Hotel California Monetary Policy

Relax, said the nightman
We are programmed to receive
You can check out any time you like
But you can never leave
--The Eagles

Early in his recent CNBC interview, Stan Druckenmiller confesses (at around the 7:40 mark), "I don't understand the Fed's monetary framework at all." He goes on to say that he grew up in an era where the Fed used monetary policy to 'lean against' extreme highs and lows in economic cycles, and that Fed policymakers under Janet Yellen missed their opportunity a few years back to return the Fed Fund Rate back more 'neutral' levels during periods of economic strength.

However, evidence suggests the Fed has rarely behaved as Druck suggests--at least for the past three decades. As indicated in the above graph of historical Fed Funds Rates (source here), the Fed never returns rates to levels that match previous cycles. New high water marks in Fed rates are always lower than previous iterations. Consequently, rates have been stair-stepping lower since their peak in the early 1980s.

With the Fed's recent walk back in its tightening policy, the central bank is signaling that it will once again repeat the pattern. The current Fed Funds Rate of almost 2.5% will almost surely mark another lower high in the series.

What drives the Fed to be secularly dovish in its monetary policy? One reason is that the Fed is a political animal. It succumbs to institutional pressures to keep money and credit flowing easily. Fed bureaucrats do not want to be seen as the party poopers that take the punch bowl away. They would surely face political, economic, and social consequences for doing so.

Another explanation is that the Fed simply realizes that it can't return rates to previous levels without imploding the financial system. Each time the Fed forces interest rates lower than true market rates, more credit is created than unhampered markets would deem prudent. Consequently, each cycle of Fed easing results in more debt and leverage than the previous one.

An axiomatic principle of leverage is this: the greater the leverage in the system, the more sensitive the system becomese to any uptick in interest rates. Higher rates increase debt servicing rates. Moreover, higher rates reduce demand (and thus prices) for assets purchased on margin. For leveraged asset owners this is bad news from a balance sheet perspective. Asset values are declining while liabilities remain constant, thereby increasing the likelihood of insolvency.

The Fed knows by lowering interest rates, it creates a more leveraged financial system. If it were to subsequently raise rates back to previous levels, the Fed also knows that it runs the risk locking the system up in the throes of a deflationary spiral.

The Fed's monetary framework that Stan Druckenmiller claims to not understand can be seen as resting on a Hotel California-like paradox. Although it is headed toward a bad destination, Fed interest rate policy can't be reversed without untenable consequences--at least in the eyes of bureacrats.