'This is not a financial crisis', and the Fed is out of options

Like nearly everything else Donald Trump said this week, 'this is not a financial crisis' is a lie. Can a crippling crisis be averted, when the markets are losing faith in the Fed's ability to provide meaningful intervention?

In his disastrous national address yesterday, Donald Trump apparently parroted a line uttered by Citibank CEO Michael Corbat: that "this is not a financial crisis." Banks, they argued, were 'well capitalized' and in a good position to weather the storm.

Then, today, comes news that the Fed is increasing its interventions in short-term funding markets to $1.5 trillion in order to prevent any 'highly unusual disruptions'. This seems a frank admission that we are, in fact, in a financial crisis. I think it is safe to say that when central banks feel it is necessary to offer hundreds of billions or trillions of dollars in short-term assistance across the financial system, that is by definition a financial crisis. Even if, by virtue of that intervention, a longer, more sustained crisis is averted, that does not mean that a crisis point had not been reached, at least temporarily.

Donald Trump, who never learned to read a balance sheet, and whose understanding of how sovereign debt works is so nonexistent that he has actually advocated for negative interest rates because he thinks that they would allow the US to 'refinance' its national debt and save money, is particularly susceptible to magical thinking in regards to economic and financial concepts. He seems to think that Fed target rates are a magic wand that can be waved to counteract any sort of negative economic outcome. Though Trump himself is particularly availed of overly simplistic mental models, this way of thinking seems to have dominated economic and financial thinking in recent years and months, as the Fed always stands ready to pull another rate cut out of its pocket to come to the rescue.

It is worth dwelling for a moment on the role of the Federal Reserve in our financial system. Officially, the Fed is supposed to be a sort of neutral arbiter, not favoring any particular market player or sector, under the dual mandate of maximum employment and stable prices (low-moderate inflation). Therefore the Fed must give the appearance that it is not putting its thumb on the scale for Wall Street, or any other narrow set of interests... Regardless of any 'objective' relationship between interest rates and asset prices, the perception (by Wall Street itself, in particular) is that low interest rates boost asset prices. In economics and finance, the perception is often the reality, and if traders and investors THINK that lower rates will lead to higher prices, their behavior in the market will create that outcome.

Obviously the Fed cannot come out and say that it is juicing stock prices and blowing up a bubble. But it is foolish not to recognize that this has happened in recent years. What is terrifying at this moment, though, is that having built up this giant bubble, the Fed is now powerless to counteract the massive damage that will be caused by its bursting. The recent rate cuts, and another one that the market has already priced in, are a drop in the bucket compared to what will be required to deal with the effects of the coronavirus-induced economic shutdown. This crisis is only beginning, and will take many months to play out across the world. Once coronavirus goes away, economic activity will not return to 'normal' for many years, if ever (look how long it took to recover from the last financial crisis). We are already almost in a 0% rate environment... Even though there has been much discussion of the huge dangers of ultra-low or negative rates (including by the Fed's own economists), it seems impossible that we will not end up in such an environment, from which some countries have found it is very difficult to escape.

There is a growing recognition that the Fed will be powerless in the face of the growing crisis. This FT piece uses the illuminating analogy of drug addiction:

Markets Contemplate A Future In Which Stimulus Does Not Work

The drugs have now run out, and the withdrawals are going to be horrendous. The realization that central bank intervention was losing relevance had already begun in the lead-up to this crisis. Now that it is sinking in further, markets are terrified. Today's 2300-point drop in the Dow following Trump's abysmally bad speech last night is, in part, a reflection of the realization that this crisis is unlike anything we have experienced, and that in the face of this massive confluence of crises, the federal government is asleep at the wheel, and the Fed is quickly running out of options.

In a rational world, central banks would exist in significant part to avoid these kinds of crisis, and provide meaningful intervention when they happened. Instead, the world's central banks quickly forgot about the last financial crisis, and squandered precious years of valuable preparation time with a misplaced focus on avoiding inflation. Let us hope that the Fed's intervention in short-term lending markets, which is the only meaningful tool that it has left, is enough to avoid a complete meltdown of the financial system, worse than in 2008 or 1929. It is still just too soon to tell, but we will know in the next days and weeks. I'm not very hopeful.


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