29 NOVEMBER 2018
THE MOST IMPORTANT STATEMENT THAT THE FED CHAIRMAN SAID IN HIS SPEECH
by Raul Elizalde
This article also appeared on Forbes.com.
Stocks surged after Federal Reserve Chairman Jerome Powell delivered a speech to the Economic Club of New York on November 28, 2018, where he introduced the Fed’s Financial Stability Report, inspired by and modeled after the European Central Bank’s Financial Stability Review.
The market became wildly enthusiastic when, a few minutes into the speech, he stated that interest rates “remain just below the broad range of estimates of the level that would be neutral”. Everyone interpreted this sentence as a signal that the Fed may be very close to the end of the tightening cycle. This immediately sparked a stock rally.
But that was not the most important point of his speech. It was his recognition that “things often turn out to be quite different from even the most careful forecasts.”
For that reason, he explained, any forecast to make policy has to be accompanied by recognizing and managing potential risks.
While he did not mention “unknown unknowns” as former Defense Secretary Donald Rumsfeld famously did in 2002, he listed four known risks the Fed is currently watching (and that the Financial Stability Report explores in depth). He quickly dispatched most of them, saying that the Fed does not think the financial sector has too much leverage or could run out of funding, or that there are any obvious bubbles in asset prices.
However, he came close to sounding the alarm on non-financial business borrowing, which as I (and others) have pointed out, is well outside historic norms. Here are his words:
"Information on individual firms reveals that, over the past year, firms with high leverage and interest burdens have been increasing their debt loads the most. In addition, other measures of underwriting quality have deteriorated, and leverage multiples have moved up. Some of these highly leveraged borrowers would surely face distress if the economy turned down, leading investors to take higher-than-expected losses--developments that could exacerbate the downturn."
As a central banker, of course, Mr. Powell focuses on how this risk could impact financial institutions. In that regard, he once again downplays this risk by saying that financial institutions are well prepared to deal with losses stemming from defaults and bankruptcies.
This is probably correct. But healthy banks are not enough to keep the economy and the stock market strong. Both can slump even with a rock-solid banking system, for example if a few key bankruptcies trigger a run to higher-quality assets and a rapid de-risking of portfolios.
The Fed Chairman’s speech was remarkably lucid and a welcome change from the days of inscrutable riddle-like Fedspeak championed by former Fed Chairman Alan Greenspan. Yet, by downplaying the danger that ballooning credit has posed in the past, he may have painted an outlook that is rosier than it merits.
He was right when saying that accurate forecasts are maddeningly difficult to make and need to be revised on an ongoing basis. Nobody should be surprised if in a future speech he comes back to the danger that corporate indebtedness presents to the economy. That may well be where the next crisis will come from.