The Fed’s Market Addiction and Future Inflation — Ramifi’s Deep Dive
Our last article explored how major central banks coordinated their policies to ensure that global inflation was consistent yet manageable.
It remained about as manageable as an escalating drug habit.
Today we’ll explore how the central banks’ addiction to market intervention spiraled over the late 20th and early 21st centuries. In other words, this is how Central bank inflation grew from a “seeing friends on the weekends” habit to full-blown “shakes at 8 am.”
You’re reading Part IV in Ramifi’s series on inflation. Want the full story?
Check out Part I: World Reserve Currencies (TL;DR Thread),
Part II: The Rise and Fall of Bretton Woods (TL;DR: Thread), and
Part III: Money After Bretton Woods: Policies Without Long-term Solutions.
How Central Banks Enabled One Another’s Addictions
The institutions mismanaged inflation until it all got out of control, but let’s back up to see how we landed at that point.
While coordinating central bank action stemmed the tide of runaway inflation temporarily, the approach resulted in a butterfly effect for capital markets. Correlations in emerging and established markets began to grow.
The fate of markets worldwide quickly became intrinsically tied to one another, with the US dollar at the helm. As went the US, so went the world.
The Fed’s increasingly large market interventions came at the cost of ballooning asset prices and hidden consumer inflation for the past few decades. Let’s check out how this nasty little habit got its start.
The Fed’s Gateway Drug
In the late 1990s, a boutique investment firm known as Long-Term Capital Management (LTCM) found itself in dire straits. Previous years were outstanding for the company’s high leverage investment strategy in emerging markets, and returns of over 40% were standard.
The party came to an abrupt halt in the 1997 Asian Currency Crisis. Compounded by Russia’s currency devaluation a year later, the crisis shocked global markets and decimated LTCM’s portfolio. The S&P 500 had plunged by almost 20% by the end of August 1998. Whoops.
The Fed “saved” the market!
LTCM was collapsing fast. Losses topped 50% that same month. Then Federal Chair Alan Greenspan stated that “he had never seen anything in his life that compared to the terror of August 1998.” Big words for a Fed chair.
The potential default of LTCM threatened to upend the entire US banking system. Stabilizing the company was paramount to avoid this catastrophe. Greenspan blinked, and the Federal Reserve stepped in to offer $3.5 billion for a 90% stake of LTCM. Talk about playing hot potato while standing as the lender of last resort.
The logic behind this decision was to soften the blow of LTCM’s inevitable collapse, preventing a string of systemic bank failures. The Fed “saved the day,” and markets continued to rally throughout the remainder of the 1990s and early 2000s! Until the Dot Com crash, but that’s a story for another day.
However, this action created another significant butterfly effect in global capital markets. Markets respond to incentives. The bailout of LTCM directly contributed to the irresponsible behavior that resulted in the 2008 Global Financial Crisis. After all, why kick the habit when the Fed is providing a free supply?
The Fed Tweaks Again
The 2008 financial crisis was the worst economic downturn in the United States since the Great Depression. Banks and investment companies, emboldened by the Federal Reserve’s tongue-in-cheek support for asset prices, engaged in irrationally risky investment decisions.
Mortgage derivative investments, allowed by the Financial Services Modernization Act of 1999, gave banks exposure to precarious, speculative mortgages.
The films “Wolf on Wall Street” and “The Big Short” portray the era flawlessly.
Bear Sterns ate the big one in March 2008. A rapid series of subsequent defaults and liquidations followed, resulted in a cascading effect in global markets.
Eventually, this panic spread to bank savings deposits — with enough liquidations, the entire banking system would collapse. Think of it as the worst series of bluffs to be called in over 100 years.
These failures led to the largest Federal Reserve bailout in history at the time. Over $1.4 trillion was pumped into the financial system, bailing out mortgage lenders and banks at taxpayers’ expense. Unemployment remained well above 10% until late 2010 — Wall Street dusted itself off while Main Street languished.
With the Federal Reserve’s balance sheet more than doubling in two years, inflation was inevitable. However, thanks to the CPI substitutions, tracking actual consumer inflation using the provided tools was next to impossible. The Fed was free to support markets while claiming low inflation.
Big bailouts all around.
Lessons Not Learned
The recent Covid-19 pandemic saw unprecedented levels of market intervention by the Federal Reserve. The Payroll Protection Program resulted in hundreds of billions of loans to businesses, with total financial injections topping $3.2 trillion and still rising.
Don’t worry though, 1% of loans accounted for 25% of all loan value — the Fed’s record for inefficiency remains intact. The Fed’s balance sheet nearly doubled for the second time in 12 years, topping $7.4 trillion by the start of 2021.
By now, most readers have noticed a clear trend: the Federal Reserve intervenes in the market, the market stabilizes for a period, and an inevitably worse crisis arises.
All the while, inflation strips away consumer purchasing power through stealth inflation of vital consumer goods.
The Fed faces a difficult decision:
- Unwind decades of erroneous investments and allow the market to adjust appropriately (0.01% chance)
Or…
- Continue to kick the financial can down the road with disastrous future consequences (99.99% chance)
Money printer goes “brrrr.”
Some now argue that due to the apparent lack of inflation and the Fed’s inaccurate reporting, the Federal Reserve should undertake endless money printing activities to stimulate the economy.
Modern Monetary Theory (the above) suggests that government debt doesn’t matter at all, despite its precise role in Federal Reserve policy and money creation. At this point, some folks are throwing in the towel.
Conclusion — Hard To Break A Habit
Since its initial intervention in 1998, the Fed’s market intervention grew in size and scope continually with ever-diminishing returns. Congress has raised the debt limit a total of 78 times since 1960, demonstrating the can-kicking mentality has had plenty of time to solidify into a powerful addiction.
Just recently, a bill that proposes doubling the Federal minimum wage entered Congress. As the purchasing power of the dollar continues to degrade, we desperately need accurate inflation metrics.
Ramifi provides an alternative in the form of a synthetic commodity that tracks a basket of dynamically weighted commodity prices.
Why is that a good idea?
Despite its best efforts to levitate markets, the Fed still can’t print oil, wool, and corn. Better inflation numbers must account for commodities.
In the next and final installment of our history of inflation series, we’ll explore hyperinflation. We’ll break down what it means, how it happens, and why the US is heading down the hyper-inflationary road. Buckle up, and stay tuned.
