I know my readers are tired of my typical line of cynicism but it has never been more relevant than this week. On Monday, NASA succeeded in landing a space vehicle on Mars. HOWEVER, the FOMC can’t even define what the NEUTRAL RATE of interest is for the U.S. economy.

The FED has been populated by mathematical theoreticians who have FOOLED the investing world with the use of high level models based on the work of the world’s top physicists. The balance sheets of the global central banks are stuffed with massive amounts of sovereign and corporate debt purchased on the basis of authoritative models.

Yes, I know the counterfactual argument: What would the world have looked like without massive QE programs? Should policy makers have chanced it based on Bernanke’s fear of a 1937 deflationary implosion? The problem is and will be what is the exit strategy for the FED, BOE, ECB, BOJ to leave the world of wanton stimulus without causing the a massive implosion because the global debt-to-GDP ratio has exploded with the advent of negative and zero interest rate policy.

As Peter Boockvar mused on Wednesday, 40 percent of Russell 2000 stocks have high debt levels tied to floating LIBOR. Fed Chairman Jerome Powell mentioned in his very appropriate speech on financial stability that many metrics are muted and not reflecting any severe increased risk. One of his preferred measures, the forward price-to-earnings ratio, is “consistent with historical benchmarks.” My problem with this is that the ratio is well-behaved because the financial engineering of corporations to use debt to repurchase stock, shrinking the P/E ratio. It is the rising cost of debt coupled with wage increases that stand to put pressure on the ability to service the increased debt load.

Powell said corporate debt has not “faced a massive credit boom like that experienced with residential mortgages before the recent crisis.” He also noted that while corporate borrowing is above trend, “the upward trend in recent years is broadly consistent with the growth in business assets relative to GDP.” Fair enough, but when residential home buyers can’t service the debt their home is foreclosed on. Likewise, corporations cut production and close factories (see GM). The FED Chairman maintains that the risk levels in some areas are rising “overall financial stability vulnerabilities are at a moderate level.”

Maybe, but I heard the same thing about housing from Bernanke in 2008 as he deemed the situation contained. Powell has inherited a difficult situation as he has to confront the system’s massive buildup in excess reserves while dealing with the threat of rapid wage increases. The U.S. debt load as measured in this year’s one trillion-plus deficit is very emblematic of the problem. The cost of servicing the entire U.S. debt grows as interest rates increase putting political pressure on discretionary program.

The problem for the Powell Fed is that with a 3.7 percent unemployment the annual deficit OUGHT to be shrinking as it did during the last four years of the Clinton administration. Will the financial stability vulnerabilities remain moderate for long?

***Martin Feldstein asked an important question to Chairman Powell: Should monetary policy take into account financial stability or in Greenspan terminology should the Fed prick a bubble? In asking the question Feldstein criticized previous Chair Janet Yellen by noting she believed monetary policy should focus on the Fed’s dual mandate. Powell danced the question but finished by saying he believes that monetary policy is not the ideal tool to deal with financial instability or possible elevated asset prices. Bill White’s important paper about the role of monetary policy to “lean or clean” remains relevant.
Powell’s wavering provided added impetus for a rally in all asset classes as STOCKS, COMMODITIES, CURRENCIES and precious metals staged robust increases. However, I do give Powell credit for delivering a major speech on the major issue facing the global financial system.
***Powell provided historical perspective when he cited a speech that was also delivered at the Economic Club of New York by Boston Fed President William Harding in March 1929. The Fed had been attacked for raising concerns about banks leaning for stock market speculation. There were critiques arguing that the FED was out of “its sphere” warning about correct asset prices and that the “banks were so well-managed” there was nothing to worry about. Financial instability at this time was not insured against by FDIC insurance, which didn’t come into law until June 16,1933, the same day as Glass-Steagall. The act was later repealed in 1999 with the passage of Gramm-Leach-Bliley.
Unfortunately, the FED is back into a position of being MORE VIGILANT because the existence of FDIC insurance has resulted in a major liability for taxpayers and savers. Sorry Chairman Powell, the use of 1929 is a flawed argument for dealing with the Fed’s role in financial stability.