The Fed Takes the Punch Bowl Away


Few Americans today remember William McChesney Martin, Jr., the longest-serving chairman of the Federal Reserve in history, having held the post from 1951 to 1970 under five presidents.

But it was Martin who, in a 1955 speech, said the Fed “is  in  the  position   of  the  chaperone  who  has  ordered  the  punch  bowl  removed  just  when  the  party  was  really  warming  up.”

The current Fed chairman, Jerome Powell, seems to have taken those words to heart. The statement following Thursday’s meeting of the Federal Open Markets Committee (FOMC), the Fed’s rate-setting body, used some variation of the word “strong” four times in its first paragraph. It went on to say that “further gradual increases in the…federal funds rate will be consistent with sustained expansion of economic activity…”

There has been talk of “gradual” rate hikes since Janet Yellen was Fed chair.  But after an eight-session-long rally that drove the Dow Jones Industrial Average up around 1,850 points and the S&P 500 up 170, oints, the FOMC’s statement—plus more uncertainty on trade–triggered profit taking on Friday.

Apparently Wall Street believes Powell is serious. Is he?

I think so. The Fed chairman studiously ignored President Trump’s pre-election hectoring to keep interest rates low (at least one of them behaved like a grown-up) and has reiterated that rates will keep rising steadily. I think the FOMC will hike the federal funds rate a fourth time this year in December and three more times next year, as planned.

Unlike both of his predecessors—Yellen and Ben Bernanke—Powell, who is not an economist (he has a law degree and worked at several investment banks), apparently is unfazed by market reactions to the Fed’s moves. Bernanke and Yellen seemed to believe that markets were too fragile to handle steady rate increases, even though the economy kept improving. So, ten years after the crisis, fed funds are barely above 2%.

That won’t give the Fed much maneuvering room when the next recession hits, and after nine years of recovery, the risk of that is rising.  Another big problem: The three rounds of bond buying under Ben Bernanke—called quantitative easing, or QE—caused the Fed’s balance sheet to balloon to $4.5 trillion.

For the past year or so, the Fed has been reducing that balance sheet by selling up to $50 billion a month. At that rate, the balance sheet will return to its pre-crisis level by 2025.

The point is, Powell apparently believes he has to keep raising rates and shrinking the balance sheet, which is another form of tightening. That is the new reality, and it will take time for investors to sort it all out.