The book talks through the point of view of Thomas Hoenig, who was often the lonely voice of dissent when the Federal Reserve Governors voted on whether to embark on QE under the chairmanship of Ben Bernanke. (There were others too but they never formalized their dissent by casting a NO vote which by the way would have shook the long standing traditions of the Fed of mostly unanimously consented decisions).
The book does an excellent job of simplifying the jargon of the Fed that is often obtuse and incomprehensible to something an average person can understand.
First off, in FedSpeak - “hawks” and “doves” mean the opposite of what they do in the context of foreign policy.
In FedSpeak:
Hawks - Try to limit the Fed’s reach.
Doves - Argue for aggressive intervention of the Fed.
The book throws some insight into how J. Powell views things related to monetary policy. He has worked in Private Equity in the past so he clearly has seen from close quarters how QE and low interest rates drive up valuations and can lead to distortions in the economy. Specifically, it incentivizes PE firms to take more adventures and make money through financial engineering. At certain points even though he himself didn’t cast an official dissenting note, he clearly voiced his concerns about QE.
Post 2008, when there were reforms to be made - the author suggests the administration did not opt for radical reforms and somewhat middle-of-the-road reforms. Hoenig’s proposal in itself was to break the riskiest parts of banking away from the economically vital part so riskier banks failing wouldn’t impact the system. However, the government. decided to create a more intricate web and labyrinth of regulatory bodies to oversee them. (CFPB/Dodd-Frank).
Fed and Capital Cycles
The cycle goes like this:
Cheaper Money → More Loans → More demand/growth → High employment + Driving up prices → High inflation → Hike interest rates → Expensive capital → Less loans and less demand → High unemployment → Less growth
In one of the chapters, the author explains there are two types of inflations - (1) Price Inflation (2) Asset Inflation.
Price Inflation implies the cost of everyday/essential items - something that is reflected in CPI.
Asset Inflation refers to the inflation in the prices of assets that are a store of value (like real estate, stocks).
Thomas Hoenig believed that low interest rates for too long would lead to Asset bubbles (or asset price inflation).
In hindsight, this seems to have been a problem that the Fed failed to address. They were so focused on CPI/regular price inflation - they did not take any meaningful steps to address the ballooning asset prices as a consequence of low interest rates and QE. This meant, people with assets became richer and richer while at the same time those without it kept falling further behind.
As per the analysis by Allan Meltzer - Reason for the high inflation in the 1970s in the US was- more weight was placed on maintaining high/full employment than on reducing inflation.
Now, let's parse this - Fed printed more money in the 70s unaware that it was causing more inflation as there was more money floating around to chase limited goods. Add to it the events like the formation of OPEC and its cartel-like policies driving up oil prices.
Effects and Side-effects of Quantitative Easing
Between 2008-2010, the Fed printed $1.2 trillion of money -more than what it had printed in the last 100 years.
Fed Balance Sheet
With interest rates near zero, banks were forced to make risky investments as they searched for yield. As an example, when interest rates are higher (say 4%) banks can make money by putting money away in government bonds that would pay the bank 4% on the loan. Such opportunities vanish when interest rates drop to 0.
Now to break the back of inflation, whenever the Fed would try to increase interest rates - unemployment would rise and growth weakend.
Overall, reducing inflation requires consistent long-term action.
When Alan Greenspan kicked off QE and focused solely on price inflation - he was very much revered by the politicians because their constituents felt wealthy due to one of the byproducts of QE which was asset inflation. They became richer on paper as assets’ value grew.
ZIRP/QE: has masked an underlying fragility in the financial system.
ZIRP has three effects:
Cost of Capital (Cheaper Debt)
Wealth Effect (Asset Prices)
Devalue Dollar (Boost exports)
Yes, ZIRP/QE led to financial engineering but it also led people to believe that it was a permanent feature of the system and they had a path to a stable middle class life.
QE results in a short supply of scrutiny and skepticism.
Fed and Repo rate
The way the Debt to Cash Conveyor Belt works is that hedge funds borrow cash from a bank and buy T-bills and then through one of the primary dealers sell those T-bills to the Fed for a profit. In times of low interest rates, they play the basis risk trade - where they lever up through repo loans and then make riskier investments.
Same for banks. They offer very low deposit rates (0.01%) to customers but then park their excess reserves with the Fed taking advantage of the high interest rates. Also, now the Fed has the mandate to deposit interest rates in lieu of the excess reserves without even having to deal with T bonds.
Things happened in 2020 that were thought to be not possible
In periods of crisis - people do not want to buy anything and just want to stay in cash. It was on display in 2020: the hedge funds who were taking advantage of the repo facility, the hidden underbelly in the system, ended up on the hook for huge payments when repo loans rates spiked up. It happened because the Fed tried to tighten and the excess reserves in the banking system vanished. Thus, the repo loans market grinded to a halt. From the usual 2-2.5%, it rose to 9%. In a massive deleveraging event, everyone started to sell and it became a firesale with no buyers in sight. March 2020 is an example of things that happened which seasoned people didn’t think were possible.
Discount window -
I liked this great line in the book -
“In 2020, there were corners of the financial system up in flames and the Fed pointed the flood of new money in that direction.”
On a few occasions, the Fed had to step in to provide a floor and take actions in the “open market” to bring back the repo loans to its normal territory.
25% of PPP loans went to just 1% of the companies.
Fed bailed out people with assets [stock/corporate debt]
Conclusion
Fed was supposed to be for the long term; insulated from the elections/voters. But the dose of QE/ZIRP has made everyone habituated to it, and as Jeremy Grantham says there are no withdrawal symptoms when it is being taken away. In hindsight, the Fed job is incredibly tough but repeated Fed interventions and longer than necessary periods of interventions have made the foundations unstable.
It has been shown time and time again (in 2018, in 2022) that the whole financial system is so used to low interest rates and QE, that whenever the Fed starts to tighten and increase interest rates - things start to break in the system and the market collapses. And the Fed has to then reverse course and inject a new round of QE. This is now cynically known as the Fed pivot or Fed put.
Reading the book it is quite clear that the Fed by itself doesn’t know what is the right level to increase interest rates to, what is the right level to drop interest rates down to and how long to keep it there. It is like a dial knob that it is working with.
In addition to an already tough job, the habituation of the masses and politicians to a low interest rate environment thanks to a sustained period of ZIRP, will intensify demands from the populists to bring Quantitative Easing back and even raise questions on the integrity and competence of the Fed on flimsy grounds like they are unelected officials guiding the economy, making Fed’s job and role increasingly tricky.
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