The equity melt-up continues, with the S&P 500 now up more than 25% year-to-date in a period of stagnant growth and an environment of declining market liquidity. The catalysts for the latest leg up were the comments and testimony by Fed Chairman-nominee Janet Yellen, whose confirmation hearings began today.
Her comments should alleviate any fear that Yellen will be anything other than the most dovish Fed Chairman in decades. Ordinarily, potential central bankers take advantage of confirmation hearings to burnish their monetarist and hawkish credentials, in much the same way that Presidential candidates always seem to try and campaign as moderates. It makes sense to do so, since the credibility of a central bank has long been considered to be related to its dedication to the philosophy that low and stable prices promote the best long-term growth/inflation tradeoff. Sadly, that no longer appears to be the case, and Janet Yellen should easily be confirmed despite some very scary remarks in both the scripted and the unscripted part of her hearing.
In her prepared remarks, Yellen commented that “A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases.” Given half a chance to repeat the tried-and-true mantra (which Greenspan used repeatedly) about the Fed balancing its growth and inflation responsibilities by focusing on inflation since growth in the long run is maximized then inflation is low and stable…Yellen focused on growth as not only the primary but virtually the only objective of the FOMC. As with Bernanke, the standard which has been set will be maintained: we now use extraordinary monetary tools until we not only get a recovery, but a strong recovery. My, have the goalposts moved quite a lot since Volcker!
That means that QE may indeed last forever, since QE may be one of the reasons that the recovery is not strong (notice that no country which has employed QE so far…or ever, as far as I know…has enjoyed a strong recovery). In a very direct sense, then, Yellen has declared that the beatings will continue until morale improves. And I always thought that was just a saying!
I would call that borderline insanity, but I am no longer sure it is borderline.
Among other points, Yellen noted that the Fed is intent on avoiding deflation. In this, they are likely to be successful just as I am likely to be successful in keeping alligators from roosting on my rooftop. So far, there is no sign of it happening, hooray! I must be doing something right!
Yellen also remarked that the Fed might still consider cutting the interest it pays on banks’ excess reserves, or IOER. The effect of this would be to release, all at once, some large but unknown quantity of sterile reserves into the transactional money supply. If there was any question that she is more dovish than Bernanke, there it is. It was never clear why the Fed was pursuing such a policy – flood the market with liquidity, and then pay the banks to not lend the money – unless the point was merely to reliquify the banks. It is as if the Fed shipped sealed crates of money to banks and then paid them rent for keeping the boxes in their safes, closed. If you’re going to do QE, this is at least a less-damaging way to do it although it raises the question of what you do when you need the boxes back. Yellen, on the other hand, is open to the idea of telling the banks that the Fed won’t pay them any longer to keep those boxes unopened, and instead will ship them crowbars. This only makes sense if you really do believe that money causes growth, but has nothing to do with inflation.
The future Fed Chairman also declared that the Fed has tools to avert emergence of asset bubble. Of course, no one really doubts that they have the tools; the question is whether they know how and when to use the tools. And, to bring this to current events, the question is no longer whether they can avert the emergence of an asset bubble, but whether they can deflate the one they have already re-inflated in stocks, and an emerging one in property! Oh, wait, she’s at the Federal Reserve…which means she won’t realize these are bubbles until after the bubble pops, and then will say that no one could have known.
Now, it may be that the U.S. is merely nominating Dr. Yellen in self-defense, to keep the dollar from becoming too strong or something. Last week’s surprise rate cut from the ECB, and the interesting interview by Peter Praet of the ECB in which he opens the door for asset purchases (which interview is ably summarized and dissected by Ambrose Evans-Pritchard here), keeps the heat on the Fed to remain the most accommodative of the major central banks.
At least the ECB had a reasonable argument that there was room for them to paint the least attractive house on the block. Europe is the only one of the four major economies (I exclude China since quality data is “iffy” at best) where central-tendency measures of inflation are declining (see chart, source Enduring Investments).
And that is, of course, not unrelated to the fact that the ECB is the only one of the four major central banks to be presiding over low and declining money supply gowth (see chart, source Enduring Investments).
There is of course little desire in the establishment to do so. The equity market continues to spiral higher, making the parties louder and longer. It is fun while it lasts, and changing to a bartender with a more-generous pour might extend the good times slightly longer.
It is no fun being the designated driver, but the good news is that I will be the one without the pounding headache tomorrow.
[Hmmm...erratum and thanks to JC for catching it. The S&P is "only" up 25.6% YTD (my Bloomberg terminal decided that it wants to default to the return in Canadian dollars). So originally the first paragraph had "32%" rather than 25%. Corrected!]
One of the more disturbing meta-trends in markets these days is the direction the evolution of central banking seems to be taking.
I have written before (and pointed to others, including within the Fed, who have written before ) about the disturbing lack of attention being paid in the discussion and execution of monetary policy to anything that remotely resembles money. Whether we have to be concerned about money growth in the short- and medium-terms, ultimately, will depend on what happens to the velocity of money, and on how rapidly the central bank responds to any increase in money velocity. But there are trends that could be much more deleterious in the long run as the fundamental nature of central banking seems to be changing.
Today the Bank of England released its Quarterly Inflation Report, in which it introduced an “Evans Rule” construction to guide its monetary policy looking forward. Specifically, the BoE pledged not to reduce asset purchases until unemployment dropped below 7% (although Mark Carney in the news conference verbally confused reducing asset purchases with raising interest rates), unless:
“in the MPC’s view, CPI inflation 18 to 24 months ahead is more likely than not to be below 2.5 percent; secondly, if medium-term inflation expectations remain sufficiently well anchored; and, thirdly, the Financial Policy Committee has not judged the stance of monetary policy — has not judged — pardon me — the Financial Policy Committee has not judged that the stance of monetary policy poses a significant threat to financial stability, a threat that cannot otherwise be contained through the considerable supervisory and regulatory policy tools of various authorities.”
This is quite considerably parallel to the FOMC’s own rule, and seems to be the “current thinking” among central bankers. But in this particular case, the emperor’s nakedness is revealed: not only is inflation in the UK already above the 2.5% target, at 2.9% and rising from the lows around 2.2% last year, but the inflation swaps market doesn’t contemplate any decline in that inflation rate for the full length of the curve. Not that the swaps market is necessarily correct…but I’ll take a market-based forecast over an economist consensus, any day of the week.
So, for all intents and purposes, while the BOE is saying that inflation remains their primary target, Carney is saying (as my friend Andy the fxpoet put it today) “…the BOE’s inflation mandate was really quite flexible. In other words, he doesn’t really care about it at all.”
Along with this, consider that the candidates which have so far been mooted as possible replacements for Bernanke at the US Fed are all various shades of dovish.
Here, then, we see the possible long-term repercussions of the 2008 crisis and the weak recovery on the whole landscape of monetary policy going forward for many years. In some sense, perhaps it is a natural response to the failure or monetary policy to “get growth going,” although as I never tire of pointing out monetary policy isn’t supposed to have a big impact on growth. So, the institutions are evolving to be even more dovish.
At one time, I thought it would happen the other way. I figured that, since the ultimate outcome of this monetary policy experiment is clearly going to be higher inflation, the reaction would be to put hawkish central bankers in charge for many years. But as it turns out, the economic cycle actually exceeded the institutional cycle in duration. In other words, institutions usually evolve so slowly that they tend not to evolve in ways that truly hurt them, since the implications of their evolution become apparent more quickly than further evolution can kick in and compound the problem. In this case, the monetary response to the crisis, and the aftermath, has taken so long – it’s only half over, since rates have gone down but not returned to normal – that the institutions in question are evolving with only half of the episode complete. That’s pretty unusual!
And it is pretty bad. Not only are central banks evolving to become ever-more-dovish right exactly at the time when they need to be guarding ever-more-diligently against rising inflation as rates and hence money velocity turn higher, but they are also becoming less independent at the same time. A reader sent me a link to an article by Philadelphia Fed President Plosser, who points out that the boundaries between fiscal and monetary policy are becoming dangerously blurred. It is somewhat comforting that some policymakers perceive this and are on guard against it, but so far they seem ineffectual in preventing the disturbing evolution of central banking.
 Consider reading almost anything by Daniel L. Thornton at the St. Louis Fed; his perspective is summed up in the opening sentence of his 2012 paper entitled “Why Money Matters, and Interest Rates Don’t,” which reads “Today ‘monetary policy’ should be more aptly named ‘interest rate policy’ because policymakers pay virtually no attention to money.”
It has been a busy couple of weeks on the business side, which is why I haven’t been writing many articles. However, I wanted to be sure and pen a quick one today.
The main economic data is due out later this week: Existing Home Sales on Wednesday, New Home Sales on Thursday (both of these more interesting for the home price indications than for the volume figures), and Durable Goods on Friday. (Some of us also get excited about the 10-year TIPS re-opening on Thursday, with real yields at a 1-year high after a 35bp selloff over the last three weeks). But Monday and Tuesday have been relatively bereft of news, except for the occasional Fed speaker.
It is that “occasional Fed speaker” that I want to mention today.
St. Louis Fed President James Bullard today gave a speech in Europe, about the need for the ECB to pursue “aggressive” QE in order to prevent a long period of low inflation and deflation such as that experienced by Japan over the last few decades.
What word am I searching for here…would it be “chutzpah?”
I realize that Chairman Bernanke has already been featured on a magazine cover as a Hero. It bears remembering that Greenspan was also called the Maestro at one point, although we are now all aware that his management of the Fed helped to precipitate a massive crisis. History isn’t written in real time by bloggers. It’s written by historians, years later.
But hasn’t the Fed, after all, been really successful? Isn’t a victory lap deserved? Haven’t they earned the right to lecture to other central banks about the proper execution of monetary policy? After all, the Fed brought down the unemployment rate while inflation remains tame. Case closed.
Perhaps that would be a good argument if Earth was hit by a comet tomorrow and all life ceased. But in the event life continues, we will need to wait until the cycle is complete. Celebrating now is like pumping one’s fist in celebration in the middle of a motorcycle jump over 25 buses. Nice trick, but we’ll hold our applause until you stick the landing if you don’t mind.
There seems to be great faith in the Federal Reserve that the tough part is over. All that they need to do now, it seems they believe, is to just start tightening before inflation gets going; they can do it very gradually, supposedly, because of the great credibility the Fed has and because they understand how inflation responds to rates.
But in fact, inflation doesn’t respond to rates but to money. And not to reserves, but to transactional money. Transactional money responds not to total reserves, but to banking activity and the resulting level of required reserves…which the Fed is unable to directly affect. When the Fed begins to taper, and then to somehow drain reserves, I predict it will have almost zero impact on the inflation process until the excess reserves have been drained.
Indeed, if interest rates rise when the Fed begins to do this, it will perversely tend to increase the velocity of money, which tends to vary inversely with the opportunity cost of holding cash balances (that is, velocity goes up when interest rates go up, all else equal). It’s not the only thing that matters, but it’s pretty important, as the chart below suggests (I think I have run something like this chart previously).
Now, ordinarily when the Fed is raising rates, they’re also draining reserves – so the increase in money velocity is balanced by the decline in money to some degree. That won’t happen this time. When rates go up, velocity will go up, but the quantity of (M2) money will not change because it is driven by a multiplier that acts on required reserves. That means inflation may well rise as interest rates increase, at least for a while.
I might be wrong, but I am willing to wait and see how it plays out. If I am wrong, then you don’t have to put me on the cover of a magazine.
To conclude that inflation is fully tamed at this point, anyway, is remarkably optimistic. Home prices are skyrocketing at rates only rarely seen, and it would be incredible if that did not lead to higher rents and higher core inflation…literally within a couple of months from now, judging from the historical lag patterns.
But, again, I should return to my main point: it isn’t that the Fed is wrong, it’s just that they are so completely certain that they are right even though the difficult part of the trick – unwinding the extraordinary policy without any adverse effects – lies ahead.
Sit down, James Bullard. Let the ECB manage its own affairs. I am sure they can mess it up on their own, without your help. And certainly, without your condescending advice!
The monthly European M2 numbers are out (they are released with approximately a one-month lag), and so we can get a look at the monetary conditions through the end of October.
The chart above (source: FRB and ECB) shows that whatever the ECB is claiming about not conducting QE, money supply growth is most definitely accelerating.
The data also allows me to update one of my current-favorite charts, showing the connection between developed markets money growth (proxied here by US M2 plus Euro M2) and core U.S. inflation. The chart is below (source: BLS, FRB, ECB, Enduring Investments calculations).
What is most amazing to me about this pretty reasonable (correlation= 0.6) relationship is that it is contemporaneous. This is really important, because what it means is that we can argue that money velocity may not actually have fallen in the U.S. as much as it is commonly believed to have. If the proper measure, now that all of our economies are so interconnected, is global money rather than narrowly domestic money, then one answer to the question “why did the 10% growth in the U.S. money supply not lead to much higher inflation, much higher real growth, or both” (the correlation between U.S. M2 growth and U.S. core inflation is only 0.44) could be “because Europe’s tight money was counterbalancing our loose money.”
If this speculation is right, then it makes the ubiquity of QE much more worrisome, because it means that even if the Fed stops throwing wood on the fire, if everyone else is doing so we may still see domestic inflation (although, in that case the dollar would likely strengthen appreciably, blunting that effect).
The most striking facet of today’s trading was that the stock market actually reacted to the Fed’s announcement, which was precisely as universally expected: no change in anything but the technical language about where the economy currently stands. It wasn’t a huge reaction, but the fact that the S&P actually dropped 5 points on the news is mind-boggling to me because it implies that some people were expecting big things out of the Fed today.
To be sure, the arrow of action on the Fed is clear and pointed to ever-increasing amounts of liquidity, but this wasn’t ever on the docket for today. However several Street economists have predicted, plausibly I think, that when Operation Twist expires in December (partly because the SOMA will run out of short-dated Treasuries to sell) the Fed might keep going with the buying leg of the Twist – effectively increasing the monthly outright purchases of paper to $85bln (including Treasuries) from $40bln (all mortgage paper) currently.
Operation Twist has been a useless operation from the standpoint of monetary policy – it has neither added nor subtracted liquidity from the system. It may have had some value from the standpoint of asset-market-maintenance policy, by removing duration from the market and forcing investors to accept more risk for the same amount of reward. So it may be the case that Twist had some effect, but mostly a bad effect since it certainly doesn’t seem from market pricing that investors have been timid about taking risk. And I suppose it ought also be observed that “asset-market-maintenance” isn’t part of the legislative mandate of the Federal Reserve. However, legislators can be generous when markets are being pumped up – it’s when the air goes out that they’re unhappy.
Weirdly, though, I would prefer Operation Twist, which has little impact, to what is likely to replace it (additional QE).
Policymakers globally are growing increasingly bold about quantitative easing. In Europe today, ECB President Draghi told German legislators that outright bond purchases by the ECB “will not lead to inflation. In our assessment, the greater risk to price stability is currently falling prices in some euro-area countries. In this sense, OMTs are not in contradiction to our mandate: in fact, they are essential for ensuring we can continue to achieve it.” (See also this story.)
Central bankers are getting bold, but I’m not sure I understand why. They clearly see the connection between QE and inflation – fending off deflation was the purpose of QE2 and Draghi is clearly indicating the same even though core inflation in the Eurozone has risen from 0.8% in 2010 to 1.5% now (see chart below, source Bloomberg). That’s not exactly flashing red signals on inflation, but it is utterly fantastic to suggest that it indicates deflation is a greater risk.
In the U.S., QE3 and the likely acceleration of QE3 later this year is happening in the context of year-on-year rises in median new home sales prices (released today) and existing home sales prices (released last week) of over 11%, as the chart below (Source: Bloomberg) shows. Note that the existing home sales data is much more dependable on a month-to-month basis, because the number of existing homes and existing home sales swamps the number of new homes sold, but both show the same, clear trend. Home prices are now rising nearly as fast, nationwide, as they did in the bubble years.
For the record, the all-time record one-year price rise in existing home sales was 17.4% in May, 1979. Of course, in May 1979 core inflation was rising at 9.4%. In fact, with the exception of the last phases of the bubble of the early ‘Aughts, existing home sales prices are rising at the fastest margin above core inflation ever, as the chart below shows (Source: Bloomberg; Enduring Investments calculations)
Policymakers, and investors, seem to be numb to the threat of additional QE for one of two reasons. Either it is because of the belief that prior QE did not cause inflation (incorrect, as illustrated above and by the statements of intentionality of the policymakers themselves) or because they’re buying the line that QE is only adding to “sterile” excess reserves.
I think that this is dangerously sanguine. In fact, although it is true that QE initially results in greater excess reserves only, and these have only slowly trickled into transactional money, I think there’s reason to believe that adding more QE may increase that pace of transmission. Picture a large cylindrical vat, open on top with a small valve at the bottom. The water in the vat represents excess reserves, and the water trickling out through the valve is transactional money.
Many things can affect the pace at which the vat water flows through the valve – lending opportunities tied to credit demand and credit quality, disincentives to lend such as Interest on Excess Reserves (IOER), and moral suasion in both directions. Crank IOER to 25%, and all of the water poured into the vat remain as sterile excess reserves and QE is just reliquifying the banking system. Put IOER at a 10% penalty rate, and all of the water going in the top will flow out of the bottom very quickly – and all of the other water that’s already in the vat, too.
But even if you don’t adjust the valve at all, the greater weight of water in the cylinder, as you keep adding more water, will increase the flow out of the valve. Adding more QE is akin, economically, to increasing the weight of water in the cylinder.
The parallel economic concept is that a greater of excess reserves increases the opportunity cost of reserves. The average return on assets for a bank gradually declines as more of these assets become excess reserves rather than required reserves against lent funds. Leverage also declines, with the result (as I have pointed out before) that return on equity suffers. The chart below (Source: Bloomberg) shows the return on equity for large banks (those with more than $10bln in assets). You can see that while bank earnings have recovered significantly from the nadir of the crisis, they also appear to have leveled off at around 8% compared to the 15% that was the consistent standard prior to 2007.
The lending officers in these banks, although they’re being told to increase the quality of their loans, are being told more and more to also increase the quantity of their loans. They cannot do both, but as the pressure of too many reserves on the balance sheet builds, the pressure to make more marginal loans increases as well. This is the part of the valve that the Fed cannot control, and where danger lies going forward. The multiplier may well respond, eventually, to the weight of the reserves themselves.
Stocks surged today, although still on fairly light volume, in a striking response to the ECB’s proposal of a plan we already knew most of the details of. The S&P rallied 2%, and Treasury yields rose 7bps at the 10-year point (1.67%), with 10y TIPS yields +5bps (-0.65%) and breakevens therefore 2bps wider. Commodities were relatively strong, outside of the livestock group.
The ECB’s plan is essentially as described in leaks previously, although apparently there are some minor asterisks that prevent the central bank from just going in to buy lots of bonds right away. The ECB didn’t cut rates, or make the deposit rate negative, as some 40% of economists expected according to Bloomberg. That cut wasn’t in the cards, for the nonce anyway. As I pointed out yesterday, if the ECB wants to sterilize bond purchases, they certainly can’t cut deposit rates and probably have to raise them (if they were serious about sterilizing). In theory, they could cut deposit rates and then offer short-term bank bills as a way to absorb the extra money in circulation, but that’s the same thing in the end: we hold your money and pay you interest. The fact that it isn’t reserves, but bills, is not relevant to the sterilization discussion, and that approach is actually somewhat more flexible since the ECB can more easily raise the rate it pays on bills to be sure of soaking up enough money than it can adjust the deposit rate to accomplish the same thing. The problem, though, is that bill sales occur in the open, and it will be really obvious if they aren’t able to sterilize the purchases.
It continues to be striking how resistant central bankers are to the notion that markets, and not central bankers, ought to set market rates. Bloomberg and other media sources wrote of the ECB’s “fight to wrest back control of rates…after nearly three years of turmoil.” When, exactly, were rates in control of central bankers to begin with? Other than the trivial case of the overnight rate, that is. That’s just crazy talk.
There is, however, still the issue that sovereign governments need to formally request aid, and agree to conditions, before the unlimited buying can begin. It occurs to me that the unlimited buying might be tied to the conditions, and so not be unlimited after all. But the bigger problem is that governments (especially now that their rates have rallied a bit and the wolf has temporarily retreated from the door) insist on having the temerity to negotiate conditions, rather than to simply accept the gruel the EU says they’re entitled to. For example, according to the Spanish news outlet El Pais, Spain’s opening bid is for a full bailout without any extra conditions (hat tip to Andy F). At least that gives them plenty of room for concessions.
Now, perhaps the rally in equities wasn’t due to the ECB’s offer to buy bonds after all. Maybe it was because the economic data was slightly stronger than expected, although I’m skeptical of that. ADP showed a gain of 201,000 jobs, the highest gain since March, plus an upward revision to 173,000 last month. Initial Claims were a bit lower than expected, at 365,000. These are both on the better side of expectations, but negligibly so given the size of the error bars involved. The ADP report may have encouraged some shorts to cover in front of the Employment Report tomorrow, but the short-term correlation between changes in ADP and changes in the Employment Report is quite poor, as the chart below shows. The R-squared of the relationship is 0.165. That is, if you know that ADP accelerated 28k this month compared with last month, it tells you almost nothing about whether Non-Farm Payrolls will accelerate or decelerate from last month’s figure.
The correlation of the levels of the changes themselves is of course much better, with an R-squared of 0.857 over the same period, but the standard error is 93k. So, today’s 201k from ADP would produce a point estimate, based on the regression (not shown here), of 210k for Payrolls. But the error bar would make the expected range 117k on the low side to 303k on the high side. Ergo, it’s still a bit early to get over-excited about the Payrolls report tomorrow.
There’s a secondary concern here that is silly, but needs to be considered. If the number is strong tomorrow, there will be some investors (and perhaps quite many) who will be skeptical that the numbers just happened to improve right in the middle of the Democratic National Convention, hours after President Obama accepts the nomination. I am not one of those who will be skeptical, not because I think any particular Administration is above the idea of manipulating the data, but because I think it would be almost impossible to do so without the conspiracy coming to light. There are simply too many people involved in the generating of this government statistic (and, of course, the ADP figure is not remotely influenced by the government). But the same people who believe the government manipulates CPI will believe they manipulate the jobs report, and this has market implications: if the figure is weak, investors will have a higher level of confidence in the data (since it goes without saying that no one would manipulate the number to be worse) than if it is strong, which further implies – especially after today’s rally – that the price response in the equity market is likely to be skewed negatively. I don’t like taking positions ahead of major numbers, but in this case I’d be inclined to shade a bit short. But just a bit.
ADP was a bit stronger-than-expected, and Payrolls may be higher or lower. But either way, these figures do have the usual error bars, and it seems unlikely that this augurs an unexpected and durable improvement in the employment situation when the man on the street is still reporting that jobs are harder to get. Nevertheless, the economy seems not to be getting worse at the moment, either, and with traditional monetary policy there would be no cause whatsoever to ease. I suppose it goes without saying that those traditions are no longer being observed, however, and I continue to think we’ll see the Fed ease next week – almost regardless of what the data does.
Don’t begin to worry, just yet, about the continued low volumes. It isn’t unusual, following a long weekend, for the first day back to still be sluggish. People are catching up with e-mail, greeting friends (friends which, in Europe at least, they may not have seen for a month or more), and so on.
And anyway, we should put today’s light volume – 599 million shares on the NYSE – in context. The average for all of last month was only 581 million shares, and only 544 million for the last half of the month. Only eight days in August were busier than today’s total, and three of those were the FOMC meeting day, the last day of the month, and Employment day. That’s slim solace if you’re a broker, I am sure, but brighter and busier days are ahead. In fact, proximately ahead.
European bonds rallied strongly as details of the ECB’s plan to buy Eurozone bonds were leaked; ECB President Draghi told the European Parliament in a “closed door” (but apparently open-mic) session that the ECB simply must buy bonds because the traditional instruments of monetary policy are ineffective. “We cannot pursue price stability now with a fragmented euro area because changes in interest rates affect only one country, or two countries at most. They have no importance whatsoever in the rest of the euro area.” It is true that to a man with a hammer, everything looks like a nail, but Draghi was essentially arguing that in want of a hammer, anything that will pound a nail will do. In short, because the traditional tools don’t work, Draghi claims that anything else which accomplishes the same ends is allowed.
The Bundesbank will not agree.
But Draghi claims the Euro’s survival depends on his being allowed to buy bonds under 3 years to maturity (why there is a limit at 3 years is unclear to me; if it was necessary to extend the program to 5 years because buying everything less than 3 years wasn’t working, why won’t the same argument work?), and it seems unlikely that there will be enough opposition to dissuade him from this action. It is one thing to ask legislatures to write a check, but the costs of profligate monetary policy (as we have seen) are not as apparent and not as immediate; and anyway, the politicians can campaign later on the need to have them around to fix whatever new problem that is created as a result.
The continuing question should be – if there is no cost to buying huge numbers of bonds, then why should the central banks ever have eschewed that action? Of course, there is no such free lunch, as William White wrote last week. But from the standpoint of a politician, it’s almost a free lunch. “I’ll glad you pay you next election cycle for a hamburger today,” as Popeye’s pal Wimpy might have said.
Or, better yet, chastise the monetary policymakers for not foreseeing the true cost of that hamburger today!
One more comment on that William White piece. In it, he discusses among other things the many ways in which overcapacity has developed last couple of decades in many countries and many industries. He does this to illustrate the concept of “malinvestment,” which mainstream economists these days pooh-pooh but which many Nobel Laureate economists (such as Hayek) did not.
However, like many of those earlier authors, White seems to take the existence of overcapacity as implying that deflation is a serious risk. I think this is based on a misunderstanding and misapplication of the original concept of malinvestment. Overcapacity implies that resources have been mis-allocated in the past, and this creates a cost in the future – but it only implies deflation in the presence of traditional monetary response (which, let’s remember, we haven’t had in a decade or more). Overcapacity implies declining real prices, and declining real returns to property, plant, and equipment relative to labor – and that is good news for consumers. But, if this overcapacity is coupled with ample money printing, this is not inconsistent with rising, rather than falling, price levels.
Remember that the original Keynesians and Austrians were writing in a period during which most of the historical record involved a money supply effectively, if not explicitly, limited by linkage to gold. In the presence of a fixed money supply, overcapacity most assuredly leads to deflation. But in the presence of a rising money supply, these are no longer automatically connected concepts: overcapacity is a statement of investments and returns in real space, while inflation measures a change in nominal prices.
And that’s why the malinvestment of the 1990s and 2000s need not lead to the same end result as the malinvestment of the 1920s. Indeed, unless something very odd happens – and I gave the parameters I would consider odd last week - deflation, with or without the hangover effects of prior malinvestment, isn’t going to happen.
The next few weeks will be more increasingly more active, to a degree that we may long for the quiet days of August. Keep in mind that it is a very strong time of the year for bonds, seasonally speaking, and a weak one (although not as consistently so) for stocks. But I wouldn’t try to play those zig-zags. The DJ-UBS index reached a 6-month high this morning, before backing off; that’s where I would have (and do have) my money.
As the end of August approaches, the somnambulation of the markets should be slowly diminishing. Events are still proceeding in slow-motion, but investors will gradually wake up and re-assess their surroundings in the days remaining before the Jackson Hole colloquium that represents the next major scheduled event on the domestic calendar.
But even in the dog days of August, governments borrow and spend money, and sometimes they even have to pay it back. Today, the emerging market of Belize missed a bond payment as its deficit swelled to a level of (gasp!) 2.5% of GDP, and the Prime Minister declared a restructuring is needed since the country simply doesn’t have the ability to pay the 8.5% coupon on its superbond. Isn’t it nice to be a superpower? The U.S. runs a deficit of around 8% of GDP, and our creditors seem to have no quarrels with us – at least, for now.
Of course, we’re too busy to worry about Belize when Greece beckons. Greek Prime Minister Samaras is asking for a two-year extension of the deadline for deep spending cuts and tax increases, but German Financial Minister Schaeuble (among others) said over the weekend that “It can’t be helped – we can’t make yet another new program. There are limits.” http://economywatch.nbcnews.com/_news/2012/08/20/13377541-germany-forcing-greeces-day-of-reckoning Certainly, the suggestion that there are limits to European largesse in the case of Greece is not a new one; the appearance of actual limits is still what all parties are waiting for. We are approaching the next showdown, surely.
More stirring was the report over the weekend in Der Spiegel that the ECB is considering a program to ‘cap’ European rates versus Bunds, such that they would determine an “appropriate” spread (appropriate in a cosmic justice sense, one supposes, not in a ‘market clearing’ sense) and then buy unlimited quantities of bonds of countries whose yields strayed above the cap. The idea, surely, is to make the cap unnecessary, since rational (and, it should be pointed out, credulous) investors would buy unlimited amounts of bonds just shy of the cap, knowing they had a much higher upside than downside, guaranteed. But ask Soros and the Bank of England how that works, when the economics aren’t there.
The Bundesbank, predictably, came out with immediate criticism of such a plan, which isn’t surprising since they had previously spanked Draghi for suggesting that the ECB would do “whatever it takes” to preserve the Euro. The ECB promptly hove to today, as well, muttering something about how it’s “misleading to report on decisions, which have not yet been taken and also on individual views, which have not yet been discussed by the ECB’s Governing Council, which will act strictly within its mandate.” And, of course, that begs the question of why they leaked the notion in the first place. Who’s in charge over there, anyway?
It also was unclear if the idea of an automatic cap replaced the prior assertion that the countries themselves must formally request help, or was in addition to that requirement.
All in all, it should be an interesting autumn.
But I nevertheless contend that the first really important event for the market is going to be the Bernanke speech at Jackson Hole on August 31st. The machine is already at work, setting up the arguments so that Bernanke need only nod in the general direction of what the Fed is going to do. An article on Bloomberg yesterday was entitled “No Inflation Proves Critics of Fed’s Bernanke Wrong.” The content of the refutation is essentially that it’s obvious that Bernanke was right, all of those opposed are just ‘haters, and clearly the money-printing didn’t cause inflation.
However, since the money-printing also didn’t evidently cause unemployment to improve very much, we are left with this: either monetary policy simply doesn’t matter, and affects neither inflation nor growth in any important degree (in which case we can safely disband the Fed since it’s just an economist-employment project), or it does matter, and it’s too early to judge the effects of a rapidly-expanding money supply which, until one month ago was still expanding at better than 10% per annum. After all, along with that expanding money supply we did, until three months ago, have core inflation that was accelerating every month, so that’s hardly an open-and-shut case in favor of the notion that large amounts of money don’t cause inflation. Moreover, clearly the Fed itself believes that QE causes inflation, or it wouldn’t have cited the possibility of deflation as a key reason for QE1! They seem to want it both ways: money-printing causes dis-deflation, but doesn’t cause inflation above target.
In my view, it is very premature to declare victory over core inflation merely because we have had a couple of months where core inflation went sideways – mostly due to base effects.
But as investors, what is more important in the near-term is that this argument is silly to make now, when its veracity won’t be judge-able for at least a year or two, unless the purpose of the argument is to encourage additional monetary easing.
Perhaps you may think that my cynicism knows no bounds. This may well be true, but is not relevant at the nonce. Consider that the Fed also has just released a study (summarized here) that argues there is much more ‘cyclical’ unemployment left from the recession that can yet be reversed. This tends to mean (according to the Bloomberg article) that more can be done on the employment front without spurring inflation. Other economists cited in the Bloomberg piece, who think structural unemployment is higher, figure that if the unemployment falls too fast it could spell inflation.
I have pointed out here a number of times that there is no strong relationship between unemployment and overall inflation, although there is a decent relationship between unemployment and wages (see this article for some pretty charts). Lower unemployment would mean higher wages, and probably higher real wages, but it doesn’t necessarily mean broad inflation (consider the late 1990s).
So we have an argument that inflation is tamed and Bernanke was right, and we have an argument that there is still more room for policy to lower unemployment without triggering inflation. Yes, I am cynical, but as investors it sometimes pays to be that way. If I were looking to push further unprecedented monetary policy on a suspicious investor community, these are just the sort of articles and studies I would like to see floated.
Draghi’s celebrated, chest-thumping, “whatever it takes” to preserve the Euro was apparently…nothing. The ECB did nothing. Perhaps he meant the value of the Euro, not its existence, and they would preserve it like the Bundesbank wants to, by controlling its supply? Yet, in his press conference he seemed to make clear that he meant the ECB would go to bat for European union, as he said the “Euro is irreversible.”
Actually, Mario, that’s precisely the question at hand!
Also, like a true central planner, he intoned that “high yields [for peripheral countries] are unacceptable.” At least, I assume he means for the peripheral countries, although it was not so long ago that 7% was considered a sustainable yield. At some level of debt, I suppose that even 2% is unsustainable! But this isn’t the point. The point is that it isn’t up to Draghi to “accept” high yields. It isn’t his market to arrange. The market itself makes the decision about what yields are “acceptable,” given the risk. I think he means the same thing my daughter means when she stamps her 5-year-old foot and declares something “unacceptable.” What she means is, she doesn’t like it. Just like with her, the answer to Draghi is “too bad.”
The Fed’s inaction was surprising (to me), but justifiable with the ECB up the following day. The inaction of the ECB is much harder to fathom in the context of President Draghi’s boast of only a few days past. A lot of theories about future paths of policy have now been thrown somewhat into question, for the ECB appears to have been Bundespanked.
Are monetary policymakers maybe finally growing concerned about money? They haven’t been for a long time; Daniel Thornton, a senior economist at the St. Louis Fed, has been fairly in the wilderness with his publications exhorting economists to actually look at the data again. His latest piece, “Monetary Policy: Why Money Matters and Interest Rates Don’t”, likely will get no more read inside the Fed than his other pieces have, more’s the pity.
Now Draghi did say in the Q&A part of his press conference that we shouldn’t assume the ECB “will or will not sterilize” any bond purchases that happen. Since always previously the ECB has claimed it was sterilizing purchases (which means they soaked up the money that they were inserting with the purchases), this would represent a weakening of hard-money resolve…if it were actually going to happen. I rather wonder if he didn’t say that just to tweak the Bundesbank. Anyway, he says that “details [are] to come in the next weeks,” which was enough to save markets from a pure meltdown.
Strangely, the Euro weakened along with stock markets in the U.S. (S&P -0.7%) and in Europe (Eurostoxx -3.0%). The Euro ought to be strengthening if investors thought that the ECB just got monetary policy religion and so would restrict the money-printing activities everyone was assuming would happen. Unless, that is, investors are selling Euro-denominated issues because they think the union will break up due to ECB inaction.
My head hurts.
What seems clear enough is that for at least a month or two, the markets are on their own. I don’t know how that’s going to work, when Greece is due to borrow money from the ECB to pay off maturing bonds in only 3 weeks. Conventional wisdom is that the ECB will advance the money, since the ECB holds most of the debt that will be paid off, but I’m no longer so sure of anything.
I do know that we have Payrolls tomorrow morning, and expectations are justifiably low. Consensus expectations are for 100k in nonfarm payrolls and an unchanged 8.2% Unemployment Rate. Payrolls over the last three months have been, after revisions, 68k, 77k, and 80k respectively. The market likely reacts to a very weak number in a positive way, because the conventional wisdom seems to be that the Fed will surely ease at the next meeting if the data remains this weak. But what do we do with a strong number that throws the Fed’s immediate next move into doubt? My guess is that something in the high 100s (175k, 190k, etc) is taken as bearish equities, bullish bonds for this reason, while much above that it all becomes confusing because it won’t be clear whether the first three months of the year were the aberration (the operating hypothesis) or the last three months were.
The only clear investment to me remains commodities, which corrected strongly today , down around 1.25-1.50% ex Nat Gas, which plummeted nearly 8%. Gasoline, however, rallied another three cents. If the central banks abruptly started to control money supply growth and shrink central bank balance sheets – a prospect that I give about a 20% chance to – then the future returns to commodities would be less than I expect. But they’re still undervalued with respect to the current money supply, so even in this case I’d expect solidly positive 5-year real returns.
And if the Bundespanking wears off (and as a father I can tell you, they tend to wear off very quickly), the near-term returns to commodities will continue to look great as well.