The Fed’s Dependence On Stability

Last week, I discussed how the Federal Reserve will likely be the culprits of whatever sparks the next major financial crisis. To wit:

“In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became ‘active,’ monetarily policy-wise, in the late 70’s. As shown in the chart below, when the Fed has lifted the short-term lending rates to a level higher than the 10-year rate, bad ‘stuff’ has historically followed.”

(Click on image to enlarge)

This past week, as Ms. Yellen relinquished her control over the Federal Reserve to Jerome Powell, the Fed stood by its position they intend to hike rates 3-more times in 2018.

With the entirety of the financial ecosystem now more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the “instability of stability” is now the biggest risk.

The “stability/instability paradox” assumes that all players are rational and such rationality implies avoidance of complete destruction. In other words, all players will act rationally and no one will push “the big red button.”

The Fed is highly dependent on this assumption. After more than 9-years of the most unprecedented monetary policy program in human history, they are now trying to extricate themselves from it. The Fed is dependent on “everyone acting rationally,” particularly as they try to reduce their balance sheet. The first attempt was seen in January.

Well…sort of…but not really.

(Click on image to enlarge)

While the Fed did “reduce” their holding by $28 billion in January, it followed an increase of $21 billion in December. Which brings up several questions?

1. Was the ramp up/run down just a test of the market’s stability?  (Seems likely.)
2. With the market throwing a “conniption fit” last week, will the Fed rethink their balance sheet reduction program? (Probably)
3. More importantly, with the government on the verge of another “shut down” this coming week due to the expiration of the “continuing resolution” from three weeks ago, will the Fed continue its current path in the face of an event that could lead to fiscal instability?(Probably not)