They finally did it – 25 bps, for the first rate increase since 2004. Surely it’s the most dovish Fed ‘tightening’ ever. Indeed, it was really no tightening at all. One has to go all the way back to 1994 for the last time the Federal Reserve commenced a true tightening cycle. That episode proved so destabilizing that the Federal Reserve assured the markets that they’d learned their lesson. And this (dovish and market-pandering) mindset was fundamental to the little baby step rate increases that ensured no tightening of financial conditions throughout the historic 2002-2007 mortgage finance Bubble inflation.
This week’s policy move will be debated for years to come. Lost in the debate is how the Fed (along with global central bankers) found itself stuck at zero for seven years (with a $4.5 TN balance sheet) and then saw it necessary to move to raise rates in the most gingerly, market-pleasing approach imaginable.
Traditionally, tightening cycles are necessary to counter mounting excess, including ill-advised lending, speculating and investing. Rate increases back in 1994 exposed what had been a dangerous expansion in speculative leveraging, derivatives and market-based Credit (at home and abroad). With the ‘bond’ market in disarray and Mexico at the precipice, the Greenspan Fed turned its attention to bolstering the markets and non-bank Credit more generally.
Market-based Credit is unstable. This remains the fundamental issue – the harsh reality – that no one dares confront. I would strongly argue that long-term stability in a Capitalistic system requires sound money and Credit (hopelessly archaic, I admit). Over the years, I’ve tried to differentiate traditional finance from unfettered ‘New Age’ finance. The former, bank lending-dominated Credit, was generally contained by various mechanisms (including the gold standard, effective currency regimes, bank capital and reserve requirements, etc.). This is in stark contrast to the current-day securities market-based global financial ‘system’ uniquely operating without restraints on either the quantity or quality of Credit created.
A few data points from the Federal Reserve’s ‘Z.1′ report illuminate why the Credit system had turned fragile back in 1994. After beginning the decade at $6.39 TN, Total Debt Securities (my compilation of Treasuries, Agency Securities, Corporate Bonds and Muni Debt) surged $2.94 TN, or 46%, in four years to end 1993 at $9.33 TN. For comparison, over this period bank (‘Private Depository Institutions’) Loans actually declined $169 billion (Total bank Assets rose $137bn to $4.9 TN). Importantly, Total Debt Securities as a percentage of GDP jumped from 113% to 135% in four years, while bank Loans to GDP declined from 57% to 44% (bank Assets 84% to 71%).
This post was published at David Stockmans Contra Corner on December 26, 2015.