Richard W Fisher: Beer goggles, monetary camels, the eye of the needle
and the first law of holes
Remarks by Mr Richard W Fisher, President and Chief Executive Officer of the Federal
Reserve Bank of Dallas, before the National Association of Corporate Directors, Dallas,
Texas, 14 January 2014.
* * *
With reference to Peter Boockvar, the Book of Matthew, Sherlock Holmes, "The Wolf of Wall Street" and Denis Healey.
The views expressed by the author do not necessarily reflect official positions of the Federal Reserve System.
Thank you, George [Jones]. George is a great member of the Dallas Fed board of directors,
and I am honored he would take the time to introduce me. Waylon Jennings said of your
namesake that "if we could all sound like we wanted to, we'd all sound like George Jones."1 I
often feel that way about George at our board meetings. He gives a sharp, crisp, spot-on
briefing of banking conditions in that deep, beautiful voice of his and I always think: I want to
be just like George when I grow up. Again, thank you George for that kind introduction.
During the holiday break, I spent a good deal of time trying to organize my thoughts on how I
will approach monetary policy going forward. Today, I am going to share some of those
thoughts that might be of interest to you as corporate directors.
At the last meeting of the Federal Open Market Committee (FOMC), it was decided that the
amount of Treasuries and mortgage-backed securities (MBS) we have been purchasing
should each be pared back by $5 billion, so that we would be purchasing a total of $75 billion
a month (in addition to reinvesting the proceeds of maturing issues we hold) rather than
$85 billion per month. In addition, it was noted that "if incoming information broadly supports
the Committee's expectation(s) ... the Committee will likely reduce the pace of asset
purchases in further measured steps at future meetings." And it was made clear that the
FOMC expects it will hold the base rate that anchors the yield curve - the federal funds rate,
or the rate on overnight money - to its present near-zero rate well past the time when
unemployment is reduced to 61⁄2 percent.
I was pleased with the decision to finally begin tapering our bond purchases, though I would
have preferred to pull back our purchases by double the announced amount. But the
important thing for me is that the committee began the process of slowing down the
ballooning of our balance sheet, which at year-end exceeded $4 trillion. And we began - and
I use that word deliberately, for we have more to do on this front - to clarify our intentions for
managing the overnight money rate.
As an economist would say, "on net" I was rather pleased with the decision taken at the
December FOMC meeting.
Under the chairmanship of Ben Bernanke, all 12 Federal Reserve Bank presidents, together
with the sitting governors of the Federal Reserve Board, have input into the decision-making
process. There is a formal vote - regardless of who is the Fed chair - that includes only five
of the 12 regional Bank presidents plus the governors, but all of the principals seated at the
table participate fully in the discussion of what to do. And yet, either because we will effect a
change in the chairmanship starting in February or because at the last meeting we took the
step of tapering back by a small amount our massive purchase of Treasuries and MBS, great
attention is being placed on the voters for 2014, of which I am one.
Two comments I recently read have been buzzing around my mind as I think about the many
issues that will condition my actions as a voter.
Beer goggles ...
The first was by Peter Boockvar, who is among the plethora of analysts offering different
viewpoints that I regularly read to get a sense of how we are being viewed in the
marketplace. Here is a rather pungent quote from a note he sent out on Jan. 2:
"...QE [quantitative easing] puts beer goggles on investors by creating a line of sight where
everything looks good..."
For those of you unfamiliar with the term "beer goggles", the Urban Dictionary defines it as
"the effect that alcohol ... has in rendering a person who one would ordinarily regard as
unattractive as ... alluring". This audience might substitute "wine" or "martini" or "margarita"
for "beer" to make it more age-appropriate, but the effect is the same: Things often look
better when one is under the influence of free-flowing liquidity. This is one reason why
William McChesney Martin, the longest-serving Fed chairman in our institution's 100-year
history, famously said that the Fed's job is to take away the punchbowl just as the party gets
going.2
... and the eye of the needle
The other eye catcher for me was a cartoon in the Jan. 6 issue of The New Yorker. Sitting in
a room are two businessmen who are apparently conversant with the New Testament's book
of Matthew. One says to the other, "We need either bigger needles or smaller camels".
Today, I want to muse aloud about whether QE has indeed put beer goggles on investors
and whether we, the Fed, can pass the camel of massive quantitative easing through the eye
of the needle of normalizing monetary policy without creating havoc.
Free and abundant money changes perspective
Boockvar is right. When money available to investors is close to free and is widely available,
and there is a presumption that the central bank will keep it that way indefinitely, discount
rates applied to assessing the value of future cash flows shift downward, making for lower
hurdle rates for valuations. A bull market for stocks and other claims on tradable companies
ensues; the financial world looks rather comely.
Market operators donning beer goggles and even some sober economists consider analysts
like Boockvar party poopers. But I have found myself making arguments similar to his and to
those of other skeptics at recent FOMC meetings, pointing to some developments that signal
we have made for an intoxicating brew as we have continued pouring liquidity down the
economy's throat.
Among them:
• Share buybacks financed by debt issuance that after tax treatment and inflation
incur minimal, and in some cases negative, cost; this has a most pleasant effect on
earnings per share apart from top-line revenue growth.
• Dividend payouts financed by cheap debt that bolster share prices.
• The "bull/bear spread" for equities now being higher than in October 2007.
• Stock market metrics such as price-to-sales ratios and market capitalization as a
percentage of gross domestic product at eye-popping levels not seen since the
dot-com boom of the late 1990s.
• Margin debt that is pushing up against all-time records.
In the bond market, investment-grade yield spreads over "risk free" government
•
bonds becoming abnormally tight.
• "Covenant lite" lending becoming robust and the spread between CCC credit and
investment-grade credit or the risk-free rate historically narrow. I will note here that I
am all for helping businesses get back on their feet so that they can expand
employment and America's prosperity: This is the root desire of the FOMC. But I
worry when "junk" companies that should borrow at a premium reflecting their risk of
failure are able to borrow (or have their shares priced) at rates that defy the odds of
that risk. I may be too close to this given my background. From 1989 through 1997, I
was managing partner of a fund that bought distressed debt, used our positions to
bring about changes in the companies we invested in, and made a handsome profit
from the dividends, interest payments and stock price appreciation that flowed from
the restructured companies. Today, I would have to hire Sherlock Holmes to find a
single distressed company priced attractively enough to buy.
And then there are the knock-on effects of all of the above. Market operators are once again
spending money freely outside of their day jobs. An example: For almost 40 years, I have
spent a not insignificant portion of my savings collecting rare, first-edition books. Like any
patient investor in any market, I have learned through several market cycles that you buy
when nobody wants something and sell when everyone clamors for more. During the
financial debacle of 2007-09, I was able to buy for a song volumes I have long coveted
(including a mint-condition first printing from 1841 of Mackay's Memoirs of Extraordinary
Popular Delusions, which every one of you should read and re-read, certainly if you are
contemplating seeing the movie The Wolf of Wall Street). Today, I could not afford them.
First editions, like paintings, sculptures, fine wines, Bugattis and homes in Highland Park or
River Oaks, have become the by-product of what I am sure Bill Martin would consider a party
well underway.
I want to make clear that I am not among those who think we are presently in a "bubble"
mode for stocks or bonds or most other assets. But this much I know: Just as Martin knew by
virtue of his background as a noneconomist who had hands-on Wall Street experience,
markets for anything tradable overshoot and one must be prepared for adjustments that bring
markets back to normal valuations.
This need not threaten the real economy. The "slow correction" of 1962 comes to mind as an
example: A stock market correction took place, and yet the economy continued to fare well.
Here is the point as to the market's beer goggles. Were a stock market correction to ensue
while I have the vote, I would not flinch from supporting continued reductions in the size of
our asset purchases as long as the real economy is growing, cyclical unemployment is
declining and demand-driven deflation remains a small tail risk; I would vote for continued
reductions in our asset purchases, with an eye toward eliminating them entirely at the earliest
practicable date.
How large is the camel?
Let's turn to the camel, by which I mean the size of the Fed's balance sheet.
A little history provides some perspective. We began to grow our balance sheet as we
approached year-end 2008. On Sept. 10, 2008, the amount of Reserve Bank credit
outstanding was $867 billion. On Nov. 25, 2008, we announced a program to purchase
$100 billion of securities issued by the housing-related government-sponsored enterprises,
together with our intent to purchase up to $500 billion in MBS in order to goose the housing
market. I supported these initiatives, recognizing that the economy was in the throes of a
financial panic.
Following our December 2008 meeting, the FOMC announced that it had cut the target range
for the fed funds rate to 0-to-1/4 of 1 percent, and being thus "zero bound", we floated the
idea of purchasing longer-term Treasuries in order to provide further monetary
accommodation (when we buy Treasuries or MBS and agency debt, we put money into the
financial system, substituting for further interest rate cuts). On March 18, 2009, we
announced additional purchases of up to $750 billion of agency MBS and up to $100 billion
of agency debt, plus purchases of up to $300 billion of longer-term Treasury securities over
six months. That day, our balance sheet was marked at $2 trillion.
There are some details that impacted our balance sheet, which I have omitted so as not to
bore you or entangle you in the entrails of central bank operations: For example, liquidity
swaps with other central banks declined from a peak occasioned by the financial crisis of
$583 billion the week ended Dec. 10, 2008, to $330 billion the following March, thus
somewhat mitigating the growth of our balance sheet over that period.3
From my perch, I considered a balance sheet of $2-plus trillion and a base lending rate of
0-to-1/4 of 1 percent more than sufficient to stimulate not just the housing market but the
stock market, too, thus placing us on the path of what economists refer to as "the wealth
effect" - the working assumption that rising prices for homes, stocks and bonds floats the
income boat of all Americans.
I basically said so publicly on March 26, 2009, in a speech to the RISE Forum, an annual
student investment conference. At the time, the S&P 500 was priced at 814, the Nasdaq at
1,529 and the Dow at 7,750. The mindset of investors at that moment was summarized at an
earlier FOMC meeting by one of my most esteemed colleagues at the Fed, who quipped that
in looking at the balance sheets of most financial institutions, "nothing on the right is right and
nothing on the left is left". As I looked at the faces of the students gathered in that vast
auditorium, I could see in their eyes a reflection of the gloom and doom of the time.
Here is what I told these young investors that dark morning: "... the current economic and
financial predicament represents a potential gold mine rather than a minefield. Historically,
great investors have made their money by climbing a wall of worry rather than letting a
woeful consensus cow them. ... Your job as investors is ... to ferret out from the
generalmarket malaise good financial and business operators whose franchises and prospects are
overdiscounted at current prices. Were I you ... I would be licking my chops at the
opportunities that always abound in times of adversity. ... There are a lot of dollar bills that
can be found in the debris of the current markets that can be picked up for nickels and
dimes."
Of course, I would not mention this today had I been wrong! Currently, the right hand side of
the balance sheet of most any well-managed market-traded business is chock-full of
restructured, cheap debt and leaner common stock, while the left side is bulging with surplus
cash. The S&P closed yesterday at 1,819, the Nasdaq at 4,113 and the Dow at 16,258 - a
plateau over two times above the valley into which they had descended in 2009.
And, again, there are the signs of conspicuous consumption I mentioned earlier that reflect a
fully robust stock market. If there is indeed a wealth effect that spreads from clever market
operators to the working people of America, a $2 trillion balance sheet might well have been
sufficient to have performed the trick.
The FOMC is a committee, however, and the majority of my colleagues have disagreed with
me on this point. We have since doubled our balance sheet to $4 trillion. This has resulted
not only in saltatory4 housing, bond and stock markets, but a real economy that is on the
mend, with cyclical unemployment declining and inflation thus far held at bay.
Here is the rub. We have accomplished the last $2 trillion of balance-sheet expansion by
purchasing unprecedented amounts of longer-maturity assets: As of Jan. 8, 2014, 75 percent
of Federal Reserve-held loans and securities had remaining maturities in excess of five years.
A narrow needle eye
The brow begins to furrow. To be sure, Treasury and MBS markets are liquid markets. But
the old market operator in me is conscious that we hold nearly 40 percent of outstanding
eligible MBS and of Treasuries with more than five years to maturity. Selling that
concentrated an amount of even the most presumably liquid assets would be a heck of lot
more complicated than accumulating it.
Currently, this is not an issue. But as the economy grows, the massive amount of money
sitting on the sidelines will be activated; the "velocity" of money will accelerate. If it does so
too quickly, we might create inflation or financial market instability or both.
The 12 Federal Reserve Banks house the excess reserves of the depository institutions of
America: If loan demand fails to grow at the same rate as banks accumulate reserves due to
our hyperaccommodative monetary policy, the resultant excess reserves are deposited with
us at a rate of return of 25 basis points (1/4 of 1 percent per annum).
Here is some math confronting policymakers: Excess reserves are currently 65 percent of
the monetary base and rising. The only other time excess reserves as a percentage of the
base have come anywhere close to this level was at the close of the 1930s, when the ratio
hit 41 percent. We are in uncharted territory.
To prevent excess reserves from fueling a too-rapid expansion of bank lending in an
expanding economy, the Fed will need to either drain reserves on a large scale by selling
longer-term assets at a loss or provide inducements to banks to keep reserves idle, by
offering interest on excess reserves at a rate competitive with what banks might earn on
loans to businesses and consumers. Or we might employ more widely new techniques we
are currently testing, such as "reverse repos", complex transactions in which we, in effect,
borrow cash overnight from market operators while posting securities as collateral.
Such inducements to control the velocity of the monetary base might expose the Fed to
intense scrutiny and criticism. The big banks that park the lion's share of excess reserves
with us are hardly the darlings of public sentiment. Raising interest payments to them while
scaling back our remittances to the Treasury might raise a few congressional eyebrows. And
as to our repo operations, we have never implemented them on anywhere near the scale
envisioned.
Of greatest concern to me is that the risk of scrutiny and criticism might hinder policymakers
from acting quickly enough to remove or dampen the dry inflationary tinder that is inherent in
the massive, but currently fallow, monetary base.
In the parlance of central banking, the "exit" challenge we now face is somewhat daunting:
How do we pass a camel fattened by trillions of dollars of longer-term, less-liquid purchases
through the eye of the needle of getting back to a "normalized" balance sheet so as to keep
inflation under wraps and yet provide the right amount of monetary impetus for the economy
to keep growing and expanding?
The first law of holes
I have great faith in the integrity and brainpower of my fellow policymakers. I am confident
that the 19 earnest women and men that make up the FOMC will do their level best under
Chairwoman Janet Yellen's leadership to accomplish a smooth exit that keeps prices stable
and the economy in a job-creating mode. But my confidence will be bolstered if my
colleagues adopt the First Law of Holes espoused in the late '70s by then-British Chancellor
of the Exchequer Denis Healey: "If you find yourself in a hole, stop digging".
The housing market is well along in repair;5 the economy is expanding; cyclical
unemployment is declining. To be sure, there will be individual data points that appear to
challenge confidence, like the just-released employment report for December. But I believe
the odds favor continued economic progress. And I believe that continuing large-scale asset
purchases risks placing us in an untenable position, both from the standpoint of
unreasonably inflating the stock, bond and other tradable asset markets and from the
perspective of complicating the future conduct of monetary policy.
The eye of the needle of pulling off a clean exit is narrow; the camel is already too fat. As
soon as feasible, we should change tack. We should stop digging. I plan to cast my votes at
FOMC meetings accordingly.
Thank you.