From the Wall Street Journal, an opinion piece from Christian Broda and Stanley Druckenmiller of Duquesne Family Office, LLC that echoes everything we’ve been writing for the past year. They call it “playing with fire” while I’ve termed it “rolling the dice.” Either way, the Fed/Treasury have created a very dangerous trap from which there is no easy exit.
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The Fed Is Playing With Fire
Clinging to an emergency policy after the emergency has passed, Chairman Powell courts asset bubbles.
With Covid uncertainty receding fast, and several quarters deep into the strongest recovery from any postwar recession, the Federal Reserve’s guidance continues to be the most accommodative on record, by a mile. Keeping emergency settings after the emergency has passed carries bigger risks for the Fed than missing its inflation target by a few decimal points. It’s time for a change.
The American economy is back to prerecession levels of gross domestic product and the unemployment rate has recovered 70% of the initial pandemic hit in only six months, four times as fast as in a typical recession. Normally at this stage of a recovery, the Fed would be planning its first rate hike. This time the Fed is telling markets that the first hike will happen in 32 months, 2½ years later than normal. In addition, the Fed continues to buy $40 billion a month in mortgages even as housing is clearly running out of supply. And the central bank still isn’t even thinking about ending $120 billion a month of bond purchases.
Not only is the recovery happening at record speed, excesses of fiscal policy are already visible. Consumers are spending like never before, construction is booming, and labor shortages are ubiquitous, thanks to direct government transfers. Two-thirds of all relief checks were sent after the vaccines were proved effective and the recovery was accelerating. Opportunistic politicians didn’t let the pandemic go to waste. Especially after the Trump years, Congress has decided to satisfy its long list of unmet desires.
Isn’t the Fed’s independence supposed to act as a counterbalance to these political whims? The emergency conditions are behind us. Inflation is already at historical averages. Serious economists soundly rejected price controls 40 years ago. Yet the Fed regularly distorts the most important price of all—long-term interest rates. This behavior is risky, for both the economy at large and the Fed itself.
Future fiscal burdens will put the kind of political pressure on the central bank that hasn’t been seen in decades. The federal government has added 30% of GDP in extra fiscal deficits in only two years, right as the baby-boomer retirement wave is beginning to accelerate. The Congressional Budget Office projects that in 20 years almost 30% of all yearly fiscal revenues will have to be used solely to pay back interests on government debt, up from a current level of 8%. More taxes simply won’t be enough to bridge the gap, so pressures to monetize the deficit will inevitably rise over the years. The Fed should be adapting policy today to minimize these risks.
The risks are no longer hypothetical. For decades Treasurys have been the preferred asset for foreigners looking to hedge global portfolios. It was therefore shocking and unprecedented that in the midst of last year’s stock-market meltdown and while the Cares Act was being debated, foreigners aggressively sold Treasurys. This was dismissed by the Fed as a problem in the plumbing of financial markets. Even after trillions spent to prop up the bond market, foreigners have continued to be net sellers. The Fed chooses to interpret this troubling sign as the result of technicalities rather than doubts about the soundness of current and past policies.
America’s deep divisions also make the central bank’s independence crucial. Fighting inequality and climate change are very far from the Fed’s central mission. There’s a reason central bankers are supposed to be unpopular. Inflation is often the result of a fragmented society that feels unrepresented by weak political leadership. Eventually, the choice between fiscal discipline—lower taxes or higher spending—and forcing the central bank’s hand becomes an easy one for politicians to make.
With these risks in mind, and with unambiguous evidence of a strong recovery, the Fed should be doing more than just reanchoring inflation expectations to a slightly higher level. Fed policy has enabled financial-market excesses. Today’s high stock-market valuations, the crypto craze, and the frenzy over special-purpose acquisition companies, or SPACs, are just a few examples of the response to the Fed’s aggressive policies. The central bank should balance rather than fuel asset prices. The pernicious deflationary episodes of the past century started not because inflation was too close to zero but because of the popping of asset bubbles.
With its narrow focus on inflation expectations, the Fed seems to be fighting the last battle. Just because the Fed hasn’t faced big trade-offs in recent decades doesn’t mean trade-offs aren’t coming or that they no longer exist. Chairman Jerome Powell needs to recognize the likelihood of future political pressures on the Fed and stop enabling fiscal and market excesses. The long-term risks from asset bubbles and fiscal dominance dwarf the short-term risk of putting the brakes on a booming economy in 2022.
Mr. Broda is a partner at Duquesne Family Office LLC, where Mr. Druckenmiller is chairman and CEO.
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We began pointing out the coming inflation problem over a year ago, when it was only an oil and gas phenomenon. Since oil and gas are integral to so many other industries – agriculture, transportation, manufacturing, etc. – the inflation problem has evolved from a triple backflip to one involving 3 1/2 twists. The Fed insists it is transitory, meaning it will pass relatively quickly and without incident. 
This is wishful thinking at best and, more accurately, a false narrative geared to keeping bond yields in check and equity markets on the rise. CPI data is due out tomorrow will be the first aha moment for many investors.
Futures continued tumbling this morning, giving up all of the Bostic gains and more. While I might differ with Mr. Druckenmiller regarding the “market’s” response to the coming turmoil, I agree wholeheartedly with the fact that there will be turmoil. At this point, it is unavoidable.
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The annual data was, of course, very positive given where the country was a year ago. Perhaps the better way to evaluate it is by looking at the longer-term picture. Thanks to the stimulus payments, retail sales blew through the long-term trend in January and are just now settling back to trend.
Of course, the pandemic drove a sharp increase in online sales – while retail employment dropped like a rock during the shutdowns. It has yet to come close to pre-pandemic levels and, given the general decline already underway since 2016, is unlikely to do so anytime soon.
The markets could care less about unemployment – focusing instead on the effects of trillions in stimulus and QE, the justification for which is said unemployment. If more people returned to work, the Fed would presumably trim back its support for the markets.
But don’t count on it. Yield Curve Control is effective, but quite addictive.
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