The Fed’s New Job: Financing Rationality Deficits

There is no amorphous Warren Buffett aphorism about ignoring “noise” that works here; no wise, old adage about investing for the long-term and leaving the day-to-day hand-wringing to the “fools” is sufficient to relieve you of the responsibility to pay attention.

That’s an excerpt from a somewhat generic piece published elsewhere. The point is simply that while analyzing the interplay between politics, markets and policy may not be within the purview of average investors, it’s incumbent upon all market participants to at least take note of the fact that how the Fed decides to negotiate the web of embedded contingencies staring US monetary policy in the face will shape the contours of the institution for decades to come.

There is no “right” answer if you’re Jerome Powell. And even if there are answers which are conditionally right, they can be rendered “wrong” depending on how Donald Trump reacts to them.

For instance, the Fed could decide that the “right” decision is to hold off on committing to rate cuts or to otherwise lean hawkish in light of still firm data (recent stumbles on ISM and payrolls notwithstanding). That may be “right” on some interpretations, and if you’re in the camp that believes rate cuts could make things worse by emboldening Trump to push the protectionism envelope even further, pushing back against market expectations for cuts is not just “right” in some narrow context, but also in a wider, normative sense to the extent it discourages the erosion of international norms around trade and commerce.

But what if pushing back against calls for rate cuts prompts Trump to double down on the tariff threats on the assumption that Powell just needs more “convincing”? That would not only mean the Fed’s strategy had backfired, but in fact in spectacular fashion, as the Committee would have accidentally encouraged more trade aggression while attempting to discourage it.

On the other hand, validating market pricing and placating Trump with rate cuts carries clear risks, the most obvious of which is that it opens the door to the central bank becoming a permanent fixture of the policy mix – overt, open politicization – a stain on the institution that won’t easily be washed away even when Trump is gone (assuming, of course, he ever leaves office, which no longer seems like a sure bet).

Read more: Powell Fed Faces ‘Political Event Horizon’ And Crossing It May Mean No Way Back

Deutsche Bank’s Aleksandar Kocic has talked at length about the current setup in a series of recent notes. In his most recent effort, dated Friday, Kocic expands a bit on the notion that while the two-way communication loop between markets and the Fed remains intact, “the communication between politics and the Fed or between politics and the markets is only one way — a monologue — without any feedback into politics”.

“At the moment, there are three main agents that define the backbone of the underlying configuration with distinct economic profiles and attributes: Fed (fully rational), markets (conditionally rational), and politics which, from the economic view, can be characterized as conditionally irrational”, he writes.

Previously, it was possible to conceive of a kind of countercyclical protectionism, where the Trump administration became more hawkish on trade the higher the market flew, and more conciliatory when equities sold off. Recently, though, Trump appears to have adopted a less predictable approach – as he put it on Wednesday, “Nobody can quite figure it out.”

That poses a significant problem, and, as Kocic suggested a week ago, it leaves recession as the only potential circuit breaker, assuming equity selloffs are no longer sufficient to force Trump to tone down the trade bombast.

At the very least, the president has become more of a black box recently. The May selloff in stocks did not deter him on China. Also, it’s worth noting that he moved ahead with the Mexico tariff threat after US equities plunged more than 6%. Contrary to some narratives, Trump did not suspend the planned duties on Mexico to placate stocks. In fact, US equities were riding a massive four-day surge when he announced the “agreement” with Mexican officials.

Good luck drawing any conclusions from that. Trump’s decision calculus no longer seems amenable to analysis based on the idea that he deescalates things when stocks fall and vice versa. Recently, it’s been the opposite of that. That’s why recession may now be the only circuit breaker.

Kocic underscores this. “At the moment, the market is not fully convinced about the existence of near-term circuit breakers in the political channel”, he says, adding that while “there is an open communication channel between the markets and the Fed – the two are fully adaptive, both relative to each other and relative to politics, politics remains non-adaptive – the information flows from politics to the Fed and markets, but does not flow back.”

Hence my contention that Trump is becoming more of a black box. Things are going in, but what comes out (policy) no longer has any immediately discernible (let alone logical) connection to the original inputs. “This is making the markets nervous”, Kocic flatly notes.

And this is where the Fed is expected to step in. To wit, from Aleks:

In the absence of conviction about the existence of political circuit breakers, the market is coopting the Fed to complete the market and offset any rationality gaps and finance potential deficits of economic rationality. The dilemma that defines the current structural instability is the tension between the desire to co-opt monetary policy to complete the markets and the Fed’s resistance towards its exaptation the effort to drag the Fed into the policy mix and change or augment its role to subsidize the markets subjected to the side-effects of politics. Effectively, the Fed is expected to finance a potential supply of short-term protection (e.g. a lower deductibility S&P put) with long dated (OTM) put on its credibility; this is a position of increasing liability for them and is logical to expect some kind of contestation.

The problem is that while contesting exaptation is, in the current context, highly desirable to the extent it means the central bank is pushing back on being made a permanent fixture of the policy mix/political decision calculus, politics has become so unpredictable and markets so keen on the Fed financing Trump’s assumed rationality deficits, that even a slight pushback means delivering what, relative to market pricing anyway, will look like a huge hawkish surprise.

That, in turn, could lead to a large selloff.

If Trump is no longer responding to selloffs and/or is inclined to view hawkish surprises as an affront to his dignity (and akin to treason), he might well resort to punishing the Fed by doubling down on tariffs (i.e, taking the US economy hostage – “Cut rates, Jay, and nobody gets hurt”).

We’re all in a real pickle, aren’t we?