In yellen we trust...

February 23, 2015 by Matt McCracken

The headline story on Bloomberg yesterday was titled, "In yellen we trust is Bond Mantra as Inflation Dismissed.”  This story line is obviously a play on the American patriotic motto “In God we Trust”.  So in the minds of investors, has the FED replaced God?  Or is the FED god?  Is the FED an omnipotent force for good in capital markets? (I use FED in all caps for the Federal Reserve Bank). 

Currently, the bond and equity markets are priced as if the FED is an all-powerful force in the markets, able to “support” asset prices in any way needed.  But the FED has failed over and over again in the past. They knew the housing bubble was bursting and the mortgage market was crashing yet could not contain it.  They knew Lehman was a goner but could not save it.  Prior to that, they knew Enron and Worldcom were shams but could not stop the contagion.  Why so much Faith in the FED this time around?  How quickly do markets forget?  Maybe the FED is omnipotent but just not omniscient?

I think the issue is a matter of human nature.  Since the beginning of time, humans have sought a power greater than themselves to protect them from the evils of the world.  We seek safety in numbers, in government and now in central bankers.  Unfortunately, this power is all too often their ultimate undoing.

I think there is a very interesting parellel from the Bible on this topic.  Over 2000 years ago, the people of the nation of Israel asked Samuel for a king.  A king like the other nations had a king.  A king to fight their battles and protect them from their enemies.  100 years ago, we asked for a Central Bank like all the other nations.  To protect us from “Panics” like the one that took place in 1907.  And depressions like the first Great Depression spanning from 1873 through the 1890’s.  And if you consider the US to be an economic empire, should we not have an economic king (or queen)?  The FED chairman afterall is appointed not elected and his or her power is largely unchallenged as the FED is not audited, has total control over the currency and is only paraded in front of congress a couple of times per year.  (As Mayer Rothschild famously said, "Permit me to issue and control the money of a nation, and I care not who makes its laws!")

So how has the FED done?  Is so much faith merited?

  • The original purpose of the FED was to prevent a banking crisis by providing a flexible currency.  Since its creation, there have been six stock market crashes associated with some form of banking seizure (’29, ’74, ’87, 98, ’02 & ’08).  
  • In addition, the FED is to promote price stability.  The US currency has lost 98% percent of its purchasing power under the FED's watch.
  • Finally, they have the objective of full employment.  And today's unemployment remains stubbornly high, underemployment is rampant and wage growth is nill. 

The FED's power is derived from its notes (USDs) acting as the world’s reserve currency backed by petrodollar hegemony.  Because of this, the FED can continue to print to infinity largely because of two factors.  First, other countries have to buy dollars to buy oil.  Second, any debasement in the value of FED notes would hurt the value of existing holdings of FED notes that have piled up for decades.  But if anything compromises the strength of the USD, the FED becomes impotent real quick. 

I Samuel 8 tells us explicitly the fate of those who put their faith in human institutions like the FED.  The Israelites experienced newfound wealth as King David and Solomon expanded their empire just as we have under the FED.  But eventually their empire splintered and then collapsed.  The FED is a terribly powerful force in the capital markets but should assets be priced as if they are invincible?  Will they be the first human institution to provide endless prosperity?  What happens if they fail?  What happens if oil is priced in something other than USDs or inflation spikes due to shortages or trade embargos?  Where do bond yields go and subsequently how would the US stock markets be repriced?