Category Archives: Federal Reserve

the Fed’s new inflation stance

August 28, 2020 By in economics, Federal Reserve, Uncategorized Tags: , Leave a comment

Fed Chair Powell, speaking virtually at what would otherwise be the annual monetary policy conference in Jackson Hole, Wyoming, set out a new protocol yesterday for what the Fed would do if the US ever had inflation (a sustained period in which prices in general rise) again.

The old policy was to begin to choke back economic growth by raising interest rates once price increases started to roll, with the objective of holding inflation at or below a 2% annual rate. The new policy is basically to not be so eager, but rather to sit back for a while and see what happens.

Why the change? What does it mean?

some context first

The late 1970s was a baaad time for the US economy. Politicians had successfully arm-twisted the Fed into running an extra-loose money policy for most of that decade. This ended up creating runaway inflation, an economy-killing disease thought to only be found in the worst third-world countries (and Weimar Germany, of course). Prices were rising at close to an 8% clip in 1978, with 11% in prospect for 1979 and progressively bigger figures after than.

Families began to turn their paper money into physical things as fast as they could so that inflation wouldn’t eat into value. They accumulated large inventories of everyday items, on the idea that they’d only be more expensive later on. This hoarding itself drove prices up more. Companies began to borrow heavily, thinking they’d make money just by repaying fixed-rate loans in inflation-diluted dollars. They used the funds to acquire hard assets–real estate developments or gold mines or cement plants or ships–that had absolutely nothing to do with their core businesses but which they told themselves would be inflation-proof and maybe even rise in value.

To shatter the belief in ever-rising prices, and the loony-tunes behavior it sparked, Paul Volcker raised the fed funds rate to 20% in early 1980 and kept it ultra-high until mid-1981, causing a deep recession. This also made prices fall, breaking the inflationary spiral that had developed in the late 1970s. This left families trying to figure out what to do with eight years’ worth of canned goods and corporate boards stewing about their brand-new gold mines–just as the gold price began a fourteen-year swoon.

a 2% target

As inflation and nominal interest rates both continued to decline for decades (the 10-year Treasury yieldid about 5.7% in 1999), theoretical economists began to discuss what the ideal inflation rate might be. They arrived at 2% as their ultimate goal. The Fed decided to see if it could accomplish this with the real economy.

And it succeeded. Some years ago, however, it and other national central banks began to realize that while they’d done a bang-up job getting interest rates down, they had somehow lost the ability to get them, even temporarily, to move in the other direction. What was once an aspirational downside goal had suddenly become an unattainable ceiling.

How so? Who knows. The result is that the world has been constantly been flirting with deflation–the bane of the Great Depression of the 1930s. Whoops.

back to Powell’s statement

I think he’s saying two things:

–given the gigantic amount of government debt run up by Trump administration bungling and its questionable decision to fund the lion’s share in very short-term instruments (which disguises the extent of the damage but puts the country at risk should rates begin to rise), he is not about to create a new crisis by prematurely raising short rates

–given that monetary theory has trapped us in a place where traditional policy tools don’t work so well, Powell would like to see us well above the 2% line before he begins to tighten

Yields went up by a mere 0.05% on the announcement, meaning Wall Street had been assuming the Fed would remain an island of calm in a sea of administration economic madness.

Macroeconomics for Professionals

July 31, 2019 By in administration economic strategy, economics, fed funds rate, Federal Reserve, macroeconomics, Strategy, Uncategorized Tags: , , , , , , 3 Comments

Starting-out note:  there’s an investment idea in here eventually.

I’ve been going through Macroeconomics for Professionals:  a Guide for Analysts and Those Who Need to Understand Them, written by two IMF professionals, with the intention of giving it, or something like it, to one of my children who’s getting more interested in stock market investing.  I’m not finished with the book, but so far, so good.

counter-cyclical government policy

The initial chapter of MfP is about counter-cyclical government policy, a topic I think is especially important right now.

Picture an upward sloping sine curve.  That’s a stylized version of the pattern of economic advance and contraction that market economies experience.  Left to their own devices, the size of economic booms and subsequent depressions tend to be very large.  The Great Depression of the 1930s that followed the Roaring Twenties–featuring a 25% drop in output in the US and a decade of unemployment that ranged between 14%-25%–is the prime example of this.  National governments around the world made that situation worse with tariff wars and attempts to weaken their currencies to gain a trade advantage.  A chief goal of post-WWII economics has been to avoid a recurrence of this tragedy.

The general idea is counter-cyclical government policy, meaning to slow economic growth when a country is expanding at a rate higher than its long-term potential (about 2% in the US) and to stimulate growth when expansion falls below potential.

 

applying theory in today’s Washington

Entering the ninth year of economic expansion–and with the economy already growing at potential–Washington, which had provided no fiscal stimulus in 2009 when it was desperately needed, decided to give the economy a boost with a large tax cut. Although pitched as a reform, with lower rates offset by the elimination of special interest tax breaks, none of the latter happened.  Then, just a few days ago, Washington gave the economy another fiscal boost.  Mr. Trump, channeling his inner Herbert Hoover, is also pressing for further interest rate cuts to achieve a trade advantage through a weakened dollar.

This is scary stuff for any American.  The country faced a similar situation during the Nixon administration, which exerted pressure on the Fed to keep rates too low during the early 1970s.  Serious economic problems that this brought on didn’t emerge until several years later, when they were compounded by the second oil shock in 1978 (that was my first year in the stock market; I was a fledgling oil analyst).

why??

Why, then, is Mr. Trump trying to juice the US economy when he should really be trying to wean it off the drug of ultra-low rates?

I think it’s safe to assume that he doesn’t understand the implications of what he’s doing (the thing Americans of all stripes recognize, and like the least, about Mr. Trump, a brilliant marketer, is how little he actually knows).   If so, I can think of two reasons:

–as with many presidents a generation ago, he may see ultra-loose money as helping his reelection bid, and/or

–the “easy to win” trade wars may be hurting the US economy much more deeply than he expected and he sees no way to reverse course.

If I had to guess, I suspect the latter is the case and that the former is an added bonus.  I think the main counter argument, i.e., that this is all about the 2020 election, is that the administration seems to be systematically eliminating any parties/agencies that want to investigate Russian interference in domestic politics.

Either would imply that software-based multinational tech companies that have led the stock market for a long time will continue to be Wall Street winners–and that the weakness they are currently experiencing is mostly an adjustment of the valuation gap (which has become too large) between them and the rest of the market.

In any event, interest rate-sensitives and fixed income are the main areas to avoid.  If the impact of tariffs is an important motivating factor, then domestic businesses that cater to families with average or below-average incomes will likely be hurt the worst.

 

 

 

 

cutting the fed funds rate

July 16, 2019 By in Federal Reserve, interest rates, Uncategorized Tags: , , , 1 Comment

The main value you and me in Mohamed El-Erian’s observations on financial markets is that he has a knack for framing accurately, if longwindedly, the consensus view of financial professionals on topics of the day.  Nothing profound, but a solid base for figuring out how to fashion contrary bets.

In a piece for Yahoo Finance this week, however, Mr. El-Erian has neatly made a number of points about the fed funds rate cut that seems to be on the cards for later this month:

–there’s little justification for the cut on traditional economic grounds

–the reduction will likely have little impact on the real economy

–the cut won’t weaken the dollar, because other nations will reduce their equivalent rates

–at a time when financial speculation is already running hot, a rate cut risks adding accelerant to the fire

–cuts reduce the scope for the Fed to act in case of a real financial emergency

–the Fed will lose at least some credibility as an independent body whose signals should be followed by financial markets (my note: in fact, the parallels are already being drawn between Trump and Nixon, whose meddling with the Fed for political reasons in the early 1970s led to financial disaster later in that decade).

no good reason to cut, so why?

If everything’s going so well, why bully the Fed into easing?

I think it has to do with stock market earnings growth.  Last year overall eps for the S&P 500 grew by about 18%.  My back-of-the-envelope estimation is that operating earnings grew by 8% and the other 10% was a one-time upward adjustment for lower US taxes.  A reasonable guess for 2019–without including the negative effect of tariffs–would have been another 8% growth for the US portion of S&P earnings and, say, 6% for the foreign component.  Figuring that both are roughly equal in size, that would imply +7% for 2019 eps.

So far, though, eps are coming in about flat. And analyst predictions, always on the sunny side, are now for slight year-on-year dips for the June and September quarters.  Yes, Europe is weaker than one might have thought.  So that’s a (small) part of the disappointment.  But it seems to me the Trump tariffs + retaliation to them must be biting much deeper into the domestic economy than Wall Street (or I) had been expecting.   …and that’s without considering the longer-term structural harm I think they are likely to do.

If so, the solution is to find a face-saving way to reduce or eliminate tariffs.  it is certainly not to introduce further distortions into fixed income markets.

PS:  it seems to me that the best way to compete with China is to strengthen the education system and to support government-assisted scientific research.   Both are non-starters in today’s domestic politics.

 

 

 

the Fed’s dilemma

June 6, 2019 By in Federal Reserve, macroeconomics, microeconomics, tariffs, Uncategorized Tags: , , , , , , 1 Comment

history

From almost my first day in the stock market, domestic macroeconomic policy has been implemented by and large by the Federal Reserve.  Two reasons:  a theoretical argument that fiscal policy is subject to long lead times–that by the time Congress acts to stimulate the economy through increased spending, circumstances will have changed enough to warrant the opposite; and ( my view), until very recently neither Democrats nor Republicans have had coherent or relevant macroeconomic platforms.

If pressed, Wall Streeters would likely say that Washington has historically represented a net drag on the country’s economic performance of, say, 1% yearly, but that it was ok with financial markets if politicians didn’t do anything crazily negative–the Smoot-Hawley tariffs of 1930, for example.

During the Volcker years (1979-87), money policy was severely restrictive because the country was struggling to control runaway inflation spawned by misguided policy decisions of the 1970s (Mr. Nixon pressuring the Fed to keep policy too loose).  Since then, the stock market has operated under the belief that the Fed’s mandate also includes mitigating stock market losses by loosening policy, the so-called Greenspan, Bernanke and Yellen “puts.”

recent past

We’ve learned that monetary policy is not the miracle cure-all that we once thought.  We could have figured this out from Japan’s experience in the 1980s.  But the message came home in spectacular fashion domestically during the financial crisis last decade.  As rates go lower and policy loosens, lots of “extra” money starts sloshing around.   Fixed income managers gravitate toward increasingly arcane and illiquid markets.  In their eagerness to not be left out of the latest fad product, they begin to take on risks they really don’t understand as  well as to forego standard protective covenants.

We could almost hear the sigh of relief from the Fed as the tax bill of 2017, which reduced payments for the ultra-rich and brought the corporate tax rate down to about the world average, passed.  Because the bill was so stimulative, it gave the Fed the chance to raise rates as an offset, meaning it could tamp down the speculative fires.

today

Enter the Trump tariffs.

Two preliminaries:

–tariffs are taxes.  Strictly speaking, importers, not foreign suppliers (as the president maintains (could it be he actually believes this?)) pay them to customs officials.  But the importer tries to ease his pain by asking for price reductions from suppliers and for selling price increases from customers.  How this all settles out depends on who has market power.  In this case,it looks like virtually all the cost will be borne by domestic parties.  Domestic economic growth will slow.  The relevant stock market question is how much of the pain consumers will bear and how much will be concentrated in a reduction of import business profits.

–I think Mr. Trump is correct that the US subsidy of NATO is excessive.  It represents the situation at the end of WWII, when the US left standing–or at best the time when the USSR began to disintegrate into today’s Russia (whose GDP = Pennsylvania + Ohio, or California/2).  I also think that China, with a population five times ours and an economy 1.25x as big as the US (using PPP), is a more serious economic rival than we have seen in decades.  It doesn’t have the post-WWII sense of obligation to us that we have seen elsewhere.  So we have to rethink our relationship.

Having written that, I don’t see that Mr. Trump has even the vaguest clue about how the country should proceed, given these insights.

To my mind, tariffs + retaliation mean both domestic and foreign companies will be reluctant to locate new operations in the US.  Tariffs on Chinese handicrafts may bring industries of the past back to the US, at the same time they force China to increase emphasis on industries of the future.  I don’t get how either of these moves should be a US strategic goal….

the dilemma

The question for the Fed:  should it enable the president’s spate of shoot-yourself-in-the-foot tariff policies by lowering rates?  …or should it let the economy slide into recession, hoping this will jar Congress into action?

 

Trump and the Federal Reserve

April 10, 2019 By in Federal Reserve, interest rates, Strategy, Uncategorized Tags: , , , 1 Comment

dubious strategies…

I was thinking about last year’s Federal government shutdown the other day.  There are two million+ Federal workers.  They make an average salary of just above $90,000 a year, which is 50% more than the typical worker in the US.   Add in health insurance and pension benefits and their total compensation is double the national average.

On the surface, it seems odd to me that Federal workers began to run out of money almost the minute Mr. Trump laid them all off late last year.  On second thought, though, given their apparent job security and generous benefits, there’s arguably no urgent reason for them to build up savings.  Maybe they do live at what for others might be right on the edge.

That might explain the outsized negative impact laying Federal workers off en masse had on the economy, given that they represent only about 1.3% of the workforce?  If each consumes as much as two average workers, which I think is a reasonable guess, then the layoff does the same damage as 2.5% of the total American workforce becoming unemployed.

This is bigger than you might think.  A 2.5% rise in unemployment is what happens in a garden-variety recession.  No wonder the economy appeared to fall off a cliff in January.

 

Consider, too, the effect of the Trump decision to withdraw from international associations in favor of waging country-to-country trade warfare.  The resulting flurry of highly targeted tariffs and retaliatory counter-tariffs has made the US, at least for the moment, a uniquely bad place for new capital investment.  That’s even without considering the administration’s policy of restricting domestic firms’ ability to hire highly talented foreign technicians and executives–a policy that has made Toronto the fastest-growing tech city in North America.  Again, no surprise that new domestic capital additions sparked by tax cuts have fallen far below Washington estimates.  And, of course, tariff wars have lowered demand for US goods abroad and raised prices of foreign goods here.

My point is that–apart from the ultimate merits of administration goals–they are being pursued in a strikingly shoot-yourself-in-the-foot way.

…continue

Yes, Federal workers are back on the job.  I can’t imagine that they will resume their old spending habits, though, given the new employment uncertainty they are facing.  Last week the administration discussed disrupting the supply chains of American multinationals with operations in Mexico.  Yesterday, the talk was of a possible $11 billion in new tariffs on imports from the EU …and the retaliation that would surely follow.  Even if none of this materializes, their possibility alone will increase the reluctance of companies to operate inside the US.  The negative effect of all this may be much greater than the consensus thinks.

 

now the Federal Reserve

This central bank’s official role is to set monetary policy through its control of short-term interest rates.  Its unoffical role is to be a political whipping boy.  It takes the blame for (always) unpopular rises in interest rates that are needed to keep the economy from overheating, and on track to achieve maximum sustainable long-term GDP growth.

The two instances where the Fed has succumbed to Washington arm-twisting–the late 1970s and the early 2000s–have created really disastrous outcomes, the big recessions in 1981 and 2008.

Despite this, Mr. Trump has apparently decided to offset the negative economic effects of his tax and trade policies, not by stopping doing what’s causing harm, but by forcing the Federal Reserve into an ill-advised reduction in interest rates.  His first step down this road will apparently be the nomination of two loyalists without economic credentials to fill open seats on the Fed’s board.

If the two, or similar individuals, are nominated and confirmed, the likely result will be a decline in the dollar, the start of a residential real estate bubble and a further shift of corporate expansion plans away from the US.  We may also see the beginnings of the kind of upward inflationary spiral that plagued us in the late 1970s.

 

investment implications

Replying to a comment on my MMT post, I wrote:

“Ultimately, though, the results would be a loss of confidence, both home and abroad, that lenders to the government would be paid back in full. That would show itself in some combination of currency weakness, accelerating inflation and higher interest rates. Typically, bonds and bond-like investments would fare the worst; investments in hard-currency assets or physical assets like real estate/minerals, or in companies with hard-currency revenues would fare the best. I think gold, bitcoin and other cryptocurrencies would go through the roof.”

I think the same applies to Mr. Trump gaining control over the Fed.