calling for higher inflation

Last week a group of prominent economists wrote an open letter to the Federal Reserve arguing that the current Fed target of 2% annual inflation is too low.

Their basic view is:

–circumstances have changed a lot in the US since 2% became the economists’ consensus for the right level of inflation a quarter-century ago, so it isn’t necessarily the right number anymore, and

–the lack of oomph in the US economy is a result of maintaining an inflation target that’s too low.  So let’s try 3% instead.

Having a 3% inflation target instead of 2% isn’t a new idea.  I heard it for the first time about 20 years ago, from an economist at the then Swiss Bank Corp.  Her argument was that getting from 3% to 2% inflation would require an enormous amount of effort without any obvious payoff.  The whole idea of inflation targeting is to eliminate the possibility of the kind of runaway inflation–and associated crazy economic choices–of the kind the US had begun to experience in the late 1970s.  Whether actual inflation is 3% or 2% matters little, just as long as the current level is not the launching pad for a progression of 4%, 6% 9%…

Another way of looking at this would be to say that the nominal figures matter much more than academic economists realize, and that 4% nominal GDP growth (2% trend economic growth + 2% inflation) feels too much like stagnation.  Therefore, it undermines the entrepreneurial tendencies of ordinary people.

 

How to create 3% inflation?  …slower interest rate increases and/or increased government stimulus (meaning tax cuts and infrastructure spending).

 

The letter certainly won’t affect the Fed’s thinking about a rate rise in June.  But it seems to me that the debate on this issue can only intensify.

By the way, I think 3% inflation would be good for stocks, neutral/bad for fixed income.

 

reversing quantitative easing

US stocks were up by about 1% yesterday when the minutes of the last Fed meeting came out.  As Fed watchers saw the topic of paring down the Fed’s $4 trillion+ holdings of government bonds was mentioned, stocks (but not bonds) began to give back their gains and ultimately finished the day lower.

What’s this about?

  1.  The Fed typically uses the Federal Funds rate for overnight loan to loosen or tighten money policy.  In doing so, it depends on the banking system to broadcast increases or declines in interest rates into the market for longer-term debt.  The problem since 2008 is that the banks had destroyed their own creditworthiness through years of unsavory and unsuccessful speculative financial markets trading.  So they were ineffective in performing this crucial rate-determining role.  Congress and the administration were–and still remain–lost in their inside-the-Beltway alternative universe, so there was no hope of help for the failing economy from that source.  The Fed’s solution was to begin “unconventional” operations, by buying huge amounts of longer-dated government debt in order to push down long-term interest rates itself.  It now holds something like $4.3 trillion worth of Treasury and government agency debt.
  2. The Fed has long since stopped making new net purchases of longer-dated bonds.  But as its existing bonds mature, it has continued to roll over the money it gets from them into new bond purchases.  The next step for the Fed in normalizing the long-term debt market will be to stop this rollover.  The consensus is that this change will happen later this year or early next.
  3. What’s “new” from yesterday is that the Fed put this thought down in writing, without specifying any details.

My take:  while the Fed announcement may have been the trigger for an intra-day selloff in stocks, the Fed minutes are not a big deal.  There is an investment issue as to how the Fed will proceed, but that will ultimately be influenced by how capable Mr. Trump will be to get Washington working again.

The President’s early performance has had two consequences:  US investors are beginning to think about shifting money to Europe.  Despite Brexit, that region is beginning to experience its own economic growth.  As well, it is having deep second thoughts about electing Trump-like figures in their own countries (we’ll learn more in the first round of the French elections on April 23rd), thereby increasing their attractiveness as an investment destination.

the Fed’s inflation target: 2% or 3%?

There seems to me to be increasing questioning recently among professional economists about whether the Fed’s official inflation target of 2% is a good thing or whether the target should be changed to, say, 3%.

The 2% number has been a canon of academic thought in macroeconomics for a long time.  But the practical issue has become whether 2% inflation and zero are meaningfully different.  Critics of 2% point out that governments around the world haven’t been able to stabilize inflation at that level.  Rather, inflation seems to want to dive either to zero or into the minus column once it gets down that low, with all the macro problems that entails.  It’s also proving exceptionally hard to get the needle moving in the upward direction from t sub-2% starting point.  My sense is that the 3% view is gaining significant momentum because of current central bank struggles.

This is not the totally wonkish topic it sounds like at first.  A 2% inflation target or 3% actually makes a lot of difference for us as stock market investors:

–If the target is 3%, Fed interest rate hikes will happen more slowly than Wall Street is now expecting.

–At the same time, the end point for normalization of rates–having cash instruments provide at least protection from inflation–is 100 basis points higher, which would be another minus for bonds (other than inflation-adjusted ones) during the normalization process.

–Over long periods of time, stocks have tended to deliver annual returns of inflation + 6%.  If inflation is 2%, nominal returns are 8% yearly; at 3% inflation, returns are 9%.  In the first case, your money doubles in 9 years, in the second, 8 years.  This doesn’t sound like much, either, although over three decades the higher rate of compounding produces a third more nominal dollars.

Yes, the real returns are the same.

But the point is that the pain of holding fixed income instruments that have negative real yields is greater with even modestly higher inflation than with lower.  So in a 3% inflation world, investors will likely be more prone to favor equities over bonds than in a 2% one.

–Inflation is a rise in prices in general.  In a 3% world, there’s more room for differentiation between winners and losers.  That’s good for you and me as stock pickers.

 

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.

 

 

 

the Fed’s rate rise dilemma

It’s looking more and more to me as if the Fed is being paralyzed into inaction by worries about two possible negative effects of beginning to raise rates now.  The dilemma is that the current zero interest rate policy is playing a large role in making each situation worse.

 

The IMF is arguing that economies in the emerging world are too fragile at present to withstand even a small rate rise in the US.  The agency points out that many emerging economies are very dependent on dollar-denominated natural resources, and therefore are being hurt badly by the current slump in demand for minerals.  In addition, many have borrowed heavily in US dollars to finance industrial (read: natural resources) capacity expansion.  Even a small rise in US interest rates, the IMF says, could spark a sharp upward spike in the value of the dollar against other currencies.  This would further dampen demand for natural resources.  At the same time it would make the local currency cost of dollar-denominated loans skyrocket, possibly into impossible-to-repay territory.  In other words, the Fed could trigger an emerging market crisis similar to the one in smaller Asian countries in the late 1990s.

Of course, what made natural resources firms so foolish as to create wild overcapacity?   …one big reason has been the availability of cheap (by historical standards) dollar-denominated loans.   What has prompted (and continues to prompt) US investors (among many others) to take the risk of lending crazy-large amounts of money for projects in places they know nothing about and for projects they didn’t understand   …years and years of low interest rates on Treasury securities and other safe alternative caused by the Fed’s intensive-care low rates.

 

The Fed has carefully studied the failure of Japan in the early 1990s to reignite economic growth after its economic meltdown in late 1989.  The key factor there, in the Fed’s view (mine, too, for what that’s worth) was that the country tried to remove policy stimulus too soon.  The Fed knows that it has already used up all its economy-healing power, so the country would be reliant on Washington for fiscal stimulus to rescue us in the event it makes a similar mistake.  But we all know that Congress has a poor track record for corrective action in crisis and is particularly dysfunctional now.  So the price to the economy of acting too soon could be very high.

How is it, though, that Congress has been able to ignore its economic responsibilities for so long?  …it’s at least partly due to the fact that the Fed continues to cover for lack of legislative action by running a super-easy monetary policy.  The Fed is an enabler.

 

my thoughts

Neither threat to policy normalization–the potential effect on emerging markets and the lack of an economic backup–is going to go away.  Arguably, the situation will deteriorate the longer the Fed waits.  I think the Fed should start the normalization process now.

Janet Yellen, this week and last

Fridays are strange days on Wall Street.  That’s because, unless they’re super-confident, short-term traders don’t like to hold a large inventory of securities over a weekend.  Too much time for bad stuff to happen.  So they sell enthusiastically on Friday afternoons.

There’s certain sense to this behavior.  For them two days+ may be a long holding period.  Also, companies and people, particularly sneaky ones, like to save bad news up for late Friday afternoon or the weekend, when they think no one is paying attention.  This lessens the pain, they think.  Often, it has the opposite effect, however, since anyone who’s been around for a while knows what a late-Friday press release invariably contains.

 

So in one sense it’s not a great surprise that the huge effort–enough to send her staggering off the stage–Janet Yellen put out yesterday to explain that, yes, the US economy is in great shape and, yes, the Fed is going to take the first baby steps to get the country out of interest rate intensive care (IRIC (?)–although it may be too late for this acronym) before New Year’s eve had no lasting positive effect on stock prices today.

The reason is that, aside from robots designed to react to newsfeeds, everyone knew that already.  In fact, her announcement on Thursday the 15th that the Fed Funds rate would stay at zero for now wasn’t a shock, either.  Futures markets had been putting the odds of a rate hike in September at less than one in three.

Yet the stock market took something Ms. Yellen said last week the wrong way.  If it wasn’t the interest rate announcement, what was it?

Actually, I think there are two things, one said and one not.

The first, and more important, in my view, is the unspoken but strongly held belief by the nation’s finest economists that if we have to depend on the White House and Congress for economic support, we’re doomed.  That’s because monetary possibilities to plug up a hole in the bottom of the boat are all used up.  The federal arsenal now contains only fiscal policy—changes in government regulation of business, or in spending priorities or in taxes.  The Fed knows it isn’t going to get bailed out by Washington if it raises rates too soon–something that has gotten many nations into trouble in the past.  Therefore, it has to err on the side of caution, even if that’s unhealthy to do.

We all sot of know this, but it’s not a plus to be reminded that as a nation we’re stuck in at best second gear as long as Washington dysfunctions its way through life.

The second, the one said, is that developments in China have the potential to hurt US growth enough to tip us over the edge.  I don’t think the effect on the stock market is so much about the details.  It’s the headline that matters–that the US is no longer so large that we’re impervious to what may happen in any other single country.  It conjures up thoughts of the post-WWI, when the UK passed the mantle of world economic leadership to the US, except that we’re now in the role of the UK.

Again, everyone sort of knew this was happening.  But having it confirmed by our foremost economists is another thing.

To put this in stock market terms, I don’t think Ms. Yellen is calling into question the market’s ideas about current earnings as about the multiple those earnings are worth.

 

 

 

navigating the next twelve months (i)

As I wrote on Friday, I think we’re at an inflection point in the US stock market.  It seems to me the market is now beginning to take seriously the idea that the Fed will soon be beginning to raise interest rates from the current near-zero.

In one sense, this is not Wall Street’s first rodeo.  There are plenty of times in the past when the Fed has been reversing emergency monetary accommodation applied during a recession.  The investment community has already sifted through them ad nauseam.

On the other hand, the extent and duration of the current monetary easing are both without precedent.  At the same time, the way the market factors new information into stock prices has changed considerably over the last decade.  The goals and risk preferences of the Baby Boom, the most powerful retail influence on stocks, have shifted as well, as that generation has aged.

Boomers are more interested in income than in capital gains.  Hedge fund managers and algorithm-fashioners seem to have very short time horizons–almost reacting to information as it hits the news media rather than anticipating it.  (I almost cringe to write this last.  It reads a lot like the criticisms made by elderly patrician money managers of the past (whom I made fun of at the time) who held stocks for decades at a time and were struggling to adjust to the faster-paced market of my early years on Wall Street.  Still, I think what I’m saying is correct.)

Therefore, I think, we can’t just blindly apply generalizations from the past to our present situations.

two types of tightening

It’s important from the outset to distinguish between two types of Fed tightening:

–restoration of the real rate of interest from negative to positive as the economy recovers from recession, and

–raising the real rate of interest substantially above inflation in order to slow down an economy that’s potentially overheating.

Today, we’re dealing with the first kind, not the second.

what the past tells us

During past periods of Fed tightening of the first type, stocks have been volatile but have generally gone sideways to up.  Bonds, on the other hand, go down.

This, in itself, has implications for stock market strategy.  Stocks that resemble bonds the most tend to do particularly badly; (at least some of) those that resemble bonds the least do the best.

More tomorrow.