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Growling Dogs Sometimes Bite


I think it’s really interesting that suddenly, we are hearing from both hawks and doves on the Federal Reserve that the Fed is starting to worry whether some “complacency” has snuck into the market.

No kidding?

It is sort of a strange claim, since a really important part of QE and about how it was supposed to work was through the “portfolio balance channel.” In a nutshell, the idea of the portfolio balance channel is that if the Fed removes sufficient of the “safe” securities from the market, then people will be forced to buy riskier securities. Thus, the Fed was intentionally trying to substitute for animal spirits. And they were successful at it, which I illustrated in this post more than a year ago.  So now, the Fed is surprised that the riskier asset classes are getting very expensive?

It is sometimes hard to keep track of all of the Fed’s arguments, since they seem to shift as frequently as necessary to make them appear to be on the right side of the data. Honestly, it’s a little bit like the way politicians work the “spin” cycle. The portfolio balance channel was good, and a goal of policy; now it’s surprising. You need to take good notes to keep this stuff straight.

That being said, it is not usually a coincidence when three Fed officials use nearly the same words in consecutive speeches, particularly when those three Fed officials include both hawks (Fisher, George) and doves (Dudley). The difference here is that Fisher and George are probably making this argument because they’d like to see the Fed pull back on the reins a bit, while Dudley probably doesn’t intend to do anything about the fear of complacency other than talk about it.

What does this mean?

  1. I am not the only person who is worried about not being worried (see my article from Monday).
  2. At least some people at the Fed are concerned that they have gone too far. This isn’t really news; the only news would be if that’s starting to be a majority opinion.
  3. At least some people at the Fed think that policymakers should be trying to ‘talk down’ markets.

Why do I include the third point? Because, if the Fed really was planning to do anything about it, they would just do it. Talking about complacency might cause some people to decrease their risky-market bets, but putting Treasuries back on the street and taking in cash would force the de-risking to happen. Call it the portfolio “rebalance” channel. No doubt, there is plenty of fear at the Fed about the possibility that the complacency might break suddenly in a sloppy, discontinuous way, but there are a couple of decades of experience with the lack of success of FOMC “open mouth policy.” Does the phrase “irrational exuberance” mean anything to you? Did Greenspan’s utterance of that phrase in December 1996 affect in any way the trajectory of the over-complacent equity market? Nope.

Ironically, I think what really galls the Fed is that market measures of policy rate expectations over the next few years imply a lower trajectory than the Fed feels they have laid out as their road map. The Committee, it seems doesn’t mind surprising the market on the dovish side but is wary of surprising them on the hawkish side. I predict that, if the short end of the rates curve steepens just a little bit, Fed officials will stop worrying so much about “complacency” even if stocks continue to ramp up.

In any case, it is worth listening when the Fed starts talking with one voice. There are lots of other reasons to be the first person to shed complacency, but here is a new one: whether it’s a bona fide signal or just central banker bluster, there is a new tone coming from Fed speakers. Beware of dogs that growl; sometimes they bite.

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