Trump and the Federal Reserve

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.

 

 

 

 

 

 

 

 

 

 

 

Venezuela’s proposed “petro” cryptocurrency

the petro

Yesterday Venezuela began pre-sales of its petrocurrency, called the petro.  The idea is that each token the government creates will be freely exchangeable into Venezuelan bolivars at the previous day’s price of a barrel of a specified Venezuelan crude oil produced by the national oil company.  According to the Washington Post,  $735 million worth of the tokens were sold on the first day.

uses?

For people with money trapped inside Venezuela, the petro may have some utility, since it will be accepted by Caracas for any official payments.  For such potential users, the fact that the government determines the dollar/bolivar exchange rate and that a discount to the crude price will be applied are niggling worries.

perils

The wider issue, which remains unaddressed in this case, is that the spirit behind cryptocurrencies is a deep distrust of government, a strong belief that practically no ruling body will do the right thing to protect the fiscal well-being of users of its currency.

In Venezuela’s case, just look at the bolivar.  The official exchange rate says $US1 = B10.  But the actual rate, as far as I can tell, has fallen from that level over the past year or so to $US1 = B25000.

a little history

The more serious worry is that the history of commodity-backed currencies isn’t pretty.

Mexico

In the 1980s, for example a struggling Mexican government issued petrobonds.  The idea was that at maturity the holder could choose to receive either $1000 or the value of a specified number of barrels of Mexican state-produced crude.  Unfortunately for holders, Mexico reneged on the oil-price link.  My recollection (this happened pre-internet so I can’t find confirmation online) is the Mexico also declined to make the return of principal on time.

the US

The fate of gold-backed securities around the world during the 1930s isn’t so hot, either.  The US, for example, massively devalued (through depreciation of the gold exchange rate) the gold-backed currency it issued.  It also basically banned the private ownership of physical gold and forced holders to turn in the lion’s share of their holdings to Washington in return for paper currency.

 

In short, when the going gets tough, there’s a big risk that the terms of any government-backed financial instrument get drastically rewritten.  This recasting can come silently through inflation.  But, if history holds true, government backing of a commodity link to financial instruments gives more the illusion of protection than the reality–especially so in cases where the reality is needed.

 

 

 

inflation and stocks

wage inflation in the US?  …finally?

In my earlier post today, I didn’t mention that in the Employment Situation report from the Labor Department a week ago Friday, the annual rate of growth in wages rose from the 2.5% at which it had been stuck for a very long time, despite declining unemployment, to almost 3%.

an aside

Inflation in general is about prices in general increasing.  Deflation is when prices in general are actually falling.  Deflation is scarier than inflation both because it’s less common/harder to treat and because we have the object lesson of Japan, where a quarter-century of unchecked deflation has moved that country from penthouse to basement among world economic powers.

curing inflation

In developed countries, inflation is always about wages.

The garden variety, which seems to be what the Employment Situation may be signaling, is easy to cure.  …a little painful, but easy.

Raise interest rates.

The idea:  businesses want to expand.  To do that they need more workers.  But everyone is already employed somewhere.  So firms have to offer big wage boosts to poach workers from rivals.  Raising interest rates (eventually) stops that.  It increases the cost of expansion and also slows down demand.

Also nipping incipient inflation in the bud prevents consumer behavior from becoming all about defending oneself from it.

who wasn’t expecting this?

For years, economists have been anticipating a rise in inflation.  The first (false, then) alarms sounded maybe six years ago.

But, as they say, nothing is ever fully discounted until it happens.  In addition, Washington is arguably compounding the problem by enacting fiscal stimulus almost a decade too late–making it more likely that rates will go up sooner and more rapidly than if Washington had done nothing.  (Where did the deficit hawks disappear to?)

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.

 

stocks vs. bonds when interest rates are rising (ii)

yesterday’s post: bonds

To summarize yesterday’s post, when interest rates are rising, newly-issued bonds bear higher coupons than ones issued in the recent past. Older bonds look less attractive, because they provide less return.  So they have to go down in price until they’re trading at equivalent returns to new ones.

Other than inflation-indexed bonds, Treasuries have no defense against this.

What about stocks?

Here the issue is a bit more complicated.

Let’s make the useful, and more or less correct, assumption that stocks and bonds are in equilibrium before rates start to rise.  If so, if bonds get cheaper, stocks will also have to get cheaper in order to compete for investor money against now-higher-yielding bonds.

This means rising rates puts downward pressure on stocks, too.

But stocks do have a defense.  It has to do with why rates are rising.

In most cases, rates begin to rise when either bond investors or the Fed sense incipient inflation that threatens to erode the purchasing power of money.  This is what triggers the impulse to raise rates.  Since in advanced economies, inflation is always an issue of wage inflation, its early warning signs are that the economy is reaching full employment and/or wages are beginning to rise at an accelerating rate.  In the US, that’s where we are now.

But more workers employed and wages rising at a healthy clip imply that consumer spending is likely to rise at an accelerating rate.  This implies accelerating profit growth for, in sequence, retailers, their suppliers and the providers of capital goods to both retailers and suppliers.  To the extent that a given stock market represents the local economy (which about half of the S&P 500 does), profits of publicly traded companies will start to go up at an unexpectedly sharp rate.

Rising profits create upward pressure on stock prices that serves as at least a partial counter to the downward pressure created by rising rates.

currency

A second issue that will affect stocks directly is how the combination of inflation and higher rates affects the local currency.

If the currency falls, which is the most common case, export-oriented or import-competing companies will have the best results.  Purely domestic firms, and domestic firms that use foreign inputs, will fare relatively poorly.

If the currency rises, the opposite will most likely happen.

the S&P 500 in past times of rising rates

In the US in the past, the upward pressure from rising profits and the downward pressure from rising interest rates have most often neutralized each other.  There have certainly been diverse sector and industry performances, based on currency, technology, government fiscal policy and the overall state of the world economy.  So there have typically been substantial outperformance opportunities even in a sideways market.  But the overall market tendency in the early year or so of rising rates has typically been sideways, not down.

 

Tomorrow, REITs.

 

 

current Japanese inflation? ..there is none

Deflation means that prices in general are falling.  If this is the case, it’s better to put off buying new things for as long as possible, until they’re 100% absolutely needed.  That’s because anything you buy today will be cheaper tomorrow.

After a while, non-consumption becomes a habit, and an economy stagnates.

Conversely, in an inflationary environment, everything is more expensive tomorrow than it is today.  So consumers buy in advance.  In addition to things they need, they may also purchase items they have no intention of consuming.  They may think that keeping physical objects which they can later resell is a better way of preserving or enhancing purchasing power than keeping savings in the bank.

Japan has been in a deflationary economic funk for over a quarter century.   When Shinzo Abe became Prime Minister of Japan in late 2012, he decided to attack deflation as a way of boosting economic growth.  He had a plan that has become famous for its three “arrows”:  a massive depreciation of the yen, large-scale government deficit spending, and corporate/regulatory reform.  Each of the three should have been enough by itself to spark inflation.

The expense of the plan has been enormous, both in terms of the loss of international purchasing power of yen-denominated assets and in increased national debt.

The result after close to four years?   ….as the Tokyo government reported last week, no inflation at all.

How can this be?

From its outset, I’ve believed that Abenomics would be unsuccessful.  I thought the stumbling block would be corporate reform.  The earliest evidence that would indicate I would be wrong would, I thought/think, take the form of an effort to remove the legislative barriers to reform that the Liberal Democrats in the Diet had installed after the deflationary crisis had already begun.  So far, for all practical purposes there’s been nada.  So I continue to be convinced that corporate leaders will resist any changes to the status quo, aided as they are by the Diet’s removal of any levers to force reform from the outside.

Of course, any inflation-induced oomph to consumption won’t last forever.  People and institutions adjust. If nothing else, consumers run out of storage space for the extra stuff they’ve bought.  They then have to throttle back their spending   …or rent a storage unit  …or contemplate a McMansion.

What’s surprising to me, however, is that the same reluctance to spend–although perhaps not to the same degree–is evident in both the US and in Europe.  We might figure that the austerity approach of EU countries wouldn’t exactly spur consumers on.  But the lack of inflation and the paucity of mall-storming or website-crashing consumption in the US after eight years of extraordinary stimulus seem to argue that the overarching economic theories about how to induce inflation are incorrect.

Demographics as the cause?

 

interest rates, inflation and economic growth

A reader asked me to write about this.  I think it’s an interesting topic, since traditional relationships appear to be be breaking down.

interest rates

Let’s just focus on government debt, since other debt markets tend to key off what happens here.

 

At the end of the term of a loan, lenders expect the safe return of their principal plus compensation for having made it.  In the case of all but gigantic mutual fund/ETF lenders, participants in government bonds also enjoy a highly liquid secondary market where they can sell their holdings.

The compensation a lender receives is normally broken out into:  protection against inflation + a possible real return.

In the case of T-bills, that is, loans to the government lasting one year or less, the total return in normal times would be: protection against inflation + an annual real return of, say, 0.5%.  In a world where inflation was at the Fed target of 2%, that would mean one-year T-bills would be sold at par and yield 2.5%.

In the case of a 10-year T-bond, the annual return would be inflation + a real return of around 3% per year, the latter as compensation for the lender tying up his money for ten years.  In a normal world, that would be 2% + 3% = a 5% annual interest rate for a bond sold at par.

Compare those figures with today’s one-year T-bill yield of 0.6% and 1.62% for the ten-year and we can see we’re not in anything near normal times.  We haven’t been for almost a decade.

How did this happen?

Fed policy

The highest-level economic objective of the government in Washington is to achieve maximum sustainable long-term economic growth for the country. Policymakers think that growth rate is about 2.0% real per annum.  Assuming inflation at 2.0%, this would imply nominal growth at 4.0% yearly.

expanding too fast

In theory, if the economy is running at a nominal rate much faster than 4% for an extended period, companies will reach a point where they’re ramping up operations even when there are no more unemployed workers.  So they’ll staff up by poaching workers from each other by offering higher wages.  But since there are no net new workers, all that will happen is that wages–and selling prices–will go up a lot.  They’re be no greater amount of output, only an acceleration in inflation.  This last happened in the US in the late 1970s.

Before things get to this state, the Federal government will act–either by lowering spending, raising taxes or raising interest rates–to slow the economy back down to the 2% real growth level.  Typically, the economy ends up contracting mildly while this is going on.

Given long-standing dysfunction in Congress, the first two of these remedies are long since off the table.  This leaves money policy–raising interest rates–as the only weapon in the government arsenal.

growing too slowly/external shock

If the economy slows too much or if it suffers a sharp out-of-the-blue economic shock, the possible government remedies are: lower taxes, increase spending, reduce interest rates.  Washington has elected to do neither of the first two in response to the financial collapse in 2008-09, leaving monetary policy to do all the work of helping the country recover.

Fed policy in cases like this is to reduce the cost of debt to below the rate of inflation.  That hurts lenders (the wealthy, pension funds, retirees) severely, since they are no longer able to earn a real return or even preserve the purchasing power of their money through buyng government securities.

On the other hand, this is like Christmas come early for borrowers.  In theory, they now have many more viable projects they can launch.  They’ll not only be making money on the merits of their new products/services; inflation will also be eroding the real value of the loans they will eventually have to pay back.

 

More on Monday.