February 18, 2025 | For long-time readers of The Institutional Risk Analyst, hearing that the Federal Open Market Committee is uncertain about the direction of inflation or the US economy is no surprise. Even though FOMC members have managed to travel to warmer climates to express their carefully considered views of monetary policy, their assessments remains frosty regarding the prospect for near-term interest rate cuts. Meanwhile, residential mortgage rates are over 7% and default rates are rising across asset classes.
The cautious Fed view is informed by data as well as partisan politics inside Washington. The Fed is the most political institution of all. Nothing better illustrates that dimension of the central bank than the discovery of the secret FOMC minutes in 1993 by our friend Rep. Henry B. Gonzalez, Chairman of the House Banking Committee. As we note in the upcoming second edition of “Inflated: Money, Debt and the American Dream,” the Fed chair must be above all political:
"The FOMC minutes that contain the discussion of the S&L bailout and many other topics remained secret for two more decades, until the author reported their existence in the Wires Washington news service in October 1993. Greenspan was almost forced to reveal the existence of the minutes under oath, but was saved by the gavel of Chairman Gonzalez in one of the greatest public crises to ever threaten the central bank. I wrote in the Christian Science Monitor about the congressional hearing with Fed Chairman Alan Greenspan to discuss the minutes:
After last week’s congressional hearing, Greenspan was overheard telling one Fed bank official that, had Roth been allowed to ask another question (he was cut off by a punctual Gonzalez gavel), he might have been compelled to reveal the existence of an entire set of secret written transcripts. Dr. [Anna] Schwartz likewise says, ‘Gonzalez cut Roth off from asking a further question.’ Whatever Greenspan’s reasons for not addressing the issue, the ambiguous result of the Oct. 19 hearing makes it clear that neither Congress nor Gonzalez will soon drop the subject of Fed reform. Roth was shaken by the hearing and warned that the Fed soon must accept the political and practical necessity of releasing more information about the FOMC’s deliberations.
Today none of the questions asked of the Fed Chairman by the Big Media elicit particular concern. The media does not know what to ask. Indeed, since the election of President Donald Trump, the FOMC has been in a state of disarray and confusion, both with respect to the Fed’s legal mandate and the impact of the Trump Administration’s actions on the inflation outlook and financial markets.
In basic terms, the FOMC has pivoted from a positive view of inflation, to a posture of cautious pessimism driven largely by what the Trump Administration may or may not do in coming weeks and months on tariffs and other policies. Rising equity market valuations are now apparently part of the monetary policy analysis as well.
Fed Governor Michelle Bowman noted Monday that the Fed's recent progress on inflation may have been hampered by rising asset prices. We might offer that asset prices have been rising because of the enormous amount of liquidity that remains in the US financial system, liquidity that the FOMC has been unwilling or unable to remove. The uptick in consumer prices shows how increases in food and other areas continue to reverberate through the economy.
“Having entered a new phase in the process of moving the federal funds rate toward a more neutral policy stance, there are a few considerations that lead me to prefer a cautious and gradual approach,” Bowman opined at an ABA event in sunny Phoenix. “Given the current policy stance, I think that easier financial conditions from higher equity prices over the past year may have slowed progress on disinflation.”
Linking the movement in equity prices and the inflation outlook is a novel construction for an FOMC member, but hardly the most notable. Strictly speaking, changes in bank reserves should not impact stocks, but the shrinkage of the Fed’s balance sheet also shrinks bank deposits 1:1. More to the point, do you think Governor Bowman and other FOMC members understand that the post-election equity market rally that greeted Donald Trump may be over?
"A strong signal of stock market downside risk is when hedge funds are going short yet retail money is still pouring in," writes Simon White of Blooomberg. "That's the case today... The market has overcome recent shocks such as DeepSeek and tariffs to sit near all time highs, yet stocks face a widening gulf of risks."
Many FOMC members have pivoted to super hawk status even as equity markets and other speculative endeavors such as dealing in crypto tokens show signs of exhaustion. Dallas Fed President Lori Logan, intellectual author of the big Fed balance sheet, had been calling on the Committee to slow the pace of shrinking the Fed’s balance sheet. Now, however, she’s saying that further contraction is in order for the balance sheet. The chart below from FRED shows the Fed balance sheet and the S&P 500.
“Even if we do get better data — and it does look like it’s coming close to 2% — I think we should be cautious,” Logan said Friday during a moderated discussion in balmy Palm Desert, California. “Because if the labor market and the overall economy is strong, even in that environment, it doesn’t necessarily mean there’s room to cut rates further.”
“What if inflation comes in close to 2% in coming months?” Logan asked earlier in prepared remarks for an event in lovely Mexico City. “While that would be good news, it wouldn’t necessarily allow the FOMC to cut rates soon, in my view.” The data dependent FOMC now seems to be increasingly prone to fine tuning, but is the caution regarding inflation really about monetary policy or politics?
Federal Reserve Governor Christopher Waller says recent “disappointing” economic data support keeping interest rates on hold, but if inflation behaves as it did in 2024, policymakers can get back to cutting “at some point this year.” In remarks to be delivered in Sydney, Waller basically allows for a wide range of possibilities and outcomes. So much for being data dependent.
Behind the scenes, however, Fed governors are worried about a lot more than monetary policy. As we’ve noted in past comments, President Trump signed Executive Order 12866 in his first term, which essentially updates a Bill Clinton era budget initiative that requires all executive agencies to “report up” to the White House and the Office of Management & Budget in the absence of specific instructions from Congress.
“So, it was an open question what Executive Order 12866’s status would be during a second Trump administration, notes the Center for Progressive Reform. “For now, it seems like Trump intends to retain it. If so, we can expect more haphazard reviews and slapdash cost-benefit analyses. In the future, though, it is possible Trump may replace Executive Order 12866 with a new centralized regime that is more amenable to deregulation.”
Everything that the Fed does outside of monetary policy, from Basel to payments to cooperation with international organizations, is now subject to review by the Executive Branch. If DOGE wants to propose privatization of the FedNow payments platform, for example, there is nothing that Chairman Jerome Powell and the other governors can say about it. Congress never specifically authorized FedNow and the over $550 million spent to date launching this redundant payments platform.
While Fed governors ponder the impact of seasonal factors on inflation, the Trump Administration is working on a deregulatory agenda that may surprise many Fed watchers and related media. It is entirely possible that the updates to the Basel bank capital framework, for example, which is not explicitly authorized by Congress, will not happen at all. Once the Trump Administration passes its tax and spending legislation through Congress, and gains approval of new agency heads at FDIC and OCC, the focus will move to deregulation and deconstructing the administrative state.
So when JPMorgan (JPM) declined to provide confidential client data to federal regulators interested in credit exposure from buyout firms, Jamie Dimon showed that the times they are a changing. The rule mandating increased disclosure on credit exposure to nonbank firms was inserted into the bank reporting taxonomy late in the Biden Administration, but the Trump White House will ignore it. And there is nothing that the Fed can do about it. Other banks will figure this out in good time.
“JPMorgan Chase has dealt a blow to regulators’ efforts to understand the depth of ties between banks, buyout firms and the fast-growing private credit sector,” reports Stephen Gandel in the FT. “declining to disclose its lending in an area of increasing systemic concern.”
Is bank exposure to nonbanks and buyouts a legitimate credit concern? Oh yeah. The whole landscape of buyout loans and private equity is a cesspool with a significant blockage on the outbound end in terms of IPOs. So while President Trump will pursue removing the special tax treatment for carried interest for private equity funds, he’ll ignore hundreds of billions in losses in private equity portfolios. And there is nothing that the Fed can do about it, especially with Trump appointees at the other agencies.
“You can only wonder about how Private Equity-affiliated insurers are valuing their Private Credit portfolios, especially as many underlying corporate borrowers are defaulting in silence and without penalty,” observes uber risk manager Nom de Plumber this week. “This comes under Payment-in-Kind provisions, by adding past-due interest and principal payments to outstanding principal. Extend and pretend. Mark down as late as possible, to earn as much fees for as long as possible.”
We’re not sure that the changed regulatory environment will necessarily help valuations for financials over the next four years, but it will certainly help earnings to reduce operating expenses and aggravation from dealing with federal regulators. So Powell has told Congress that the Basel III Endgame proposal will be re-proposed as soon as possible, but he has not given given a specific date.
Maybe Powell will get a chance to discuss Basel III with Kevin Hassett, a key economic adviser to President Donald Trump, who said this week that he will hold regular lunch meetings with Fed Chair Jerome Powell. In the future, the Fed will be compelled to “report up” to the Treasury and White House on bank bank supervision, market structure and many other matters. Kevin Hassert is now effectively Powell’s boss on everything other than monetary policy. Welcome to the world.
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