The Crisis In Monetary Policy: It Doesn't Matter That Much | Mark Dow

The Federal Reserve does not control the quantity of money; chartered banks and shadow banks create the bulk of money supply. Banks can create money by lending without requiring reserves, only needing to stay within capital and liquidity ratios. The Fed only controls reserves in the settlement system.

“the bulk of the money in our system is issued by chartered Banks and and Shadow Banks they're the ones who create the bulk of the money right uh and you don't need reserves to you don't need reserves to lend you know the mechanism a bank says I want to lend to Jack and they lend you at the same time they credit your your deposit account with funds the same amount right they've just created money they didn't need reserves to do that”

The yield curve inversion was not a reliable signal of recession in the modern financial system because maturity transformation has changed: via swaps and derivatives, a bank can borrow and lend at the same maturity (e.g., both at the 10-year point), eliminating classic interest-rate-risk from inverted curves.

“the yield inverted yield curve wasn't a good a good signal or at least a trustworthy signal now with through swaps markets and maturity transformation with derivatives you can lend at the 10-year Mark and you can borrow the fund that lending at the 10-year Mark so you're it's not like you're borrowing short to lend long”

The distinction between Fed as liquidity provider (market-making) vs Fed as lender (financial rescue) is crucial: March 2020 was liquidity provision (circuit-breaker), not a bailout, because the Fed was just providing the elasticity the market needed to clear, not rescuing insolvent actors.

“I wouldn't use the word bail it out because I think they just they just provided liquidity so that the market could start to clear on its own...their mindset is not to bail out anybody their mindset is to ensure that the markets can work”

A central bank's job is to keep long-term inflation expectations anchored and signaling that they're aware of inflation, not to prevent all inflation. If the shock is supply-side (ports, semiconductors), no amount of Fed tightening stops the initial inflation; the Fed's job is credibility maintenance.

“what can the Central Bank do though keep long-term inflation expectations in check let people know that you're on it and as soon as you work through these these transitory proms or whatever whatever name you want to put on them right you know what these short-term issues that are causing inflation in this case the supply side falling apart once we put that back together your inflation is going to be low again”

Hyman Minsky's financial instability hypothesis states that stability breeds instability: 'you can lead a banker to liquidity but you can't make them lend'—a banker with a bad balance sheet won't lend at any rate, and only late in the cycle when they're optimistic will they lend aggressively.

“Heyman Minsky who I'm sure you've heard of also has a thesis that it's called the financial instability and stability hypothesis and basically it means stability breeds instability when you can lead a banker to liquidity but you can't make them land that's the problem”

The JP Morgan quote 'nothing so undermines a man's financial judgment as seeing his neighbor get rich' explains why lenders are willing to lend at lower rates during booms—it's not about the rate level but about fear of missing out and competitive pressure.

“the quote I always cite is that one from JP Morgan the famous Banker uh who said nothing so undermines a man's Financial judgment as seeing his neighbor get rich”

Japan has higher debt-to-GDP (higher than US), zero inflation problem, and no crisis despite this high debt, proving that high debt levels alone don't force either inflation or crisis if you're the reserve currency.

“Japan has a much higher debt ratio than we do and they don't have any problems we're the center of the universe and we just don't have any problems issuing our debt it just hasn't been a problem”

The 2000 tech bubble had the highest valuations in Mark's lifetime with Fed funds at 5% and 10-year at 7%, and the 2008 financial crisis featured the highest quantity and worst quality of mortgages during the three preceding years when Fed funds was at 5% average, yet we call the Fed rates 'easy' in hindsight.

“if you look back just to start off at 2000 the biggest bubble in my lifetime with the highest valuations going into it fed funds was at 5% and the 10e was at 7%”

People overestimate their own rationality and this self-serving bias leads to overstatement of rational factors (like monetary policy precision) and underestimation of irrational factors (like FOMO). This bias is stronger for finance professionals who have incentives to believe markets are mechanistic.

“uh we always over I mean it gets back to overestimating how rational we are and some of that is kind of self-serving for us because we're in markets we want to think we're smart we want to think you know that we're the the master of the universe there's there's that you know conceit we don't want to say oh we're just monkeys uh flipping coins”

March 2020 treasury market crisis was not just a supply-demand imbalance but was exacerbated by structural issues: hedge funds in basis trades (long bonds, short futures) who had no obligation to maintain market-making, unlike Treasury-dealer-affiliated banks.

“the hedge funds uh in basis trades yes that that made it even worse so it was exacerbated by that push triggering stops on a on on a lot of these trades”

Leverage (29x at Lehman leading to 2008) is a key cyclical factor: if you come into a recession without extreme leverage and with good balance sheets, recession risk is low even with monetary tightening; if you're extended and on margin, even a 2% stock market decline triggers forced liquidations.

“so if you're not that far out over your skis if you're not on margin when the when when the economy when when the stock market tanks 2% you're not worried but if you're margined up to the hillt you're going to say oh geez I better liquidate something right”

QE1, 2, and 3 all happened while long-term interest rates were RISING, not falling, contradicting the core theory that QE should drive rates down. The placebo effect (psychological perception that QE is stimulative) may have changed economic expectations (making rates rise), but that's psychology not mechanics.

“as we know when qe1 2 and three we saw those when those happened yields were going higher not lower why because the it changed because the placebo effect changed economic expectations”

Convexity burnout in mortgages (repeated refinancing during low-rate periods) meant there were fewer mortgages left to refinance when rates eventually fell again, reducing the leverage effect of rate declines on housing demand.

“it's called convexity burnout in the mortgage Market when you've been up and down in that area so long that there no mortgages left to refy when the rates when the rates go lower”

Technical analysis reveals other traders' beliefs and psychological biases through chart patterns (resistance levels, head-and-shoulders, breakouts) that repeat because human behavior repeats, not because of mechanical price action.

“you see repeated behaviors uh and it's it's not like yeah you just see patterns you say okay I see this like the gold pattern recently I said this gold pattern's going to break higher it's going to break sharply higher because it had built up a lot of pressure at a resistance resistance level that it had run into several several times”

Spread cycles are driven by behavioral shifts, not supply: cycles begin with wide spreads and people unwilling to lend; cycles end with tight spreads and everyone wanting to lend. This shift from unwilling to willing can't happen unless driven by something other than price (rate level), proving behavior dominates price.

“you can see this too in the way people take risk like I was saying it makes sense why people would borrow more when want to borrow more when when other things equal when interest rates are low but why would people lend more would you look back at every single cycle has this characteristic it starts with wides spreads and people not wanting to lend you know higher rates uh typically High spreads people not wanting to lend and it ends with much tighter uh spreads and everybody wanting to lend why does that happen that can't happen unless the process is driven by something much more more important than price”

People confuse Fed policy stance with the outcome Fed was responding to: the Fed raised rates because the economy was overheating, so one might conclude 'loose policy caused overheating.' But this confuses cause and effect—the overheating came from supply shocks and fiscal stimulus, and the Fed was correctly tightening in response.

“what if it it is that the reason interest rates the Federal Reserve had to raise interest rates was because the economy was too hot and the stock Market was too hot and that what caused the interest rates to go up is that they were too loose”

QE doesn't work as a stimulus because it just swaps one government liability (bonds) for another (deposits/reserves) at roughly equal interest rates; this swap doesn't induce anyone to change their 60/40 allocation because the swap itself changes nothing fundamental about their opportunity set.

“the government is just giving you one liability in exchange for another in your fixed income portfolio that's not going to make you go out and change your allocation between fixed income and and uh and and stocks right if you instead of holding a t- bill you hold a government deposit with roughly the same interest rate just to make it simple right you still got your 6040 you're not going to change it to to 7030 because of that right”

Gold's recent rise is driven by diversification fear (weaponization of dollar) not by inflation expectations or debt fears; the correlation between gold and real rates broke down months ahead of the Russian invasion when state actors began diversifying.

“it broke down a few months ahead of I'm going to say four five six months ahead of um uh the r the Russian invasion why Russia wanted to diversify to the extent they could”

The critical distinction between monetary policy for plumbing (settlement liquidity in crisis) vs monetary policy for stimulus (economic growth) must be preserved; evidence shows QE/QT have near-zero stimulus effect but solve real plumbing problems.

“I should make this distinction Jack it's really important um because I kind of say things very forcefully it's easy to to think I don't think monetary policy matters at all or whatever but there's an important distinction between monetary so QE or balance sheet size or monetary policy for the plumbing and monetary policy for economic stimulus”

Monetary policy matters less than people think because it gets swamped by other factors like behavioral/animal spirits, fear, greed, and economic expectations, particularly in a globalized financial system with shadow banking.

“I was one of the ones as you know said that monetary policy matters less than we think it does it's not that it doesn't matter but it tends to get get swamped by other factors”

Behavioral macro framework analyzes markets through narratives, risk structure, and revealed preferences rather than economic theory, because actual behavior is narrative-driven (what people believe about the future), not theory-consistent.

“I have my behav my whole behavioral macro set up to help guys trade thinking in terms of narratives thinking in terms of of risk structure thinking in terms of revealed uh preferences rather than uh economic theory”

Risk management is more important than fundamental correctness for trading success; being right on thesis but wrong on timing/leverage can wipe you out, whereas being wrong on thesis but right on stops can leave you profitable.

“you can be a good Trader without knowing much about the fundamentals uh but you can't be a good Trader if you don't know much about risk management uh and it's not about a lot of people say well I'll just be right on the thesis that doesn't you you need strategies to protect you from yourself”

If the Fed is buying bonds and primary dealers receive the cash, those dealers are institutional investors (banks, asset managers) with mandates that don't include buying equities like Nvidia; thus they use the cash to buy other fixed-income assets, creating a flow within fixed income but not from fixed income to equities.

“like I said these guys aren't going to be buying equities right so they might buy they they might say okay well I sold my bonds going to replace them with another Bond somewhere else on the curve or maybe a mortgage Bond or maybe a high-grade bond but the guys from whom the FED is buying don't have it in their mandate to buy uh Nvidia or Tesla right so it's not like people have this idea that they're they're pumping money into the financial system and they're pumping money into the settlement system a very different animal”

Initial conditions (balance sheet health, employment, consumer savings) matter far more than monetary policy for determining whether a rate increase causes a recession; because households and corporations had strong balance sheets and fiscal support had bolstered savings going into 2022, the Fed's 500bp rate increase did not cause a recession despite hitting the tightest financial conditions in years.

“the major lesson people should take I think uh from this cycle if you want to call it that for me we're in a new cycle the old cycle ended in October 2022 the the rist rist cycle but the lesson we should take away from that is the importance of initial conditions to the transmission mechanism of monetary policy people just said oh three out of the last four recessions this happened or and they start talking about historical it doesn't matter what matters is what is your state going in right and in this particular case uh the private sector the financial you know the both house households corporations and and and the financial sector were in good shape so to get back to one La last little thing is um you can see this too in the way people take risk”

The pandemic created a massive sectoral reallocation: incomes were maintained through fiscal support but people couldn't consume services, so everything went into goods, creating inventory backlogs that took years to clear; the statistical system overweighted these goods indicators because it's geared to the old manufacturing-heavy economy, causing people to overestimate recession probability.

“covid basically shut down Services right so as we know incomes were maintained and it all went into Goods we couldn't go to the go to restaurants we couldn't travel we couldn't you know go to the movies whatever whatever it is we couldn't do those things so we had a big surge in manufacturing and there was a backlog and then because supply of that got curtailed too and then everyone scrambled to ramp up their production of of goods and we all of a sudden we had an inventory glut right so as Services were coming back we were developing an inventory glut on the good side so these just massive sectoral swings now our statistical system is geared towards the old economy we used to have that was much more manufacturing heavy so people were looking at the indicators coming across the transom and they were saying you know oh and they were overstating the I'm not saying they were wrong I'm yeah they were wrong but they understandable that they say oh the probability of recession is increasing but they were getting carried away with what the pro the the absolute level of probability was because they were missing the point that this was only capturing uh one part of the economy”

The GFC recovery was slower than the COVID recovery because the GFC relied entirely on monetary stimulus (weak) without adequate fiscal support, while COVID had both (strong). This historical comparison proves fiscal is the powerful tool, not monetary.

“we can lead a banker to liquidity but you can't make them land do you also think that in the great financial crisis there were pipes over which the Federal Reserve did not have control like asset back commercial paper Market or something something like that CDO Market or the liore market the the euro dollar market whereas now much more of that because of the size of the fed's balance sheet but also because of uh Sofer has replaced liore”

Fiscal stimulus in response to the COVID shock filled a 'hole' in aggregate income, which prevented hysteresis (permanent loss of productive capacity). Overfilling the hole slightly (creating 1-2% extra inflation per year) was worth the cost of preventing permanent supply-side damage.

“I always think of long-term income growth is kind of a line that's that gently slopes upwards right when you get one of these shocks it's like you have a big u a big dent in that line big downward dent and fiscal policy is designed to fill that hole”

For distressed companies with highly uncertain cash flows, the discount rate (Fed policy) doesn't matter at all; you only care about binary 'will they survive' questions. This proves the finance principle: discount rate relevance is inversely proportional to cash flow uncertainty.

“take the Other Extreme a distressed company you buy a distressed company you don't care what the discount the fed the 10year FED uh you know 10y year treasury rate is all you care about are they going to make it”

The post hoc ergo propter hoc fallacy is rampant in financial analysis: people observe 'this happened and then that happened' and conclude 'this caused that' without considering alternative causes, particularly with QE where timing is confounded with other economic factors.

“we have we have a lot of that thinking and I think there's a lot of that thinking in QE U that Q QE as well but there's just a lot of thinking that leads that that we we convince ourselves that we're much more rational uh than we are”