Bogleheads on Investing- Episode 022 transcript

Ed Yardeni

Dr. Yardine is a legendary Wall Street economist and investment strategist. We will be discussing his new book, Fed Watching for Fun & Profit (free on Kindle), and his insights and lessons learned forecasting the economy and financial markets over the past 40 years.

Dr. Yardeni is the President of Yardeni Research, Inc., a provider of global investment strategy and asset allocation analyses and recommendations. He previously served as Chief Investment Strategist of Oak Associates, Prudential Equity Group, and Deutsche Bank’s US equities division in New York City. He was also the Chief Economist of CJ Lawrence, Prudential-Bache Securities, and EF Hutton. He taught at Columbia University’s Graduate School of Business and was an economist with the Federal Reserve Bank of New York. He also held positions at the Federal Reserve Board of Governors and the US Treasury Department in Washington, D.C.

Dr. Yardeni earned his PhD in economics from Yale University in 1976, having completed his doctoral dissertation under Nobel Laureate James Tobin. Previously, he received a master’s degree in international relations from Yale. He completed his undergraduate studies magna cum laude at Cornell University.

Dr. Yardeni is frequently quoted in the financial press, including The Wall Street Journal, the Financial Times, The New York Times, and Barron’s. He was dubbed Wall Street Seer in a Barron’s cover story. He appears frequently on CNBC and Bloomberg Television.

Episode 022- guest Ed Yardeni,

Ferricircle

Rick Ferri, June 01, 2020

Rick Ferri: Welcome to Bogleheads on Investing episode number 22. Today my special guest is Dr Ed Yardeni, a long time economist who has been analyzing the Fed and the Federal Reserve board chairman’s for 40 years today we’ll be discussing Dr. Yardeni’s new book, Fed Watching for Fun and Profit.

Hi everyone my name is Rick Ferri and I’m the host of Bogleheads on Investing. This episode, as with all episodes, is sponsored by the John C. Bogle Center for Financial Literacy, a 501c3 corporation. Today my special guest is Dr. Ed Yardeni. Dr. Yardeni received his undergraduate degree in economics and government from Cornell University in 1972, and then went on to receive his PhD in economics from Yale University in 1976. He then joined the Federal Reserve and later moved to Wall Street and became a famous Wall Street economist and now has his own consulting firm. Dr. Yardeni learned early on to watch the Federal Reserve. By controlling interest rates and other key variables the Fed has enormous impact on financial markets and the economy. Today we’re going to be talking about just that. I’m happy to have with us Dr. Ed Yardeni. Welcome doctor.

Ed Yardeni: Thank you very much. Just call me Ed.

Rick Ferri: Thank you. I’m very pleased to have you on the show Ed. I’ve been following you basically my entire career for more than 30 years, and really fascinated by the work that you do and your background. And I really appreciate that every day I go and I read your morning notes on your website, yardeni.com. Lots of great commentary there. Before we get into your book, Fed Watching for Fun and Profit, I wanted to have our listeners learn a little bit about you.

Ed Yardeni: Well I started out my college years as an engineer, actually, for the first semester and after a course in differential calculus made me realize that I just wasn’t going to be an engineer. I transferred over to the government department in the Arts and Sciences school and subsequently I wound up double majoring at Cornell in government and economics. So that was my undergraduate years, and then I went to Yale and more or less did the same. I took an MA masters of arts in international relations for two years and managed to take enough courses in economics so that I could after my MA move over and in the next two years complete a PhD in economics. My education was very much focused on politics, international relations and economics and then I wound up getting a job at the Federal Reserve Bank of New York. So that that was sort of the beginning of my educational background and the beginning of my career.

Rick Ferri: I understand that you worked for Paul Volcker when you were at the Fed.

Ed Yardeni: He was the President and I was just a lowly economist in the research department. Every now and then we’d have a meeting where Volcker would be there and a research economist like myself would make presentations. So I wouldn’t want to characterize it as I worked directly for him but he was the President and I was one of his many employed economists.

Rick Ferri: And after you left the Fed you went to work for Wall Street.

Ed Yardeni: Yeah I got a call from a headhunter about a year at the Fed and I had no intention of leaving. I did enjoy my day there, but on the other hand I had long admired Henry Kaufman, who had been the chief economist of Solomon Brothers for many years and in many ways he pioneered the concept of a Wall Street firm having an economist and a strategist.  So when I got the call from the headhunter, he offered me the opportunity to interview at EF Hutton.

Remember that firm, “when EF Hutton talks, people listen” was their motto. It was a very classy firm. It was catered to wealthy individuals as well as institutional accounts. And so I went for the interview and worked out great. The chief economist at the time hired me to do the work on the financial side of the economy and there was another fellow who focused on the real side and the GDP side of the economy.

Rick Ferri: And from there you started to create quite a name for yourself. You were on Wall Street Week with Louis Rukeyser and you became quite famous. Well, right away.

Ed Yardeni: Well one of the things that I did early on is I put a lot of financial reporters on my distribution list and I produced a monthly at first, then a weekly and subsequently I went for a daily and I’m fairly opinionated but I always try to back up my opinions with the facts and the data and I answer my own phone. So reporters have found it very easy to get a hold of me and to get an analysis of whatever they’re interested in. So I guess that kind of open communications with the financial media helped. I think that’s part of it. The other part is I do write a lot and comment on issues that everybody is concerned about. My job is to help institutional and back then retail accounts try to make money in the financial markets, and at least avoid losing money. And so those are issues that are relevant to a lot of people and certainly in the financial press.

Rick Ferri: And back in 2007 you decided to go out on your own and start your own company.

Ed Yardeni: Right. I had been on Wall Street and a few firms, and then I went off to a money management firm out in Akron, Ohio for a couple years. And then I decided that I really wanted to do what I’d been doing all along, which was economic and investment strategy research. And I had the opportunity to start my own firm, kind of leveraging up the account base that I had had on Wall Street. Many of them signed up when I reached out to them and told them that I’d hung out my shingle and that I was in business on my own.

Rick Ferri: You’re a very good writer by the way. It’s easy to read what you write, I can understand it. There are so many times you know, at the PhD level, you start reading this stuff and they simply want to impress each other. But here, the way you write is to me like you’re talking with me, which is very good. And you’ve written a lot of books. One of the books you wrote recently was Predicting the Markets, a professional autobiography back in 2018, whichis an in-depth book. But as you were writing that book you decided that book probably could have been three or four books. It could have been a series of books and which in a way did become a series. You wrote another book called Stock Buybacks: The True Story, which I read. I read your research on stock buybacks and I’ve really changed my opinion about it by the way, it was very fascinating to read. And then The Yield Curve: What is it Really Predicting in 2019, and most recently, and the book that I want to talk about today is Fed Watching for Fun and Profit, and I really enjoyed this book and wanted to have you on the show to talk about the Fed because you stated right at the beginning of the book that you need to watch the Fed and you need to know who the Fed chairmans are, and what their biases are, and what their beliefs are, and how important that is to your role, which is trying to anticipate what’s going to happen in the markets next. And this is such a thorough investigation, history if you will, and I just found it fascinating as I read through it so I really wanted to go through this book with you because I think the audience would really love to hear exactly what is this thing called the Federal Reserve and how does it work? Let’s just start at the beginning.

Ed Yardeni: Well the Fed was created in late 1913 and it was created mostly because there was a concern that we just kept having these financial crises and the previous crisis occurred in 1907 and J.P. Morgan, the famous banker, stepped in and managed to calm things down in the financial markets and so he was, in a sense, the Fed at the time, he was the power in the financial markets. But there was a sense that we were getting too many of these financial disruptions and creating too much havoc in the economy, and that the money supply just wasn’t elastic enough. It wasn’t responding to the cyclical needs of the economy for farming, for example, commerce, international trade. And so some politicians and Wall Street types got together and started to map out a central bank for the United States. And by the late 1913 Congress passed the Federal Reserve Act which created the Fed and, again, back then the key mandate was to provide a currency that accommodated the needs of the economy, but in the context of what happened in 1907, but to avoid financial instability.

In our conversation we’ll see how that mandate has changed into something completely different and how that may have kind of led to some of the issues that confront us today. The Act kind of left things in the hands of twelve regional banks. These regional fed banks are essentially owned through stock ownership by other banks, by private sector banks, so it’s a quasi-private and governmental organization. But it clearly is very much a regulatory agent in our economy, responsible for regulating the banks. But it also has become very important in managing the monetary system, the financial system.

Now most of the power originally rested with the Federal Reserve Bank of New York under Benjamin Strong, who was the president of that bank. He was a financial conservative. He believed in the gold standard and he did a pretty good job but unfortunately he passed away in the late 20s, just before the Great Depression hit and the Fed just did a horrible job during the Great Depression and as a result in 1933 the Federal Reserve Act was amended to create the Federal Open Market Committee, which includes the governors of the Federal Reserve Board and the regional presidents of the Federal Reserve Banks around the country. And the power shifted away from New York to Washington DC and that kind of created a new version of the Fed, much more powerful than it had been before, much more centralized than located in Washington rather than New York. So really became part of the Washington government and became a little less beholden to the financial system which was epicenters in New York city.

And so after that change we did start to see that the FOMC became much more important in our economy, but that really didn’t occur until after World War II.  With World War II what happened of course, is we had, we wanted to win the world as we all do in those kinds of situations, and the Fed basically provided very low interest rates to the Treasury to borrow money to finance the war. And then in the early 50s the Treasury and the Fed came up with an agreement where the Fed basically got its power that it has today to manage monetary policy independently of the Treasury and other government pressures. So since the early 50s the Fed’s been running monetary policy, more or less independently. 

I mean there’s been a lot of criticism that sometimes that’s not quite the case but for all practical purposes the Fed determines interest rates, determines the amount of reserves that banks have in the monetary system. So that’s kind of a really brief overview of where the Fed originated, what its original mandate was, and how it evolved until today. I should just mention that in the late 70s this mandate changed to a dual mandate which is to focus on keeping unemployment as low as possible and to keep price inflation extremely low as well. So we went from an original premise of financial stability to managing the business cycle and I think that created a lot of problems that have come to haunt us to this very day.

Rick Ferri: What I found interesting when you gave the history of the first Federal Reserve presidents prior to Arthur Burns was a lot of them were business tycoons.They weren’t banking people. 

Ed Yardeni: Correct.

Rick Ferri: And then Richard Nixon appointed Arthur Burns. He was the first academic. When that occurred was there a big shift in the way in which the Fed operated?

Ed Yardeni: I think there was. Right before Arthur Burns, William McChesney Martin had been the Fed Chair from April 1951 to January 1970, so he was in there for quite a long period of time, and he was a financial conservative and he warned a few times, and I highlighted in my book a few times, that he warned that the Fed really shouldn’t try to manage the business cycle. That there was something kind of natural about business cycles. During booms you wanted to take away the punch bowl, in the famous speech he gave. But I think with Arthur Burns, with economists increasingly coming into the Fed replacing bankers and lawyers, business people, that macroeconomics became more important in the way the Fed was run.

And Arthur Burns was a macroeconomist. I don’t know that he particularly was the originator of the idea of managing the business cycle but I think the criticism that many have had about Burns is that he wasn’t independent enough of Richard Nixon and that he let inflation rise a bit too much. Burns was in there from February 1970 to January 1978 so he was there when we had the first oil shock. And he did raise interest rates but not enough to really bring inflation down and it just remained on an upward course that was only exacerbated by a fellow who was there for a very short period of time. And his background was business not economics — that was G. William Miller. And G. William Miller was there from March 1978 to August 1979 and he also was a little bit too lax about dealing with inflation and sure enough we got hit by another energy crisis in 1979.

The problem with the inflation of the 1970s is that it went straight from oil prices into wages because the labor markets were fairly rigid and there were these large unions that had cost of living adjustments in their contracts so that an increase in the price of oil really became a general inflation problem. And that’s when Paul Volcker came on the scene in August of 1979. He was there until 1987. Volcker was not an economist, he was a financial conservative and he really felt that, you know, he couldn’t let this inflation problem continue. And at the time people were pretty convinced that inflation was kind of stuck in the system, that you couldn’t really get it out. And what Volcker demonstrated is that you could if you were willing to tolerate a really bad recession which he was until it became so bad that he had to relent. But by then he’d achieved his goal of bringing inflation down.

Rick Ferri: Early in 1971, when Arthur Burns was named as a Fed chairman, one of the first things that happened was the Bretton Woods Agreement or the Bretton Woods system of international currency management was dissolved by Nixon. He basically, what we say, closed the gold window and that led to price controls and led to food, oil, labor shocks,and so forth under Burns. And this is what caused this high inflation during the 1970s. And I want you to compare and contrast the concern that people have right now, and I’m going to jump ahead a little bit here, but we see the Fed is just printing money and people say it will become extremely inflationary but at history when looking back at the 1970s and comparing that to today and what’s going on. I know I’m jumping ahead a little bit in our conversation here. But it is different, I mean it’s not automatically inflation.

Ed Yardeni: Right. Well that’s the thing is the sort of knee-jerk approach to understanding what the Fed is doing and what the consequences of its actions are. Many of these things are just kind of based on a perception that history repeats itself and sometimes it does and sometimes it doesn’t. I think in the 70s, I think the 70s were really a unique period, highly inflationary period and it was pretty traumatic. I mean people are still looking back then and saying it could happen again and my spin is that I don’t think that’s the case. So we don’t have a union power that used to be in the private sector. There’s still lots of unions in the public sector but we had cost of living adjustments back then so that an oil price shock went straight into wages and was passed through into higher prices.

During the subsequent decades we saw several forces coming into play that have kept inflation down, brought inflation down. One of them was globalization, which may very well be at risk here, may be challenged by the way the world is evolving away from globalization. The globalization with the end of the cold war in the late 80s, with China joining the world trade organization in 2001, I argued that globalization was fundamentally deflationary because the reality was that manufacturers could manufacture anywhere in the world where labor was particularly cheap and the result was relatively attractively priced goods and some services that Americans could benefit from, but many Americans did in fact lose their jobs to countries with low wages, particularly China. 

But that’s not the only deflationary force we’ve had occurring in recent decades. Technological disruption is a very deflationary force. We just have ongoing technological innovations that are all designed to produce better goods and services at lower and lower prices, with technologies that are extraordinarily productive. And in some ways we may very well be at the beginning of another technology revolution and you know you don’t have to imagine it. And we know about 3D manufacturing. We know about our artificial intelligence. Robotics, automation, they’re all there and they’re getting very rapidly implemented into our lives and they’re inherently deflationary. 

Another important force of deflation, which has evolved since the 70s into a very powerful force of deflation, I think, is geriatric profiles of more and more populations around the world. The reality is in many places fertility rates have plunged so we’re not having as many babies and people are living longer, so we’re seeing populations on average getting older. And older populations, I think for a lot of reasons, are less prone to inflation. And you know that includes the young, young people today tend to be minimalists. A lot of them are not getting married early in life, or if they’re getting married at all. And they’re not having children. So that’s deflationary and that’s ongoing, there’s no sign that’s going to change. 

And then debt. We’re used to thinking of debt as being inflationary, as being stimulative and I think that’s one of the problems we have with the central bankers. They still believe that if you lower interest rates you’ll stimulate people to borrow more and that’ll stimulate the economy and I think they’ve been doing that for so long that they don’t realize that a lot of us have already got more debt than we can handle and that a lot of the easy money has actually allowed what I call zombie companies to exist. Meaning companies that should be out of business are staying in business because they can get financing so cheaply. 

So the 70s was the 70s, and the 2020s– history repeats itself to a certain extent, but there’s so many structural changes in our economy. In other words the Fed isn’t the whole story. The Fed’s part of the story, a very important part of the story, but just knowing what the Fed’s going to do isn’t sufficient to really understand how our economy works and how that all influences the financial markets. 

Rick Ferri: So the four D’s right.

Ed Yardeni: Yeah the four D’s are the four forces of deflation. And you know, it’s globalization starts with the G so let’s call it the same concept, and then you know technology starts with the T so let’s call it technological disruption, and then it’s easier, it’s demography and debt.

Rick Ferri: All right, perfect. So let’s go back to how Volcker fought inflation by creating a different model that basically tracked money supply and basically automatically reset interest rates based on where the money supply was.

Ed Yardeni: Correct. That was really something quite radical. A few months after coming to run the Fed he realized that he was having a problem with the Federal Open Market Committee and getting an agreement on raising interest rates to break the back of inflation. So he was worried that the Fed would lose its credibility in bringing down inflation. So he on a Saturday night came up with a press conference and basically said that he had met in an emergency session with the FOMC and that they had agreed that they would adopt a new approach to managing monetary policy, which was to really just focus on the growth of the money supply and let interest rates fall where or rise wherever they would. It was basically a way to let the markets determine where interest rates had to go in a highly inflationary environment. And the markets immediately realized that the Fed that was letting interest rates go to where they should go, which is a lot higher as a result of inflation and that meant that the FOMC was no longer targeting interest rates, but was letting interest rates rise high enough to break the back of inflation.

And of course, the way that happened, the higher interest rates created a credit crunch which historically has really been the way that we’ve run and gone into recessions. We’ve had these credit crunches very often caused by the Fed raising interest rates when they perceive that inflation was becoming a problem, and at some point interest rates got high enough that credit conditions tightened up and when that happened that we’d have a recession.

Rick Ferri: So in many ways a lot of these legacies are still with us today, right. We talked about people believe that inflation is coming back because the money supply is increasing in there. And then well if inflation comes back then interest rates have to rise and therefore you should, you know, sit on your zero percent yielding money market fund and wait for interest rates to go up. But I remember back in 2018 as the Fed was increasing interest rates, people believed that they were going to continue to go higher, back to a normal rate, right. They didn’t. Didn’t last very long.

Ed Yardeni: No no you’re right, we’re all only humans and very much influenced by history, particularly the history that we’ve lived through. Which is kind of one of the reasons I wrote the book. There are a lot of things that have happened over the past few decades that people really don’t know, and I think it’s very important to have sort of a continuous historical perspective on how we got to where we are today.

Rick Ferri: So Alan Greenspan comes in after Paul Volcker and he is the great inflator of asset prices.

Ed Yardeni: Yes right, and that’s what I call them in my book, correct.

Rick Ferri: And a believer in financial engineering, derivatives, you know, hands-off approach. Could have created what occurred in 2006, 2007, 2008 with financial derivatives.

Ed Yardeni: Yeah, I think Paul Volcker was probably the greatest chair of the Fed that we had. He was very conservative. He was still true to the original mandate of the Fed, which was financial stability, and in his mind keeping inflation down was a much more important mandate, implicit mandate, than having full employment. Alan Greenspan was a macroeconomist. I mean Arthur Burns was a Phd. economist but in terms of sort of the run of economists here, the most relevant one for us is Alan Greenspan, then Ben Bernanke, then Janet Yellen, all basically kind of following the same underlying macroeconomic assumptions and using the same models.

Alan Greenspan was very different from Paul Volcker. Volker was a conservative and believed that the financial system had to be regulated and that you had to be very careful not to let the banks run wild again. That was the original mandate of the Fed. Don’t let 1907 happen all over again. But Alan Greenspan, as you said, he was laissez faire, he was a deregulator. He believed that Wall Street had to compete with London and Frankfurt and other international markets, and if we didn’t let Wall Street do what they do best without a lot of regulation that we would lose competitiveness relative to other financial centers. So he was all for letting Wall Street do its thing and particularly in the area of credit derivatives. There was a debate that didn’t last very long where there were a few officials who really wanted to regulate credit derivatives — the folks who were regulating the commodity markets. But Greenspan, along with a few others, totally resisted that and supported laws that allowed Wall Street to create these credit derivatives without any regulation whatsoever. His basic assumption was, you know these are smart people, they know what they’re doing and we should let them do it. But that really set the stage for, I think, much of the problems we’re confronting today.

Rick Ferri: There was sort of a warning shot, right, with the collapse of Long-Term Capital Management.

Ed Yardeni: Yes. Well when Greenspan came in, a few months after he came in– he came in August 1987–by October 1987 we had a crash in the stock market, and at the time, I think, there was recognition that some of it had to do with what were then basically derivatives. Some of Wall Street’s geniuses created this concept of portfolio insurance, which promised that if we ever got into a crash that the insurance policies created by these derivatives would protect you from the downside. Instead they just really made things much worse.

And Alan Greenspan jumped in and provided at the time easier credit conditions and helped to relieve the pressures on the financial markets. And that experience was viewed as being the beginning of the Greenspan Put, which is the Fed under Greenspan suddenly cared about the equity markets. Had the backs of equity investors whereas as we saw with Paul Volcker, he couldn’t care less about what the equity market was doing. He just cared about bringing inflation down and if that caused a recession and a bear market in the stocks he was willing to accept that. Whereas Alan Greenspan comes in and at the first hint that the markets that got a problem he jumps in and supports the market. And that’s really been the modus operandi not just of Alan Greenspan but the subsequent Fed chairs like Ben Bernanke, Janet Yellen and certainly now Jerome Powell. 

Rick Ferri: So now that we’re up to Jerome Powell, what is going on right now. You have written a great commentary about “no assets left behind.” You come up with all these great acronyms by the way. But boy, it just seems like I guess the only thing left is for the Fed to just outright go and buy stock.

Ed Yardeni: Well that’s the thing. We started out with Alan Greenspan being very laissez faire as long as the stock market was going up, but then when it took a dive in 1987 and then in 2000 he was clearly willing to provide stimulus to try to support the stock market. But under Greenspan it was really all focused on interest rates and with the benefit of hindsight it seems like he kept interest rates way too long in 2000 through 2006. He left in January 2006, so really 2000 to the end of 2005, interest rates were kept too low for too long. When he started raising them he raised them in a very predictable fashion, 25 basis points per meeting for a couple years, and just wasn’t tough enough the way Volcker was with regards to keeping things in check. And the result, I think, was creating the housing bubble, the credit derivatives calamity that befell us and that’s what Ben Bernanke inherited.

I don’t think Bernanke really realized what Geenspan had left him. Bernanke came in on February 1, 2006 and by 2007 Bernanke realized he was having a problem with the subprime mortgage market. Didn’t quite appreciate how big the problem was, but by 2008 it became very apparent that things were falling apart. And then I think Bernanke’s big mistake was allowing Lehman to fail. I mean they could have restructured Lehman, they could have fired the folks who ran the place into the ground, but by letting it go under he took a financial crisis which was bad and turned it into a basically a disaster. And then he turned right around and tried to save the day. Came up with bringing interest rates down to zero, came up with quantitative easing in late 2008, and then you know three programs of quantitative easing under Bernanke where they’re buying bonds.

Now Janet Yellen came in February 2014 and she was committed to keeping all this stimulus in the system but she started to recognize that the economy was in an expansion for a few years and it was time to start gradually raising interest rates. But even she, late in her first term, and she only served one term, she left in February 2018, but in 2017 in one conversation in one conference, she was actually talking about maybe the Fed should have the power to buy equities and corporate bonds. But she said maybe that’s not a good idea but we should think about it.

But Jerome Powell was the fellow where everything that had been, the stage had really been set for everything that he’s had to deal with by his predecessors, Greenspan, Bernanke, and Yellen, And with Powell we went from QE1, QE2, QE3, you know these quantitative easing programs of buying bonds, to gradually raising interest rates early on in his term. So he came in February 2018 and so he continued what Yellen was doing, but by late 2018 he was backing off already because the stock market took a dive and here was another example, this time of the Powell Put, where he backed off and started to lower interest rates in 2019.

And then the virus hit us and suddenly on March 15th it was a Sunday, he had his own Saturday night special conference, press conference, after meeting with the FOMC, where you know the parallel’s kind of interesting because Volcker had his press conference to announce that he was going to raise interest rates, allow interest rates to rise to whatever levels it needed to be to break inflation. Powell on March 15th on a Sunday said that he was going to provide QE 4 — 700 billion dollars of purchases of bonds in order to do whatever was necessary to cushion the economy from the effect of the virus crisis.

He also lowered the fed funds rate to zero, and the next day, which was March 16th, it was a Monday, the market, the stock market dropped 12 percent. Clearly suggesting that the Fed was no longer impressed. You know central bankers are very much into shock and awe, and some of these QE programs were shocking and awesome. This QE 4 on March 15th, the message from the market the next day was, aw shucks is that really the best you can do, is that all you got. And so there was clearly a message in the markets that maybe the Fed had run out of ammo and couldn’t do anymore.

And that’s when Powell really shocked and awed everybody because basically a week later on March 23rd, it was a Monday, he announced what I call QE forever, which is no limit whatsoever on the amount of bonds that they would buy, no time frame for how long this program would last other than we’ll do it until the economy shows signs of recovering from the virus crisis. And then along the way a few days later it became clear that the Fed was also going to be buying corporate bonds, which according to the Federal Reserve Act they’re not allowed to do. So they finagled it. They went around asking permission from Congress — and they probably could have gotten it from Congress — by creating these special purpose vehicles that were funded by the Treasury so that the Fed wouldn’t assume any risk if there were losses. It would be all up to the Treasury, which by the way means us the taxpayers.

But the Fed would be able to buy corporate bonds that way. So as you mentioned before, what’s left? I guess we could think about the possibility that at some point the Fed might go and buy corporate equities. That’s what the Bank of Japan’s been doing. But I don’t really think that’s necessary. I think just by being the lender of last resort in the corporate bond market and we’re talking about even junk bonds, triple B bonds, which are the lowest investment grade bonds accounted for 50 percent of the investment grade bonds before the crisis. After the crisis many of those bonds turned into junk and the Fed announced that many of those securities would in fact be part of their program for supporting the market.

Rick Ferri: The fallen angels.

Ed Yardeni: Yep right.

Rick Ferri: And it was funny because not only were they going to buy existing fallen angels bonds that went from investment grade to non-investment grade, but they were also going to buy new issues from the companies that became fallen angels, which I found really interesting.

Ed Yardeni: Right, well it’s disturbing, you know, the Fed started out with the mission of financial stability and look where we are now. We certainly don’t have financial stability. We have way too much debt. We have way too many junk bonds, leveraged loans, weak covenants and the Fed’s known about all these things.

As a matter of fact, we had a financial crisis in 2008 and it wasn’t until ten years later that the Fed started writing financial stability reports to assess that very subject. In their reports, they acknowledged that things weren’t all that good in the corporate bond market and the corporate leverage market. They said the households are in better shape than they were in 2008 and the banks were in better shape, and they said that they are aware of the problems in the corporate debt markets and are addressing them without ever saying exactly what they were doing. Then the virus crisis hits and now we know what they’re doing. They’re supporting the corporate bond market by basically buying these securities outright. And allocating capital to corporations now by doing so, and do we really want an economy where the central bank is allocating capital as opposed to the markets.

Rick Ferri: Let me ask you something that I’ve been thinking about and that is if you have the safety net, or the Powell Put where equity investors know it’s going to be Fed to the rescue, if you get volatility in the equity market, why wouldn’t the valuations of equities just continue to go up over time to 25, 35, 45 and we get to look an awful lot like Japan looked in the late 1980s. Is that a feasible scenario?

Ed Yardeni: It’s a possible scenario. I hope we don’t get there. I mean that’s the problem you have when the Fed provides ultra easy monetary policy and a lot of that easy money goes to push up valuations and financial assets, rather than going into the real economy.

You know I think the Fed has crossed a lot of lines and, you know, which made it impossible to kind of go back. It’s kind of one thing led to another and bringing us to this point. If we could rewrite history, if I could rewrite history, I’d kind of clone Volcker and make sure that whoever replaced Volcker was replaced by Volcker Two, then Volker Three and Volcker Four, and that I would have insisted that the mandate of the Fed first and foremost should be financial stability, not managing the business cycle.

Once it got into the business of managing the business cycle I think that that was the beginning of lots of the problems we have now. I mean the reality is in a capitalist system occasionally there will be downturns and companies that are aware of the downside risks and and don’t feel that there’s a Fed Put that’ll save them from a disaster, they’re going to deal with that by having enough liquidity, by not doing excessive things that create speculative booms that lead to busts.

Now we’re in the twilight zone of the monetary policy. I mean it’s surreal. It’s almost science fiction to imagine that the Fed’s balance sheet is going to just expand without limit and that the Fed this year will probably wind up financing the entire federal deficit which is projected to be something like 3.7 trillion dollars. So the Fed’s already at seven trillion dollars on its balance sheet, up from three trillion from a few months ago, and I think it’s probably headed to 10 trillion, and the consequences of that nobody knows for sure.

I think the scenario you laid out where all that stimulus creates another financial asset bubble with forward PEs for the stock market already in the low 20s going a lot higher that would be very unsettling because I think that would indicate that the markets are not really functioning, they’re not operating the way they should be and that’s because the central bank has has become the market. I mean they’ve become the bond market. And indirectly, by keeping bond yields near zero, they’re forcing a lot of investors to rebalance out of bonds and into stocks. So they don’t have to buy stocks, just by buying bonds and keeping bond yields close to zero in effect they’re supporting the stock market.

Rick Ferri: You, even in your research you recently have had to expand your forward earnings from 12 months to 18 months to come up with PEs that are reasonable, that make sense.

Yeah so now what does, what are the other countries’ central banks think about what we’re doing, or is everybody in this together.

Ed Yardeni: We’re, they’re all in it together. I mean the major central banks, the European Central Bank, the ECB, the Bank of Japan, the BOJ. They’re all doing it together. They’re all run by macroeconomists and macroeconomists are do-gooders. They think they have the power to solve a lot of our problems with their policies, and I don’t think that’s correct. For example, back in 2010 when Ben Bernanke implemented QE2, I was arguing that, you know, the fed funds rate’s down to zero, maybe they should just say that’s all we can do folks, we can’t do any more. Instead they said well we’re not going to push interest rates into negative territory, but we could do in effect do that by buying 600 billion worth of treasuries.

So they they just keep coming up with more examples of how they believe they can surmount all difficulties with their ability to in effect print money and what that just seems to do is get us from one problem to the next. I don’t know if this all ends badly, but I don’t know what we’re going to do with a Fed that’s got a balance sheet that’s a lot bigger than it is today and owns corporate bonds and has really made it very difficult for markets to operate in a competitive manner, where market prices reflect the true value of stocks and bonds as determined by investors who can make money and can lose money.

Having this huge Fed Put now is something we’ve been working ourselves up to ever since Greenspan started it, but where it all goes no one knows for sure. With regards to inflation the nightmare scenario would be that you know we get something like Weimar hyperinflation and interest rates going up after we’ve accumulated all this debt. The impact on the deficit would be that it would be huge and most of it would be just interest payments. I don’t think we’re going to go that route. I think we’re more likely to go down the road that Japan’s been going down for quite some time and that is a lot of fiscal stimulus financed by the central bank and yet it’s not inflationary because of underlying aging demography, underlying technological innovations. But it could very well create another bubble in the stock market and then what? And as you said well I mean you can’t rule out the possibility that at some point they’ll give us the ultimate put which is to buy stocks directly. I hope that never happens but I certainly can’t rule it out.

Rick Ferri: Yeah it’s interesting that you have all of these defined benefit plans that have to get a certain rate of return to meet their actuarial, and you can’t get it from bonds.

Ed Yardeni: You can’t get it from bonds so you’re forced to get into stocks. You know, March 25th, in the morning I’m proud to say that we wrote a piece saying that we thought the bear market was over. That it made its low on March 23rd and I think that insight came largely from having written my book on the Fed. You know I said that the Fed matters, and having the Fed shock and awe me, and I’m not easily shocked and awed, but I was, like, floored by what they had done on March 23rd. I called it QE forever, as I said. I concluded that the Fed had made the low so the Fed matters a lot.

I have to tell you something as a “by the way” here. In early March I was depressed like everybody else was by the virus, by what this implied for the economy. I mean it was early March, it was a nightmare. We had illiquidity in the credit markets. It really looked just horrible and as I just had posted my book on Amazon and I was wondering to myself, oh my god I just spent all this time writing this book and who could possibly be interested in the Fed. I wish I had written a book on virology. But March 23rd it was like, oh the book’s relevant again. I have to admit, even I thought the Fed, what can the Fed possibly do to make a virus go away and the answer is nothing. But on the other hand a credit crunch created by the pandemic, of fear related to the virus, the Fed could do something which is what they did. Which was, you know, where no asset left behind, QE forever. I also call it launching B-52 bombers to carpet bomb the economy with cash. Remember people used to talk about the Fed’s bazookas and then they thought maybe they were out of ammo and there was some speculation that they go to helicopter money and they didn’t even bother with helicopters, they just went straight to B-52s.

Rick Ferri: I have to ask this question about negative interest rates before we finish up today. Tell me, it’s happening in other countries, Germany why not the US?

Ed Yardeni: Well, you know, as I’ve been thinking about the Fed over the years I’ve been writing about the Fed in this book and starting to increasingly piece together, show the relevance of history to what the Fed’s been doing, and how the Fed’s ideas have changed, and all leading to where we are today, I can certainly see how history has been extremely relevant to the mess we’re in now. And in recent weeks or months this year I’ve been increasingly saying that we’ve never been in anything like this, and it’s surreal, and you have to think differently and not get kind of get too closed off in your thinking.

So things that you just can’t imagine whatever, happened. You have to think well, maybe they could. So yeah, could negative interest rates happen here in the United States? They could but they’ve got slightly negative interest rates in Europe and in Japan, so that certainly could happen here. I hope it doesn’t. I think that the concept of investing your money and getting less back, well you know some of us are used to that when it comes to inflation and that’s why people fear inflation as investors is that even if you get a nominal yield it may not be enough to cover inflation so you wind up in real terms making less. But there was an uncertainty about that and that presumably in a relatively free market investors could get the kind of yield that they think was appropriate to get a real return.

If you start out investing with a negative nominal yield where you know you’re going to lose money, well it only works if you actually have deflation and that they actually are willing to buy securities with a negative rate if you think deflation’s coming, but other than that, it you know, it’s a guaranteed losing proposition. And I’m not sure that in a free market environment that that would be the case, and it certainly leads to tremendous misallocation of capital I would think.

Rick Ferri: I don’t know how retirees who are getting social security are going to take getting less, the actual dollar amount being less.

Ed Yardeni: Well it’s a very distorted environment we live in. You know pensions have promised their pensioners that they’re going get them something like six, seven, eight percent returns, and you can’t get that in the bond market anymore and that forces them into the stock market and forces them to take on junk bonds and dicier kind of credits and it just distorts the economy beyond recognition and that’s where the Fed’s brought us.

Rick Ferri: Things look very odd right now like you said, the twilight zone, and maybe that’s why on every dollar bill there’s this saying, In God We Trust.

Ed Yardeni: Well look at the end of the day you have to have faith that things are going to get better. I mean that’s really been the case. I’ve been doing this for over 40 years and I think that the future is actually going to be fine. The Fed is not the whole story. The point of my book was to make people understand how important the Fed really is, but at the same time I think it’s important not to lose sight that the Fed doesn’t run the whole economy, that there are a lot of us that are going to work or working from home on a regular basis trying to make things better for ourselves, our families, and our communities. And I think that kind of push by us running the economy will offset some of the excesses that have been actually created by the policy makers.

And so problems are meant to be solved is kind of one of my mottos that I’ve tried to teach my children and there are a lot of problems here right now. The most immediate one we have is the virus crisis, but there’s a lot of technology being focused on solving this problem and, who knows, maybe we’ll come up with something that you know you take one shot and it kind of protects you not just from this virus but from a whole bunch of other viruses. So things always look dark just before they get better, and I’m optimistic that things will get better and hopefully so much better that the Fed could just kind of be less important and not continue with these excessive policies and just become less a factor in our lives.

Rick Ferri:The name of the book is Fed Watching for Fun and Profit by Dr. Ed Yardeni. Well thank you so much for joining us on Bogleheads on Investing. Great to have you.

Ed Yardeni: Thank you very much.

Rick Ferri: This concludes Bogleheads on Investing episode number 22. I’m your host Rick Ferri. Join us each month to hear a new special guest. In the meantime visit bogleheads.org and the Bogleheads wiki. Participate in the forum and help others find the forum. Thanks for listening.

Investment adviser, analyst, author and industry consultant

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