Fed Chair, he quickly put his theories to the test as America stared into another abyss. Alas, there was a serious complication: with interest rates already low, the Fed had little leeway to ease monetary policy with traditional tools. So it had to invent a new tool: liquidity injections from its balance sheet through unprecedented asset purchases.

The experiment, now known as quantitative easing, was a success – or so we thought. But the Fed mistakenly believed that what worked for markets in distress would also spur meaningful recovery in the real economy. It raised the stakes with additional rounds of quantitative easing, QE2 and QE3, but real GDP growth remained stuck at around 2% from 2010 through 2017 — half the norm of past recoveries. Moreover, just as it did when the dot-com bubble burst in 2000, the Fed kept monetary policy highly accommodative well into the post-crisis expansion. In both cases, when the Fed finally began to normalize, it did so slowly, thereby continuing to fuel market froth.

Here, too, the Fed’s tactics owe their origins to Bernanke’s academic work. With his colleague Mark Gertler of NYU, he argued that while monetary policy was far too blunt an instrument to prevent asset-bubbles, the Fed’s tools were far more effective in cleaning up the mess after they burst. And what a mess there was! As Fed governor in the early 2000s, Bernanke maintained that this approach was needed to avoid the pitfalls of Japanese-like deflation. Greenspan concurred with his famous “mission accomplished” speech in 2004. And as Fed Chair in the late 2000s, Bernanke doubled down on this strategy.

For financial markets, this was nirvana. The Fed had investors’ backs on the downside and, with inflation under control, would do little to constrain the upside. The resulting “wealth effects” of asset appreciation became an important source of growth in the real economy. Not only was there the psychological boost that comes from feeling richer, but also the realization of capital gains from an equity bubble and the direct extraction of wealth from the housing bubble through a profusion of secondary mortgages and home equity loans. And, of course, in the early 2000s, the Fed’s easy-money bias spawned a monstrous credit bubble, which subsidized the leveraged monetization of housing-market froth.

And so it went, from bubble to bubble. The more the real economy became dependent on the asset economy, the tougher it became for the Fed to break the daisy chain. Until now. Predictably, the current equity market rout has left many aghast that the Fed would dare continue its current normalization campaign. That criticism is ill-founded. It’s not that the Fed is simply replenishing its arsenal for the next downturn. The subtext of normalization is that economic fundamentals, not market-friendly monetary policy, will finally determine asset values.

The Fed, it is to be hoped, is finally coming clean on the perils of asset-dependent growth and the long string of financial bubbles that has done great damage to the US economy over the past 20 years. Just as Paul Volcker had the courage to tackle the Great Inflation, Jerome Powell may well be remembered for taking an equally courageous stand against the insidious perils of the Asset Economy. It is great to be a fan of the Fed again.

Stephen S. Roach, a faculty member at Yale University and former Chairman of Morgan Stanley Asia, is the author of Unbalanced: The Codependency of America and China. Copyright: Project Syndicate, 2018, published here with permission.

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Excellent article Stephen. From this point near ground zero, sustainable gain without sustained pain is just a pipe dream. With little fire power for Central Banks to play with, I feel any attempt at normalization will usher in a new crisis anyway. It takes balls that's for sure. The US Fed's only option is to drain the global financial system of excess US dollars in the hope of replenish its unconventional toolbox. Extraordinary measures are called upon in times that are far from normal.

I think in NZ we are lucky to have Adrian Orr heading the Reserve Bank. Unless there is a pressing need to move rates, let them be.

The Federal Reserve's own research show QE was the equivalent of twelve 0.25% rate cuts, so post GFC the real effective Fed Funds rate was minus 3%. So quantitative tightening of $50 billion a month is the equivalent of a 0.25% rate cut every 4 months.

Powell is not on a grand crusade he has miscalculated, he is raising rates with inflation less than 2%, even before oil has fallen 40%. The average workers were starting to get wage rises around 3%, a catch up from the post GFC era.

A recession will hurt the average worker, as they are laid off or the threat of being made redundant suppresses wages. The 1% will pick up assets at bargain prices and the cycle will begin again.

So quantitative tightening of $50 billion a month is the equivalent of a 0.25% rate cut every 4 months.

QT should be equivalent of interest rate hike ,right ? NOT cut

Gosh, where to start? The US has been backed into a hole through monetary policy that believes it can intervene for good. If Stephen Roach is correct in that “ It’s not that the Fed is simply replenishing its arsenal for the next downturn. The subtext of normalization is that economic fundamentals, not market-friendly monetary policy, will finally determine asset values.” - this is a major mea culpa.
I’m a little more pessimistic however, I believe that the fed is only replenishing it’s arsenal as next recession we will see rates drop and more money printed and the same old cycle repeat until the wheels really fall off. They can’t truely normalise without a major reset so they are stuck for the time being.

Something of a counter to the timing argument:

“There is never a good time to pierce a Bubble. There definitely is no cure, so it’s a central banker and policymaker imperative to avoid supporting a backdrop conducive to Bubble Dynamics. There was never going to be a convenient time to end the “Fed put.”

Sorry - all fingers and thumbs - this is a reply to Roelof.

Some might say it is good timing for a bubble to burst during Trumps first term, just for a conspiratorial view.

Interesting article.
Stanley Druckenmiller has a different view, more in regards to the timing of things , than the idea of normalisation.
He argues the FED has "normalised" too late... and the latest rate rise, in the face of deteriorating economic conditions is a mistake ( this is the consequence of forward guidance, which, kinda, compels them to do what they say ). Also, the FED unwinding its balance sheet in the face of very large GOvt borrowing is leading to liquidity issues...
Janet yellen handed Jay Powell a "hospital pass". Jay Powell seems like a good FED leader...
This video is worth watching..

she was late to the party to raise and as per normal central banks they are now playing catchup which can do the reverse of what they want.
I will not be surprised to see rate cuts in the next two years

Agreed, I've predicted for some time, a recession in the US around Q3 2019 followed by interest rate cuts

Yvil, how many quarters of negative growth from Q3 2019 do you predict?


That's hard to tell, I wouldn't know but to be in recession a country's GDP has to contract for min 2 successive quarters.

Yvil, this would have to be one of the most anticipated and easily forecast downturns. Predicting the severity and length is something else.

Yes it is anticipated now but I'm proud to be one of the first to have called it a long time ago


Can you give some detail on what will cause the US to go from its present growth rate of around 3% to negative in some9months? That’s a big call and would require a catastrophic chain of events to bring about.

Short of war,I can only think of a collapse in the Chinese economy.

linklater01, in May 2018, Yvil made the prognosis we are sliding towards a depression. Other than that the prediction is scant in specific triggers.

This is a surprise. So there is some sanity, even a sworn anti Trump campaigner can see that the Federal Reserve has been a disaster over the last few decades. Perhaps he can, in time, see that this has enabled the militarists to take over, leading inevitably to Trump.

Where to start? With Volcker's de-industrialisation of America and Britain? With Nixon's disconnection from the failing Bretton Woods arrangements due to Vietnam spending? Or with Greenspan's mistakes mentioned in the article? Or Bernanke's stupidity in unnecessarily bankrupting Lehman Brothers, when it's business was sound but it needed liquidity, the very purpose of a central bank, not knowing he would stop world trade in the process? Or silly Jellen, who was carefully chosen for her dovish views and inexperience?

Are all these "unintended consequences", the result of over centralisation of money and power?

Can it be unwound? Surely the opposition is too strong? The Democrats want to overspend on welfare (to buy votes) and warfare (to get rid of people they don't like), the traditional Republicans want to overspend on warfare (to make money and feel powerful). Only the forsaken people of middle America, who have paid the price for decades of continuous warfare, in blood, in broken men, in the degradation of their society, oppose the will of their Betters as best they can. By electing Trump.

The life and especially the death of Takahashi Korekiyo, the source of Bernanke's ideas, is instructive. As is the enabling of German re-armament by Hjalmar Schacht.

Great comment Roger.

Thanks for the encouragement, Rob. I need it, my ideas are just personal speculations really, trying to find a signal hidden in the noise.

very hard to taper (reduce) a ponzi.

Good article Stephen, I agree the fed are doing the right thing. The last thing the US need is another housing bubble at this time.

One basic question
What if the Fed did not increase interest rates (normalize) and did not reduce its balance sheets ( QT ) ? Is it just that savers are punished with low interest rates ? gap between asset rich people and assetless poor will lead to conflicts ?? why would Fed care about these 2 issues ?

Why would Fed care about these 2 issues?

They wouldn’t – not worth a hill of beans in terms of mandate.

Yeah.. then why should they hike rates and QT ?

Days to the General Election: 25
See Party Policies here. Party Lists here.