As I write this, the price of Crude Oil is down roughly 50% from its 2014 peak of $107.60, made exactly 6 months ago in June. It is currently the biggest single issue in the financial world, with economists and pundits debating the consequences of every tick lower. There are a few major themes being discussed – the possible reversal of fortune for countries such as Russia, Venezuela, and to a lesser extent Canada and the much talked about US oil boom. There is also some optimism that a lower oil price will lead to lower energy costs which in turn will boost the spending power of the average consumer, which in turn will increase spending and economic growth. These issues, while significant, ultimately pale in comparison to the larger issue of underlying monetary conditions, potentially burst bubbles, and contagion. The true impact of the rapid decline in oil will not be known for another few months or even longer, as the inner workings do take time to play out, but the implications aren’t great. (more…)
It is difficult to get a man to understand something, when his salary depends on his not understanding it.
The mainstream economic landscape has been predictable in its denouncement of the Swiss Referendum on gold which will take place on November 30. By far, the most spirited denouncement comes from Willem Buiter of Citi, who penned a ten page note dedicated to reducing gold to merely a 6,000 year bubble (and being equally unkind to Bitcoin). Financial Times writer Izabella Kaminska alerted me to this note in one of her recent posts. Kaminska and Buiter both sing from the same hymn sheet, and while the music written on that sheet is closer to Rebecca Black – Friday than Verdi’s La Donna e Mobile, it is treated with the reverence normally reserved for works on the level of the latter. I will delve into why that is, but before that I would like to briefly look at Kaminska’s post, in which she lays out the ‘compelling’ points Buiter makes, along with her supplementary comments. Buiter’s points fall under three, tired critiques of gold – Gold is a Barbarous Relic, Gold has No Intrinsic Value, and Gold is too volatile to Function as Money. I will address each critique in turn. (more…)
The trading landscape has been nothing short of incredible over the last month, particularly the last 20 trading days. The S&P 500 has gone from 10% correction to new all time highs in the blink of an eye. When I last wrote, on 9 October, the market was in the midst of falling, but had been rescued by a bullish interpretation of the Federal Reserve minutes released the day before. I had speculated that the massive rally was a fake rally, and that the market would eventually go lower, to about 1900. The market went there, and beyond, in short order, breaking 1900 on the futures and going all the way as low as 1813. Even though I had been looking for such a move to occur, I had thought it would be more protracted, taking until the end of the year to play out.
The ferocity of the move was surprising, and more importantly, it created a condition in which momentum indicators were screaming oversold. Thus the stage for the violent rally which took place over the second half of the month. The ease with which 1900 on the futures was overtaken from the downside was a first clue that the bears were not so strong. Then 1920-30 and 1970-80 fell, which meant that a test of the all time high of 2014 was on the cards. That was breached yesterday, confirming that indeed the bull market that has been in place for upwards of 5 years is still on.
The Federal Reserve confirmed on Wednesday that it will allow the QE program to end, finishing the last round of ‘tapering.’ I remain of the view that this development is a negative for the market going forward. This doesn’t preclude prices from rising higher – in the 9 October post I posted the following chart of the S&P 500 when the last rounds of QE ended:
The white circles represent the days that the previous QE programs ended. In each case, the market went higher immediately following the ending of QE, by roughly 5% and 3% respectively. What followed that in each case was a ~20% correction.
The reason for this is that QE is a relative tightening of monetary policy. Consider the following diagaram:
From right to left are the various actions the Federal Reserve could take to affect the economy, from loose to tight policy. On this continuum, QE was the at the easiest end of the scale. In ending QE, the Federal Reserve has now shifted to the next step, titled ‘lowering short term rates via gov’t bond purchases.’ Given rates are already at 0, this shift is effectively Neutral Policy. However, it is less easy than QE, so it does represent a relative tightening.
Many commentators do not recognize this, and only believe that we enter the realm of relative tightening when we go one step further on the continuum, to the rate normalization phase, the last occurrence of which took place in 2004-2006. In that sense, they understand that the rate normalization period could have a negative impact on prices, as the explicit withdrawal of money from the system means there is less money coming into bid up prices.
However, the same impact is had when, as you go from QE to no QE, there is relatively less money coming in than before. Said differently, if you start with a base of 100, and add 50, then 25, then 10, then 5, then 0, each addition will have a less impact on the total figure than the prior round. When starting with 100, adding 50 was a boost of 50%. Adding 25 to the increased figure of 150 represents only a boost of 16%, and so forth down the line. This, in essence is what has happened with the tapering process. Its ultimate effect will not take place immediately, but it is inevitable that without the increased impact of QE, prices will fall significantly.
At the end of the day, this is the ‘fundamental’ that matters the most, trumping most traditional data points such as earnings. That is the reality of a market that lives and dies on the whims of central bankers.
In that vein, the early hours of Halloween, the BOJ came out with an announcement that they would increase their QE program. On a larger level, this presents an interesting situation in which the Federal Reserve is ending QE (for the time being), while the BOJ and ECB are moving in the opposite direction on the policy continuum. The yen took a massive plunge, as shown in the following USDJPY charts, the first showing the action over hte last year, and the second showing the action over the last 10.
The longer term chart suggests that 123 is on the cards, which is still miles away from its current levels at over 112. With the BOJ hell bent on destroying the value of the yen, shorting it against all pairs seems to be the no brainer trade of the next few months. Tread carefully of course. Until next time.
The trend is your friend, until it ends…
The entrance of fall has seemingly brought with it a shift in the financial landscape. Mario Draghi looks ready to bring QE to Europe. Bill Gross has left PIMCO. The low volatility of summer has been replaced by a more volatile early fall, and the resulting price declines have sparked a bit of a concern. This concern is healthy, given the lengthy run up in asset prices over the last 5.5 years, and especially the last 2 years. No one rings a bell at the top, which is why it is important to be on the lookout for the early, technical signs.
S&P 500 Futures
The following is a chart of the S&P 500 futures since summer of 2011. (as with all charts, click for a larger view)
This timeframe encompasses the lows from 2011, just after the US government debt downgrade fiasco, until now. As you can see, it’s been a one way street. 3 years and over 80% appreciation later, and the trend is seriously being threatened for the first time, as seen in the action in the upper right of the chart. The following is a closer look at that more recent action:
What we have here is a daily chart going back over roughly the last 12 months of trading, with some horizontal price levels which I believe are important. Prices have been fliriting with breaking the red terndline over the last few days, and yesterday in particular was interesting. The release of the FOMC minutes from the last meeting in late September sparked a violent afternoon rally. As impressive as that was, it has yet to break the lower moving momentum which has been in place since the September 22 high at 2014. The following chart provides a closer look over the last few weeks of action:
Yesterday’s rally is a relief rally until proven otherwise. That proof would be a break of the 1970-1980 area to the upside. Until then, the sellers are in charge of this market, with how much lower they can drive things a mystery. Referring to the prior chart, the yellow horizontal lines are ‘lines in the sand’ where opportunities will present themselves. Assuming the 1970 area holds on the upside and the market is driven lower, 1900 is the first such level, and a move there would almost certainly be supported. On a very short term basis, the market would be plenty oversold, having come down from 2014. Panic would probably ensue for a few hours, especially if it happens in one day or two. But it would be a good place to bottom pick for a move back towards 1980 again.
It would however, also represent a clear break of the red trend line. It remains to be seen whether this break would be the beginning of a full on bear market, as in fall 2007 or merely a big correction, as in 2010 and in 2011. In either case, a relief rally following a break of the red trendline isn’t out of order. Below 1900 is a bit more interesting, but we’ll cross that bridge if we come to it.
Russell 2000, Social Media, Homebuilders
While the S&P 500 has only begun looking sketchy over the last month or two, other equity markets and certain sectors have been struggling for much longer. The Russell 2000 chart looks much worse than the S&P 500, which paints a darker picture from an economy point of view, given that the Russell 2000 is full of smaller cap, more domestic companies which are US facing, versus the multinationals that populate the S&P500:
The Russell 2000 has definitively broken it’s 3 year trendline and is definitively making a series of lower highs and lower lows. The following is a closer view.
On a strictly technical basis, the double top at 1219 serves as sort of a head, with the two touches of the yellow line at 1180 either side of the double top serving as shoulders. If this pattern plays out, it’s resting place would be between the 940-960 area which I’ve also drawn.
The fundamental story for the price rises in stocks since 2011 has been the bouncing back of the housing market, as well as the advances made by technology companies, particularly social media related companies. These two sectors have basically led the market up. The following two charts are two ETFs, the S&P Homebuilders ETF (XHB), and a Social Media ETF (SOCL).
Both charts show the action over the last two years, and both have seemingly run its course.
The divergence between the Russell, Homebuilders, social media and the S&P is interesting to note, with the former three being down 5.7%, 10.6% and 9.06% for the year respectively, while the latter is still up 6.5% for the year. In what could be one of those historical markers people discuss for years to come, the largest IPO of all time, Alibaba, came to market on, what is at this point, the high print of the market. This sort of divergence and individual sector weakness does not mean the larger indices will go lower tomorrow, it merely means that the pieces are starting to align themselves. Unless the market finds a new leader, or the Fed stops tapering, and reverses course, the S&P 500 will ultimately go lower.
US Dollar Strength
The other major story line in recent weeks has been the strength of the US dollar. To maintain some perspective on the recent moves, here is the view of the dollar index over the last 20 years:
The dollar is strong relative to the lows in early 2008, which had been flirted with in 2011. Having failed to make new lows, the dollar has been steadily increasing since and looks primed to reach the 92.5 level highlighted on the chart. Given this is still miles away from the highs at 120 and above from the early part of the century, it isn’t quite accurate to label the dollar as ‘strong,’ particularly when this strength is predicated on the weakness of other currencies it is compared to.
The rise in the dollar has been explained as a reaction to the tapering of QE by the Federal Reserve, a process that is scheduled to end within the month. This will mark the third time the Federal Reserve has ended QE programs, the prior two coming in 2010 and 2011. The following chart is of the S&P 500, over a time frame encompassing the ends of both QE programs.
The two white circles are the days when the QE programs officially ended. What followed both times was a slight price increase and then a sharp declines of roughly 20% each time. Fundamentally this makes sense, as in order for prices to keep rising continually, more monetary injections are also needed. Ending QE ends the impetus for price rises. The same thing is slated to happen now, which perhaps more than anything else explains the bumpy nature of prices over the last few weeks.
All that said, the S&P 500 is less than 3% from all time highs, with yesterday’s action being the best day of the entire year. While signs are emerging that the bull market is struggling, the facts are the facts. The most one can say as a longer term holder of stocks (which I’m not, I trade short term only), is that now is not the time to initiate new positions, but to monitor your portfolio and taking note of stocks which are under performing. Reassess at 1900, and doubly reassess when the Fed ends QE.
‘I see the problem of recovery in the following light: How soon will normal business enterprise come to the rescue? On what scale, by which expedients, and for how long is abnormal government expenditure advisable in in the meantime?’
John Maynard Keynes, New York Times, 1934
In 2009, then Federal Reserve Chairman Ben Bernanke outlined the ‘exit strategy,’ the steps which the bank could take to reverse its response to the Financial Crisis and subsequent Great Recession. Several measures were described with which the Fed could use to ‘tighten monetary policy when the economic outlook requires us to do so.’ Since then Fed began its systematic reduction of its latest easing program last fall, a process colloquially termed as ‘tapering,’ the discussion about the appropriateness of continuing further to normalize monetary policy has intensified. Some argue that the current economic expansion is evidence that the time is right, while others point out that the absence of significant consumer price and wage inflation dictate that not only is a complete exit premature, but so too is a shift towards the exit, which is what tapering represents.
What is nearly universally agreed upon is the idea that at some point the Fed has to exit. Sure, now might not be the right time, but a right time definitely exists, and the Fed will act accordingly when that time comes. Unfortunately, adherents of this view have been, unbeknownst to them, applying the Underpants Gnome business model to economics. For anyone unaware, the underpants gnomes were characters from an early South Park episode. Long story short, their claim to fame was their absurd presentation of their business model, which was the following three step plan:
- Collect Underpants
(Incidentally, had the underpants gnomes prepared their plan in prospectus format, I have no doubt they would have been able to go public at some point in the last three years, complete with multibillion dollar valuation, financial television fanfare, and photo ops at the NYSE, such has been the current financial climate and the intensity of the ‘chase for yield’)
The plan as applied to economics, or, the Underpants Gnome Economic Plan (UGEP), is basically the playbook the Federal Reserve follows when economic downturns present themselves. It is the following:
- Ease monetary conditions
- Demand for consumption and investment goods is restored, thereby restoring Economic Growth
- Growth feeds upon itself in a virtuous cycle
This playbook is heavily influenced by Keynes. As such, the vast majority of economic observers have by this point raised an eyebrow at the fact a comparison is being made between the foolishness of the Underpants Gnomes and the apparent time tested wisdom of Keynes. Indeed, there is even a tangible step 2 in the ‘Keynes’ version of the plan, so what gives? What gives is that most commentators are guilty of celebrating at halftime. After taking the events triggered by each step to logical conclusions over time it is becomes clear that this new step 2 is just as full of question marks as the South Park counterpart.
Step 1 – Ease Monetary Conditions
An interesting thing happened in late June/early July 2014. The Bank of International Settlements published its annual report which outlined its view that the actions taken by major central banks – including the Fed – are fraught with risks and the situation must be addressed. This is of interest only because of the source of the argument, not necessarily the argument itself. The BIS aligned itself with the Austrians, who until now had been the loudest proponents of this view. Perhaps it was merely a case of playing devil’s advocate, but the BIS paper did represent a clear split from the mainstream view from an entity very much in the mainstream camp. Janet Yellen, the current Fed chairman, essentially presented a defense of the Fed’s, and indeed the mainstream view, in a speech given a few days later at the IMF. At one point during the speech, she briefly commented on the role accommodative monetary policy has played in the recovery, stating:
In recent years, accommodative monetary policy has contributed to low interest rates, a flat yield curve, improved financial conditions more broadly, and a stronger labor market. These effects have contributed to balance sheet repair among households, improved financial conditions among businesses, and hence a strengthening in the health of the financial sector.
The interest rate is ultimately a manifestation of the perceived value of future goods in relation to present goods. All else equal, a collective preference for future goods will result in less consumption in the present, and more savings. This build up in savings is an increase in the supply of funds available for loans. As with any increase in supply, downward pressure is exerted on the price of that good, all else equal. With respect to interest rates, the end result is thus a lowering of the interest rate. Similarly, collective preference for present goods over future goods will eventually result in an increase of the interest rate.
Times of financial crisis are usually characterized by a lack of investment stemming from the diminished supply of loanable funds, which exerts an upward pressure on interest rates. In due course, market forces would address this issue through the higher interest rate incentivizing more saving and lower consumption of present goods. The mainstream, Keynesian view, does not wish to wait for the market to do as it must, because, according to Keyes ‘in the long run we are all dead.’ Meaning the consumer good price declines associated with increased savings and lower consumption in the short term will eventually lead the economy to a place it can’t recover from in the long run.
The Federal Reserve thus acts to bring about lower interest rates and easier financial conditions through its open monetary operations, circumventing the slower market process of increasing savings and the supply of loanable funds. In simply creating money and using it to buy existing government bonds from financial institutions, the Federal Reserve can expand the total supply of loanable funds in those institutions, which in turn serves to lower the interest rate towards whatever rate the Federal Reserve desires (currently zero), thereby making investment more viable in the immediate term.* Thus, the foundation upon which a new economic edifice can be built has been set.
*As an aside, I am fully aware of the fact that, in practice, commercial banks are technically the initiators of the expansion in the supply of loanable funds by making loans, regardless of their deposit level. This fact has been misinterpreted by many commentators as evidence that the Federal Reserve doesn’t really have control over this process and that they are merely passive actors. The reality is that institutions which exceed their required loan to reserve ratio temporarily must rectify that by either selling an asset, or borrowing funds from other institutions – actions that prevent the ability of the system as a whole to increase the supply of loans – unless the Fed is there to provide the extra liquidity needed. For more read the following.
Step 2 – Restoration of Economic Growth via Increased Demand
What is economic growth, and how does the process initiated in step one lead to it? For a brief, yet comprehensive explanation of economic growth and how it manifests itself in society, consider the following from John Hussman, who writes a must read weekly commentary. The full column I reference is here.
The standard of living of a country is measured by the amount of output that individuals are able to consume as a result of their work. The productivity of a country is measured by the amount that individuals are able to produce as a result of their work. Over time, growth in the standard of living is chained to and limited by growth in productivity. Productivity, in turn, rests on two factors: a productive capital base, and an active pool of productive domestic labor. The accumulation of productive factors is what drives long-term growth.
Economic growth is a process, which begins with the accumulation of productive factors (labor and capital), is continued through the act of production and completed with the act of consumption. The only way to achieve growth is to accumulate those factors of production. As mentioned earlier, financial crises are characterized by a lack of investment. Said differently, financial crises are characterized by a failure to accumulate capital and labor for use in productive activity. This is what policymakers seek to rectify when embarking on step one, the easing of financial conditions.
An important feature of the Underpants Gnome Economic Plan is the fact that the increase in loanable funds from the Federal Reserve is immediate, compared with the indeterminate period of time it may take unaltered market forces to solicit more loanable funds via increases in interest rates. Be that as it may, what is not and can never be increased with such promptness is the supply of real, productive factors. For example, at this exact moment in time, there are X tons of steel in existence, available for use in production. One second from now, there may be $X billion of new funds in the financial system courtesy of the Federal Reserve, some of which may be eventually used to fund investments which require the use of steel. In that second however, no new steel had been added to the stock of steel available. In order for more steel to become available, iron ore and other natural inputs must be collected, fashioned in blast furnaces, subjected to various other treatments and so forth. This takes considerably longer than the split second it takes the Federal Reserve to create billions of new dollars. This is important because it means that the only thing that the Fed can actually accomplish when it eases financial conditions is to promote spending on existing factors of production, rather than to promote the accumulation of additional productive factors, which, as Hussman points out, is the driver of long-term growth.
Since the immediate effect of step one is increased economic activity, shown in the increased demand for investment and consumer goods, most observers see little objectionable about it. Paul Krugman, the most visible of the mainstream economists, crystalized this belief in a column written last November, emphasis mine:
This is the kind of environment in which Keynes’s hypothetical policy of burying currency in coalmines and letting the private sector dig it up – or my version, which involves faking a threat from nonexistent space aliens – becomes a good thing; spending is good, and while productive spending is best, unproductive spending is still better than nothing.
Larry [Summers] also indirectly states an important corollary: this isn’t just true of public spending. Private spending that is wholly or partially wasteful is also a good thing, unless it somehow stores up trouble for the future. That last bit is an important qualification. But suppose that U.S. corporations, which are currently sitting on a huge hoard of cash, were somehow to become convinced that it would be a great idea to fit out all their employees as cyborgs, with Google Glass and smart wristwatches everywhere. And suppose that three years later they realized that there wasn’t really much payoff to all that spending. Nonetheless, the resulting investment boom would have given us several years of much higher employment, with no real waste, since the resources employed would otherwise have been idle.
As Yellen described at the IMF, the resulting infusion of cash into the economy from step one, localized in the financial sector, was deployed in various markets, positively affecting those prices. Generally, the process served to increase the supply of loanable funds. The increase in the supply of loanable funds enables more debt to be undertaken to fund investments. This increases the demand for goods and services related to the production process, as well as the securities of the companies involved. A further benefit has been increased demand for the labor required to see out the production process, and the greater demand for consumer goods and services the factors of production exhibit (a construction worker hired will be paid and in turn will use that money to buy consumer goods and services).
The problems present themselves in the longer term. The immediate phenomenon of increased demand for productive factors sparked by eased financial conditions leads to increasing costs of production (more money available for an unchanged stock of productive goods). From the perspective of the producer, this sort of increase in costs cannot be controlled. What can be controlled is the labor cost, the increase of which is kept to a minimum to avoid further gains in overall production costs. To translate: a limited rise, if any, in wages. The overall increase in production costs necessitates increasing prices of finished goods in order to recoup those costs with a profit. To the extent there is demand for those finished goods at an increasing price point is the length to which this step of the UGEP will succeed. The limiting factor is the fact that any wage increases lag behind price increases, eroding the capacity for income earners to spend. This capacity to spend can be ameliorated through debt, but that too is capped by wages. This scenario is illustrated in the following chart of real hourly earnings.
The highest data point on this graph is December 2008, which is when the Federal Reserve began its Quantitative Easing program. Since then real wages have declined, although not precipitously. Nevertheless, a restrained ability to spend does exist, particularly when the task is to spend at higher prices. This limit on demand means that at some point, the higher prices producers require to realize profitability cannot be commanded in the market. This downward pressure on prices leads to lower demands for future investment at the current price levels, which puts the economy back at square one.
Returning to the Krugman quote above, his example of illustrates the point quite nicely. Corporations flooded with cash (easy financial conditions) engaged in plenty of spending on ‘investment goods,’ such as Google Glass and smart wristwatches. If years later, the cost of all of that spending did not produce a positive result, such as increased productivity, the end result has clearly been a waste of resources. The natural resources, time and labor that went into the production of those smartwatches and Google glass could have been used to produce something which added to the stock of goods and services that are desired by us as humans. This would have increased the standard of living of humanity. Instead, nothing of value was produced, nothing was added to society, the standard of living was not improved, but rather reduced, given the potential improvement to the standard of living which was nullified.
According to Krugman and most mainstream commentators, none of that matters. The long run failure is an afterthought compared with the fact that in the short run there was spending. The perverse nature of this isn’t highlighted as much in Krugman’s example, given that on the face of it, the economy is prosperous enough not to feel a great deal of loss of capital in wasted smartphones and Google Glass. But these ideas are what drive policy for the economy as a whole. The result is a systematic destruction in capital, which effectively equates to a systematic decline in the standard of living. As shown below, decades of UGEP implementation across multiple business cycles have left us with progressively slower rates of capital accumulation, and progressively lower business investment as a percentage of the overall economy, ultimately indicating progressively lower increases in the standard of living.
In the long run, this is a step which is doomed to fail.
Step 3 – Growth Feeds on Itself in a Virtuous Cycle
Even though the UGEP is destined to fail by the completion of step 2, much like the original underpants gnomes plan, its initial success gives rise to the belief that eventually step 3 will be realized. The idea is that once evidence of growth appears, the Federal Reserve can exit to avoid the ‘inflation problem’ Bernanke wrote about in 2009. Once removed from the picture the market can stand on its own two feet, engaging in the accumulation of factors of production, production itself and consumption at the higher levels the Federal Reserve’s efforts engineered, under ‘normalized’ financial conditions.
Depending on whom you ask, this step is either in full swing, still in its embryonic stages, or so lacking in veracity that it is not really apparent that step two has even been completed. The policy recommendation of each camp thus varies from a push to normalization of monetary policy, a more cautious ‘wait and see’ approach, and a push for increasing accommodation, respectively. Indeed, the question posed by Keynes in the introductory quote is as relevant now as it was 80 years ago.
At the moment, the Fed is in self-proclaimed ‘wait and see’ mode, despite tapering, the first step along the normalization path. Yellen has reconciled this apparent discrepancy by repeatedly stating that the Federal Reserve stands ready to either engage in more or less accommodation, based on how the data looks. Perhaps the most important data point is inflation. Within the context of the UGEP, inflation acts as a buoy which helps the Fed navigate the currents of recovery. According to the playbook, the appearance of certain levels of inflation indicates that the recovery has progressed to a level that warrants the tightening of monetary conditions. Yellen has reiterated that those levels of inflation have not presented themselves in a sustained manner, and as such an accommodative level of policy is still justified. The important point here is not whether or not we are currently at levels that warrant tightening, but that the Federal Reserve will maintain accommodation and even increase it until it gets there. Thus for the purposes of this piece I will proceed forth with the exiting process.
Tightening monetary policy is simply the reverse of easing. Instead of creating money to buy government bonds and other assets, the Federal Reserve sells the assets it previously collected into the market. This selling removes cash from the market and draws it into the Federal Reserve. The effects of the easing process are also reversed under tightening conditions. Whereas easing enabled financial institutions to increase loans thus increasing the demand for goods and services, tightening decreases the wherewithal firms have to extend loans. All else equal, this decreases the demand for goods and services, leading to downward pressure on prices. While this may be ok in terms of putting the lid on prices before they rise too quickly, it also serves to compromise firms which needed those price increases to clear rising production costs, as previously noted above.
To explain differently, recall the discussion of the rate of interest in step 1. As mentioned, it is the manifestation of the value of future goods versus present goods. The manner in which the Federal Reserve eases monetary conditions enables valuations of future goods to rise while preventing valuations of present goods from falling such that the interest rate can be lowered seemingly without consequence. These increased valuations are backed by increased funds emanating from the Fed. The increased demand raises prices. When the Fed tightens, the reverse happens, as less dollars in circulation means less demand for goods and services, leading to lower prices. In theory the Fed should want this to happen at this point in the sequence, because thanks to excessive economic growth, prices have advanced too quickly.
Not only does active tightening place downward pressure on prices, but inaction by the Fed also leads to lower prices. Once prices have been pushed higher via accommodative policy, their continued rise depends on continued demand, which can only express itself when there are increased dollars in circulation. A relatively stable money supply does not suffice, and compared to an expanding supply, this stance is actually tighter, even though the absolute level of money in circulation may be very high. This is especially true in the face of an increased supply of goods and services.
No Way Out
Embarking on the UGEP eventually leaves the Fed with 3 choices: continue increasing accommodation in perpetuity, hold station at some level of accommodation, or actively tighten. All of them end in tears, meaning there really is no way out. The bottom line is that anything other than constant, increasing levels of accommodative policy will undo the gains made in prior rounds of accommodation, either during step 2 or step 3. Perpetual accommodation leads to an ‘inflation problem.’ The idea that the Fed can get in, stabilize conditions, and complete step 3, exiting without any problems is pure fiction, although the UGEP regards it as the truth. Yellen unintentionally supported the point of view that there is no way out at the IMF speech, when speaking about the prior expansion period in the middle of the last decade. Her remarks came in addressing the idea that the Federal Reserve should possibly have pricked the housing bubble of the last decade earlier through tighter policy so as to prevent the bubble from getting as large as it did. Emphasis mine:
It is not uncommon to hear it suggested that the crisis could have been prevented or significantly mitigated by substantially tighter monetary policy in the mid-2000s. At the very least, however, such an approach would have been insufficient to address the full range of critical vulnerabilities I have just described. A tighter monetary policy would not have closed the gaps in the regulatory structure that allowed some SIFIs and markets to escape comprehensive supervision; a tighter monetary policy would not have shifted supervisory attention to a macroprudential perspective; and a tighter monetary policy would not have increased the transparency of exotic financial instruments or ameliorated deficiencies in risk measurement and risk management within the private sector.
Some advocates of the view that a substantially tighter monetary policy may have helped prevent the crisis might acknowledge these points, but they might also argue that a tighter monetary policy could have limited the rise in house prices, the use of leverage within the private sector, and the excessive reliance on short-term funding, and that each of these channels would have contained–or perhaps even prevented–the worst effects of the crisis.
A review of the empirical evidence suggests that the level of interest rates does influence house prices, leverage, and maturity transformation, but it is also clear that a tighter monetary policy would have been a very blunt tool: Substantially mitigating the emerging financial vulnerabilities through higher interest rates would have had sizable adverse effects in terms of higher unemployment. In particular, a range of studies conclude that tighter monetary policy during the mid-2000s might have contributed to a slower rate of house price appreciation. But the magnitude of this effect would likely have been modest relative to the substantial momentum in these prices over the period; hence, a very significant tightening, with large increases in unemployment, would have been necessary to halt the housing bubble.2 Such a slowing in the housing market might have constrained the rise in household leverage, as mortgage debt growth would have been slower. But the job losses and higher interest payments associated with higher interest rates would have directly weakened households’ ability to repay previous debts, suggesting that a sizable tightening may have mitigated vulnerabilities in household balance sheets only modestly.3
Similar mixed results would have been likely with regard to the effects of tighter monetary policy on leverage and reliance on short-term financing within the financial sector. In particular, the evidence that low interest rates contribute to increased leverage and reliance on short-term funding points toward some ability of higher interest rates to lessen these vulnerabilities, but that evidence is typically consistent with a sizable range of quantitative effects or alternative views regarding the causal channels at work.4Furthermore, vulnerabilities from excessive leverage and reliance on short-term funding in the financial sector grew rapidly through the middle of 2007, well after monetary policy had already tightened significantly relative to the accommodative policy stance of 2003 and early 2004. In my assessment, macroprudential policies, such as regulatory limits on leverage and short-term funding, as well as stronger underwriting standards, represent far more direct and likely more effective methods to address these vulnerabilities.
Yellen states that evidence suggests that the (low) level of interest had an effect on housing prices, and thus household leverage (easy financial conditions as per step 1 of the UGEP). She then links tighter policy to the adverse effects of higher unemployment and the inability for households to repay previous debt. It is interesting to note her explicit statement that it is the easing of conditions and the issuance of new debt which enabled households to pay off prior debts (and to indulge in other spending on consumer goods), very much in keeping with the UGEP framework. Her conclusion is that in the face of bubbles, the Federal Reserve is better off trying to regulate it away via ‘macroprudential policies’ than explicit tightening measures.
This reasoning is flawed, because any ‘macroprudential policy’ would have the same effect as explicit monetary tightening – that is it would serve to limit the increase in prices which are endemic of bubbles, and which are welcomed by proponents of the UGEP because it is a sign that accommodation is having a positive effect. Remember, in this framework any spending is good spending, even if it is unproductive. The obvious sign of increased spending is higher prices, so they are always a welcome sight. Looking back to the last bubble, the increases in complex financial derivatives, lower lending standards, and so forth were all noted in real time as existing and increasing at a high rate. However, the fact that these developments served to expand the bubble, and the increase in consumption and price appreciation that went with it meant that any dangers were rationalized away. As long as the objective of constant price increases is met, the methods by which these increases are obtained will never be questioned seriously, let alone regulated away in real time.
With respect to monetary tightening, if serious problems would have resulted from such a response in the mid 2000s, it stands to reason that the same sort of result would occur if applied to the current situation. Charles Evans, President of Federal Reserve Bank of Chicago, has echoed these concerns quite vocally in recent days. From a WSJ article covering a speech Evans recently gave:
“For me, the biggest and costliest downside risk is that in our haste to get back to ‘business as usual’ monetary policy, we could stall progress and backtrack to the economic circumstances of recent years” should rates be lifted prematurely, he said.
As he has noted in recent speeches, Mr. Evans is worried about repeating past policy mistakes, when officials have raised rates before the economy was ready. He sees that as a risk right now.
One can expect the likes of Evans to err on the side of more accommodative policy for a very long time. Evans and Yellen are presenting logic which is almost circular. Returning to normal rates would undo the ‘progress’ that suppressed rates enabled, so accommodative policy must persist. However, they both are ‘upbeat’ about the economy, which should necessitate rate normalization. But that would undo the progress made…
Indeed, within the post 2008 monetary regime, we have seen two instances of effective monetary tightening, namely the ends of the original QE and QE2. Ending in March 2010 and June 2011 respectively, their passing resulted in immediate drops in the S&P 500 (which I use here as a proxy for asset prices, the appreciation of which is a positive effect of the UGEP) of 16% and 21.8% respectively. Currently, the Federal Reserve is in the closing stages of tapering the latest round of QE, providing the economy another chance to show that it can stand on its own two feet. Given how it fared after the last two QE programs ended, and how the theoretical basis for continued growth in a world with less monetary easing is full of question marks, chances are the legs will look wobblier than those of Mike Tyson’s early opponents after being struck with a blow. Perhaps Evans and Yellen would point to those episodes as a sign that the economy wasn’t ready. But when will it ever be ready? When the economy is built upon a foundation of levitating asset prices, how can it ever be ‘ready’ to absorb prices which aren’t levitating as quickly, or even at all? It isn’t, which means that the Federal Reserve will ultimately have to reverse course on the accommodative continuum. Where it is currently moving towards normative policy, it will have to eventually move beyond accommodation into further uncharted easing.
The flaws in the UGEP ultimately stem from the fact that it does not allow the economy the time to accumulate the building blocks of economic growth, capital and labor, and to direct it in accordance to prices, and the changing spending habits of consumers. The UGEP circumvents the market attempt to reorganize capital and labor by forcing it into the same structure of production that existed before the crisis, a structure that was proven to be futile as evidenced by the existence of the crisis. In the process of trying to adhere to a broken structure, capital and labor are wasted. As such, having wasted the building blocks of growth, step 2 of the UGEP is an untenable, if not impossible prospect. As Hussman writes:
When the most persistent, most aggressive, and most sizeable actions of policymakers are those that discourage saving, promote debt-financed consumption, and encourage the diversion of scarce savings to yield-seeking financial speculation rather than productive investment, the backbone that supports a rising standard of living is broken.
From there, one wonders how a virtuous cycle of continuous growth can be achieved when merely sustaining growth at all isn’t possible, just as one wonders how a collection of stolen underpants may turn into profit.
There is simply no way out. But that won’t stop the Underpants Gnome Economic Plan from being the most widely supported and implemented view.
Joe Wiesenthal is ‘infuriated’ at the fact that ‘Fed Haters’ haven’t put their collective hand up in admission of error in assessing the economy in the wake of the actions taken on by the Federal Reserve. This group, which I am sympathetic to, for the most part predicted that the Federal Reserve policies of the last 5 years would eventually lead to high levels of inflation. That they haven’t, at least in terms of the CPI, hasn’t moved these ‘haters’ to reassess their views, which annoys Wiesenthal. He writes:
This is what makes folks like Paul Krugman so infuriated and why he is so harsh toward his critics, because he regards them as intellectually dishonest.
There’s more evidence of that Thursday, courtesy of a great Bloomberg piece by Caleb Melby, Laura Marcinek, and Danielle Burger in which they called up various signatories to a 2010 letter that warned former Fed chair Ben Bernanke about impending inflation.
The upshot: For the most part, they don’t accept they were wrong.
My faction of the ‘haters,’ the Austrians, have a basic framework for assessing the current economic situation, which is as follows: in attempting to mitigate the bursting of the previous bubble, of which falling prices was a result, the Federal Reserve will introduce upward pressures on prices by flooding the system with liquidity. This upward pressure on prices will ultimately pose a problem for a broader consumer base which is fundamentally unable to support rising prices indefinitely; in other words attempting to breathe new air into a dead bubble will lead to the same ending as before – namely another massive economic downturn.
Inflation, a word which has been distorted over the years to now mean rising prices, is only a part of the story, which in totality is about imbalances, and the market’s attempt to address those imbalances. Jim Grant, a proponent of the Austrian theory is featured in Wiesenthal’s piece:
Here for example is Jim Grant, editor of Grant’s Interest Rate Observer and an intense critic of Fed easing:
“People say, you guys are all wrong because you predicted inflation and it hasn’t happened. I think there’s plenty of inflation — not at the checkout counter, necessarily, but on Wall Street.
“The S&P 500 might be covering its fixed charges better, it might be earning more Ebitda, but that’s at the expense of other things, including the people who saved all their lives and are now earning nothing on their savings.
“That to me is the principal distortion, is the distortion of the credit markets. The central bankers have in deeds, if not exactly in words — although I think there have been some words as well — have prodded people into riskier assets than they would have had to purchase in the absence of these great gusts of credit creation from the central banks. It’s the question of suitability.”
Grant is not 100% wrong in his concerns about the recovery. It has been disappointing. But a rising stock market is not how people measure inflation, and the labor market has recovered significantly, bringing real relief to millions of people. It is true that it hasn’t been a great time to be a saver who has been 100% in cash, but if you’ve been in stocks (or even bonds!) you’ve done quite well.
Grant is pointing out that while not much inflation has occurred in the sense of consumer prices (which is arguable), there has been significant appreciation in asset markets as a result of Fed actions. This appreciation has not necessarily been reflective of real economic conditions, but rather ‘great gusts of credit creation from the central banks.’ According to the Austrian school, this sort of appreciation is problematic precisely because of this unstable sort of foundations. What the central banks giveth in easy conditions, they can taketh away with tighter conditions. The Austrians would rather see an economy founded on savings, investment, capital and labor accumulation. Wiesenthal admits that there is some truth to what Grant is saying, but he belongs to a coterie which holds a simplistic view that prices rising = good, and falling prices = bad. As the prices in question are currently rising, Wiesenthal has no qualms rationalizing it, but within that rationale are shades of concern, namely the fact that wealth has merely been transferred from savers to speculators in financial assets. This is not real wealth creation, which is what an economy interested in improving the standard of living of its people should be focused on.
So when are the ‘haters’ actually proven wrong? Quite simply, when the Federal Reserve exits accommodation, and normalizes policy with no adverse effects. The economic theory the Fed subscribes to dictates that it can ride in to rescue the financial system, prop it up with emergency funding, and then remove it at a later date when it is confident the economy can stand on its own. The ‘haters’ bet, at least the Austrian version, is that the economy cannot stand on its own absent the Fed. Until the Fed withdraws, a process Chairman Janet Yellen suggested ‘could take to the end of the decade’ at the last FOMC policy press conference, the jury is out. To Wiesenthal, Krugman, or any of the self-proclaimed judges in The Case of the ‘Missing’ Inflation: reaching a verdict before the Fed finishes its work is nothing more than celebrating at halftime.