politics and the Federal Reserve

In my post last Friday on the Labor Department’s most recent Employment Situation report, I commented that I thought it unlikely that the Fed would raise short-term interest rates before the election in November.  How so?   …because the Fed worries about accusations that it would be intruding into the electoral process.

A reader commented that he thought such worries would be silly, either on my part or the Fed’s or both.  I thought I’d respond here.

I agree that it makes little difference for the economy whether the Fed Funds rate is at 0.25% or 0.50%.  In fact, one could easily make the argument that extreme money stimulus is no longer needed and that the US would be better off with higher rates rather than lower.

 

A generation ago, when controlling nominal short-term interest rates was the Fed’s sole policy tool, it was the norm for the sitting President to pressure the Fed in an election year to lower rates, or refrain from raising rates, in order to keep his party in power.  It was also normal for the Fed to acquiesce.  Monetary policy lore says that Gerald Ford was the first president not to do so–and he lost his reelection race.  This behavior also gave rise to the belief that an election year would usually be an up year for stocks, followed by difficulties during the first year of the next term, as the new president removed the extra stimulus.

 

The appointment of Paul Volcker as Chairman of the Fed with a mandate to get the runaway inflation of the late Seventies under control changed this situation, making the Fed the de facto government mechanism for implementing economically necessary but politically toxic decisions to slow the pace of growth.

 

Seeking not to return to its role as a tool of one political party or another, the Fed seems to outsiders to have developed a rule that it will not act within, say, four or five months prior to a presidential election, to either raise or lower rates.  One might otherwise argue that it is giving an economic boost to–or at least signalling its approval of–the sitting president by lowering rates.  It would signal disapproval by raising them.

 

However, as Alan Kaplan points out, the Fed is political.  One could easily maintain that the Fed has enabled the continuing failure of Congress to enact sensible fiscal measures to support economic growth.  (The other side of the argument would likely be that although members of Congress may have cultural agendas, the ones who show up at briefings by the Fed are shockingly ignorant about basic economics.  So they have no idea of how to craft prudent fiscal stimulus.)

One other issue.  The emergency-low interest rate policy we’ve had in place for eight years places the interests of borrowers ahead of those of savers.  Another political decision.  A generation or two ago the latter would have been the ultra-wealthy.  In today’s world, savers are Baby Boomer retirees, whose ability to establish a secure stream of interest income to support their lifestyles has been diminished by government policy.

 

Employment Situation, August 2016

This morning at 8:30 edt the Bureau of Labor Statistics of the Labor Department released its monthly Employment Situation.  This was a so-so report.

The economy added +151,000 new jobs last month.  Revisions to the prior two months were -1,000, or insignificant.  Wages were up, but only slightly, maintaining their growth of about 2.4% annually.  Service industries continued to gain; manufacturing and construction were flattish.

The results did fall short of Wall Street economists’ estimates of a +181,000 advance, but to my mind this says more about the economists and the difficulty of forecasting the jobs figure precisely than it does about the jobs.

It there’s one thing I take from it, it’s that the period of turbocharged jobs gains–well over +200,000 a month–we were experiencing earlier in the year is now behind us.  If I were forced to attribute this relative slowdown to anything, it would be the strength of the dollar.

For me, the most curious thing about the report is that it appears to have sparked a rally on Wall Street, on the notion that this report makes it less likely that the Fed will raise interest rates later this month.  This makes little sense to me, although I’ll take an up day rather than a down one any time.  Personally, I think the Fed risks accusations of trying to influence the election if it acts before November, so not matter what its rhetoric it’s unlikely to move now.  Looking at the character of gaining stocks, it’s primarily smaller doing better than larger, something that mostly happens when rates are rising.

This is the first time in a long while I’ve been nonplussed by market movements.

 

keeping nominal GDP growth above zero

A reader asked a question about this after my Stephen King post from last Friday.  I think the best place for an answer is here.

In most circumstances, what counts is real GDP, not nominal.  That latter is, after all, just real GDP + inflation.  However, what comes to mind when people start to look for instances where nominal GDP shrinks is the Great Depression   …or maybe Japan during the series of Lost Decades it has been experiencing since 1990.

A potentially huge economic problem during a period of declining nominal GDP is that virtually all borrowing contracts–bonds or bank debt–are written in nominal terms.    In many places, labor contracts are also framed the same way, with an x% increase in wages yearly over the term of the agreement.

The revenues that businesses generate to meet these obligations are a function of unit volumes and price changes.  If real GDP is falling by, say, 3% and prices rising by only 1%, overall revenues are contracting.  Given that operating costs are typically fixed over the short term, this means firms in the aggregate will have less income to meet debt repayments and salary obligations.  For highly operationally or financially leveraged companies, even small declines in revenues can be deadly.

If, on the other hand, volumes are down by 3% and prices are rising by 4%, then revenue growth will still be positive.  On the margin, at least, this means fewer layoffs and fewer insolvencies to act as an economic drag during a time  when governments are trying to stimulate demand.

 

The situation where nominal prices are actually falling–which we’re not talking about here– is far worse.  Consumer soon learn that waiting a month, or two or three, before buying will mean a lower price.  So they just stop buying.  Given that consumers make up the bulk of economic growth in developed economies, they can ill afford to get the idea in consumers’ heads that purchasing anything today is a bad idea.

Stephen King on productivity and monetary policy

The Stephen King I’m writing about is an economic advisor to HSBC who was formerly the bank’s chief economist.  He’s one of the most interesting economists I’m aware of.  For instance, he was one of the first to warn of excesses in the US housing market a decade ago, and perhaps the most vocal in doing so.

Last week he weighed in on the issue of productivity in an Opinion article in the Financial Times.  His main points:

1. The current low level of productivity–+1% yearly in the US, flat to down elsewhere–may not be due to lack of infrastructure spending (Lawrence Summers) or that most productivity-enhancing inventions have already been made (Robert Gordon).  It may be instead that we’re seeing now is normal.  It’s the generation that rebuilt after WWII, creating high growth in productivity in the process, that’s the outlier.

2.  If #1 is true, then many of the mainstays of orthodox macroeconomic policy need to be reexamined.  In particular,

–if the world is being flooded with money, then capital is equally available at cheap prices to high productivity enterprises and low ones.  The result may be that the very process thought to be increasing economic growth is neutralizing the competitive advantage of high-productivity enterprises

–in a low-inflation, low-productivity world, interest rates will be “dragged down to incredibly low levels,” meaning recession-fighting monetary expansion may be difficult to achieve

–cultural expectations built over the past half century of ever increasing prosperity may prove to be too high.  This would be trouble for, say, pension or social security schemes around the world whose ability to deliver promised benefits assumes the robust real economic growth of the past can be extrapolated into the future.

3.  The ability of governments to create inflation may become increasingly important, as a means of keeping nominal GDP growth above zero during an economic downturn.  Monetary theorists around the globe have assumed that doing so involves only the simple expedient of increasing the money supply.  The past eight years in the US, however, have shown that creating inflation is much easier to theorize about than to do.

 

His overall conclusion:  the Lawrence Summers idea of secular stagnation–which can be addressed through increased infrastructure spending–is a much cheerier outlook than it appears at first blush.

Caesars Entertainment and private equity

I’ve been wanting to write about what might be called the private equity paradigm for some time. On the other hand, I don’t see any way for me as a portfolio investor to make money from research I might do–other than to keep as far away from private equity deals as possible–so I haven’t done as meticulous job of research on this post as I would if it involved a stock I might buy.  So regard this more of a preliminary drawing than as a finished picture.

When a private equity firm acquires a company, it seems to me it does five things:

–it cuts costs.  The experience of 3G Capital seems to show that typical mature companies are wildly overstaffed, with maybe a quarter of employees collecting a salary but doing no useful work.  Private equity also uses its negotiating power to get better input pricing, although it passes on little, if any, of the savings

–it levies fees to be paid to it for management and other services

–it increases financial leverage, either through taking on a lot of bank debt, or, more likely, issuing huge swathes of junk bonds.  An equity offering may happen, as well

–it dividends lots of available cash generated by operations and/or sales of securities to itself, thereby recovering much/all of its initial investment

–it then sits back and waits to see whether (mixing my metaphors) this leveraged cocktail to which it now has only limited financial exposure, sinks or swims.

 

Caesars Entertainment has added a new twist to this paradigm.  In 2013, its private equity masters seem to have decided that sink was the more likely outcome.  Rather than simply accept this fate, they began preparing a lifeboat for themselves by whisking away valuable assets from the subsidiary that is liable for the company debt into another one.  In January 2015, after this asset shuffling was done, they put the debt-laden subsidiary into bankruptcy.

Junk bond holders sued.  Litigation has been protracted and has reportedly cost $100 million so far.

Media reports indicate that the case is now approaching resolution–either through negotiation or court ruling.  My no-legal-background view (I was a prosecutor in my early days in the Army, but that says more about the Uniform Code of Military Justice back then than about me) is that:  these asset transfers can’t be legal; and the junk bond loan agreements should have had covenants that explicitly bar such action.  So I’m not sure what has taken this long.

Whatever the outcome of the case is, I think it will shape the nature of private equity from this point forward.

 

 

 

Intel (INTC) and ARM Holdings (ARMH)

chipmaking rivalry

The big division in the chip-making industry over the past 15-20 years has been between giant vertically integrated makers like INTC, Texas Instruments … which manufacture chips designed in-house and smaller digitally-oriented design firms who rent structural intellectual property from ARMH, modify it and have chips made in third-party contract fabrication factories like those run by TSMC.

INTC’s advantages have been the raw power of its chips and its manufacturing superiority.  Users of the ARMH framework tout the elegance of their designs that enables output to be smaller, use less electricity and generate less heat.

disruption by iPhone

The balance of power began to shift away from INTC and toward the ARMH camp when INTC decided not to make chips for the iPhone.  It may be that INTC management thought smartphones were a flash in the pan, as urban legend has it, or it may simply have been that INTC knew its chips ran too hot and used too much power for Apple to be satisfied with them.  In any event, INTC has been trying to reinvent itself since then, by improving its chip design while maintaining its manufacturing edge.

On the latter front, INTC continues do well; on the former, not so much.  Despite a lot of design effort, its low-power, low-heat solutions for the smartphone world haven’t been good enough to gain much traction.

This itself threatens the manufacturing operation.  As INTC steadily shrinks the size of its chips, each silicon wafer processed becomes capable of yielding more output.  At some point, INTC’s factories are potentially going to be capable of churning out more chips than the company can reasonably expect to sell to its PC and server customers.  The capital equipment used in chip making is so expensive–$3 billion+ today, maybe $10 billion+ for the fabs of a few years from now–that the factories have to run at high utilization rates to be profitable.  INTC has already said that next-generation (extreme ultraviolet lithography) technology is too expensive for even INTC to invest in by itself.

Hence the deal with ARMH.

three other points:

–presumably working with ARMH-based firms will help INTC fine-tune its manufacturing processes for mobile and the Internet of Things

–this may be the first step in closer cooperation between the two companies

–the arrangement has been announced very quickly after Softbank agreed to acquire ARMH.  Are the two connected?  If so, Masayoshi Son may have plans for much greater integration of the two rival firms.

 

 

 

 

the Federal Reserve and the election

The Fed is in an awkward position.

From a monetary stimulus perspective, the US has been in the equivalent of hospital intensive care for eight years.  In fact, by some measures the amount of stimulus being applied to the economy today is greater than it was during the depths of the 2008-2009 recession.

On the other hand, there’s the cautionary tale of Japan, which has been in quasi-recession for almost three decades.  At least part of this is due to three instances–one monetary, two fiscal–where the Land of Wa withdrew stimulus prematurely and nipped recovery in the bud.  Japan’s history also seems to show that reversing a policy mistake once made doesn’t undo all the damage of having made it in the first place.  This is the cause of the Fed desire to err on the side of having too much stimulus or having it for too long.

The Fed knows, too, that the legislative and executive branches in Washington are dysfunctional–that there’s no hope of government spending that would attack pockets of economic weakness through, say, programs to retrain workers displaced by technological advance or on repairing aging infrastructure.  This is despite the fact that extra dollops of monetary stimulus only improve the overall economic tone of the country and are less and less effective at addressing specific issues of great concern like chronic unemployment and bad roads.  On the other hand, the Fed is enabling this craziness by monetary accommodation.

On top of all this, the Fed is hemmed in by the presidential election cycle.  It typically does not want to make a move that could be interpreted as an attempt to influence the November election, either by lowering rates to make the economy seem more vigorous (favoring the incumbent) or raising them to make it seem less so (favoring the challenger).  In today’s case, of course, it has no scope to do the former.  And the Republicans are the party that wants to eliminate the Fed as an independent body (a lunatic move, from an economic standpoint).

So, what is the Fed going to do?

Its recent rhetoric says it wants to raise rates again before yearend.  There are three scheduled meetings left in 2016:  September, November and December.  It would seem to me that acting after either of the first two amounts to meddling in the election.  That leaves either an unscheduled meeting in August or the scheduled one in December.