Markets need Fed’s reaffirmation on moral hazard

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Today, the Fed will release their first forecasts in six months amid stock market exuberance and turbulent street protests. In a nutshell, no big policy shifts are expected, instead, many expect the Fed to reaffirm its dovish forward guidance and a willingness to take policies as far as needed.

As the first FOMC meeting since the COVID-19 pandemic, and against the current backdrop of high racial tensions in the U.S., many will be keeping a close watch this time as the Fed faces pressure to play a tricky balancing act on moral hazard.

In economics, a moral hazard occurs when one has an incentive to increase exposure to risk because one does not bear the full costs of that risk.

Bill Dudley, the former New York Fed President spelled out the issue candidly in an interview last week:

“… The Fed’s choices: not have a recovery, have less inequality; or have a recovery with buoyant financial asset prices and more inequality… the Fed has encouraged excessive risk-taking and moral hazard. This doesn’t seem to be a good road to stay on, but getting off it is very difficult.” He said on Fed policy and recent market exuberance, “After all, no one wants to risk a depression in order to teach hedge funds, mortgage REITs or mutual-fund investors a lesson.”

Indeed, the Fed has taken an extraordinarily aggressive series of steps to ease economic hardship, and continued to reassure investors that they will do anything and everything it takes, including buying back as much debt as needed to promote recovery.

It is a paradise for speculators. Due to the bail outs and supporting of asset prices, many have pounced on the window of opportunity, sparking a fierce rally that brought stock prices to near pre-pandemic all-time highs. This included pouring money into highly indebted, zombie, and even bankrupt companies – causing analysts to worry such actions could threaten financial stability.

While the Fed has been given the lion’s share of credit for the recent rapid recovery of asset prices, over on “Main Street”, the coronavirus pandemic has left a trail of destruction with tens of millions of lower-income and disproportionately Black & Hispanic Americans losing employment income.

Yet, only a third of government aid for unemployment benefits, which is set to end after July, has actually reached these affected groups. In an alarming contrast, through the Fed’s corporate credit facilities, billions of dollars of cash may have been used to reward shareholders and executives without saving any jobs.

The Fed’s own data shows that slightly more than half of U.S. households (about 65 million) own stocks in some form, and more than 60% are white families.

However, the wealthiest Americans, who own the largest share of financial assets, are reaping the biggest windfalls from the Fed’s unprecedented intervention across financial markets.

Amid the wave of mass protests against racial injustice, indeed, the Fed officials now face added pressure to address the issue which has quickly evolved into a potential new risk to the economy. Jay Powell, who is often mindful in addressing inequality and distribution effect of policies since becoming Fed chairman, is faced with the delicate responsibility of balancing any sympathy for the protests with warnings about their unintended consequences.

In my opinion, given the high uncertainty about the course of the coronavirus pandemic and its long-term impact, the Fed is quite likely to be careful and vague in its statements. However, any hesitation from Fed officials in terms of their willingness to support the economy could disrupt markets, which have seen equities rally and yields on government debt rise. Another point of interest will be last week’s surprising drop in unemployment numbers, given their correlation with economic growth rates.

While the markets’ faith in the Fed, after 2008, has often overwhelmed fundamental relationships between financial markets and the real economy… The real economy still matters.

It is mind-boggling to see that even with protests raging across the U.S and the coronavirus pandemic continuing to deal damage to the economy, that investors are paying more than 20 times of companies next year earnings.

If insolvencies rise…

If corporate earnings continue to remain dismal…

If unemployment remains exceptionally high…

And if the global recession proves to be deeper than what markets are factoring in…

There is a significant possibility that any of the above may cause the fierce rally of the past couple of weeks to be quickly unwounded…

Stay safe.

– RT

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