Cutting Through the Fed’s Orwellian Doublethink
Federal Reserve Board Governor Jerome Powell, who has been nominated by Donald Trump to succeed Janet Yellen as the next Federal Reserve chairman, is an unusual choice for a number of reasons. First, Powell is not an academic economist but rather an investment banker who understands the financial markets. Second, unlike his tight-lipped predecessors going back several decades to Paul Volcker, Powell is quite forthright in his public statements.
For example, in the October 2012 Minutes of the Federal Open Market Committee, Powell openly worried about how the Fed’s massive purchases of securities would impact the markets. He said:
[W]hen it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position.
Whereas Chairman Volcker and his successor Alan Greenspan were known for their skillful dissembling when describing their institution’s operations and intentions, Powell is a thoughtful and honest individual. As a result, one of the biggest challenges he faces as chairman is accurately describing the actions of a central bank that has seemingly lost the ability to accurately describe its actions.
For example, back in 2010 when the FOMC first considered the idea of buying hundreds of billions of dollars worth of Treasury debt and mortgage-backed securities (MBS), this ostensibly to encourage credit creation and job growth, then-chairman Ben Bernanke rightly characterized the open market operations as “large scale asset purchases.”
The Fed’s economist staff in Washington, however, came up with the misnomer of “quantitative easing” to disguise the FOMC’s actions and convey the impression that buying $4 trillion in bonds was somehow going to help the economy.
One of the reasons the Fed is so reluctant to truthfully describe what it does is that the central bank is accountable to Congress, a collection of ambitious incompetents that Mark Twain rightly described as “idiots” and a “distinctly American criminal class.” In 2015, when Congress decided to confiscate the Fed’s surplus to fund a highway bill, it capped the central bank’s capital, providing little cushion in the event of future losses. Today, the Fed’s $4 trillion balance sheet is supported by just $40 billion in capital.
Every year, the Fed transfers the earnings on its securities portfolio, less the operating expenses, to the Treasury, which is counted as “revenue” using the strange logic of Washington. In fact, the interest earned by the Fed represents a reduction in expenses for the Treasury, not new revenue. When Congress passed the aforementioned highway legislation, Congressman Randy Neugebauer bragged that grabbing the Fed’s surplus raised “real money” to fund new roads. This, of course, was a politically motivated fiction.
In fiscal terms, the Fed is the alter-ego of the Treasury; it is not actually separate from the government in an economic sense. “The Fed almost by definition cannot make a profit,” notes Robert Eisenbeis, Vice Chairman and Chief Monetary Economist at Cumberland Advisors. “It baffles me how people inside the [Fed] system can fail to see the accounting reality here. The Treasury makes interest payments to the Fed who takes out its operating costs, including interest payments on reserves and returns the remainder to the Treasury. If this intra governmental transfer were settled on a net basis like interest rate swaps, there would always be a net payment from the Treasury to the Fed.”
But of course nobody at the Federal Reserve Board in Washington dares to correct members of Congress or the Congressional Budget Office, who view the Fed’s enormous portfolio as a convenient cash cow. Indeed, in the same way that the Fed turned “large scale asset purchases” into “quantitative easing,” it has found a way to avoid reporting losses on its tiny capital cushion.
By holding its investment at cost and hiding losses via accounting legerdemain that would get bankers in the private sector thrown into prison, the Fed maintains the fiction of solvency. If it were to incur a loss on its portfolio, it would not report a capital “loss” lest it provoke fear among investors.
Instead, the Fed worked out an arrangement with the Treasury back in 2010 that allows it to avoid the risk of actually having to report a capital loss. Rather than do that, it would create a “deferred asset” equal to the loss that would reduce the amount of money it remits to Congress each year. But taking a loss, even in this manner, would create a serious political problem for the Fed.
Since the Fed is unwilling to provoke members of Congress by reducing the annual “profits” to Treasury, it has decided not to actually sell any of its bond portfolio. Instead it will simply wait for the bonds to mature at par and thus avoid taking a loss—a process that will keep U.S. markets in an induced coma for at least another five years. Even though officials at the central bank talk publicly about “reducing” the size of its portfolio, the Fed is not actually going to sell any securities.
The moral of this story is that when it comes to understanding the policies of the FOMC, watch what the Fed does, not what Fed officials say. Will new Chairman Powell change this policy of deliberate financial obfuscation and start speaking honestly about federal debt and deficits? Perhaps. But the Fed is already so heavily invested in accommodating the Treasury’s fiscal excesses, it’s hard to see any Fed chairman turning the situation around.
The more important point is that as the fiscal situation facing the Treasury continues to deteriorate, Fed officials will be under enormous pressure to accommodate swelling federal deficits—even if it means pretending that the central bank is a source of revenue to the Treasury. The operative model of political economy here is Argentina in the 1970s.
As the Treasury’s deficits grow larger and larger, you can bet that Congress will force the central bank to buy increasing amounts of public debt, which will be recycled to the Treasury as “revenue.” As George Orwell wrote in 1984: “Doublethink means the power of holding two contradictory beliefs in one’s mind simultaneously, and accepting both of them.”
Christopher Whalen is an investment banker and Chairman of Whalen Global Advisors LLC. He is the author of three books, includingFord Men: From Inspiration to Enterprise (2017) andInflated: How Money and Debt Built the American Dream (2010). He also edits The Institutional Risk Analyst, and appears regularly in such media outlets as CNBC, Bloomberg, Fox News, and Business News Network. Follow him on Twitter @rcwhalen.