the Fed’s next move

The highest economic policy objective of the US is achieving maximum sustainable growth in the economy consistent with annual inflation around 2%.

If growth deviates from this desired path, either through overheating or recession, the government has two tools it can use to nudge the economy back toward trend:

monetary policy, controlled by the Federal Reserve, which can relatively quickly alter the rate of growth of the money supply and thereby either energize or cool down activity

fiscal policy–government taxing and spending–controlled by the administration and Congress, and which may be thought of as more strategic than tactical, since there are typically long lags between need and any legislative action.

As a matter of fact, the Fed has been calling for fiscal stimulus from Congress and the administration for several years–worrying that continuing monetary stimulus is increasingly less effective and even potentially harmful to the economy.  Its pleas have fallen on deaf ears.

The Fed has been using two methods to keep rates low:

–it has kept the Federal Funds rate, the interest rate it sets for overnight bank deposits, at/near zero, and

–it has taken the unconventional step of putting downward pressure on rates of long-maturity instruments by buying a total of $4 trillion+ of government securities in the open market.  This is called quantitative easing.

Donald Trump was the only candidate to address the problem of fiscal policy inaction, by promising giant fiscal stimulus through lower corporate tax rates plus a massive spending program to repair/improve infrastructure.

After Mr. Trump’s surprise win last November, the Fed seems to have breathed a sigh of relief and aanounced a series of interest rate hikes that would begin to return monetary policy closer to a normal amount of stimulus–based on the idea that Washington would also provide serious fiscal policy stimlus in 2017.

We’re now in month nine since the election, without the slightest sign of any action on the fiscal front, despite the fact that the Republicans hold the Oval Office and both houses of Congress.  Senator Pat Toomey (R-Pa) remarked last week that this is because no one expected Mr. Trump to win, so Congress made no plans to implement his platform.   It hasn’t helped that, despite his campaign rhetoric, Mr. Trump has shown little grasp of, or interest in, the issue.

This leaves the Fed in an awkward position.

I think its solution will be to shift from raising the Fed funds rate to slowing down or stopping its purchases of securities farther along the yield curve.  Although in a sense the Fed is already no longer buying new government bonds, it is taking the money it receives in interest payments and principal return from its current holdings and reinvesting that in new securities.

Its first step will be to reduce or eliminate such reinvestment–which will presumably nudge longer-term interest rates upward.  Since the process is being so well advertised in advance by the Fed, it’s likely that most of the upward movement in rates will have occurred before the Fed begins to act.  The most likely date for the Fed to more is in September.


quantitative easing in Japan: implications

quantitative easing in Japan

With all eyes on Greece, one of the less noticed developments in global securities markets is the recent decline of the ¥ versus the US$.  As I’m writing this on Thursday morning, the ¥ has weakened from a high of ¥76 = US$1 reached on February 2nd to the current ¥80 = US$1.

This is not just the result of one of Japan’s periodic, ultimately fruitless, attempts to intervene in currency markets to temporarily weaken the ¥.  Instead, it’s the currency markets reaction to what appears to me to be a substantial shift toward monetary easing by the Bank of Japan.

Why do so?

After over two decades of minimal economic growth and mild deflation, citizens’ tolerance for political and bureaucratic bungling of Japan’s economic policy seems to me to have finally been exhausted.  Voters are deeply unhappy with the administration of the recently installed Democratic Party of Japan.  But no one wants the Liberal Democrats back either.  There’s serious discussion about forming a third political party–really radical thinking in a country where politics has been dominated by a single party, the LDP, for a half century.

There’s also been talk in the Diet of legislation that would take away from the Bank of Japan its Federal Reserve-like role in setting monetary policy.  This threat appears to be what’s prompted the central bank to launch the new program of quantitative easing.  The BoJ is basically saying that it will continue to inject money into the system in large amounts until inflation reappears.  In other words, the new stance is the Fed’s approach, but on steroids.


In the near term, this policy will likely continue to weaken the ¥, removing one source of pressure on the profits of Japanese export-oriented companies.  It’s already prompting investors in the Tokyo stock market to re-orient their portfolios toward export-oriented stocks.  I don’t think this policy move, by itself, has the slightest chance of removing Japan from the morass in which it has been trapped for many years, however.  And substantial negative consequences may lie down the road.

As anyone who has read me on Japan before knows, I think the fundamental issue for that economy is the ground-level social decision made twenty years ago not to adapt to a changing world, but to preserve the traditional social order even if that meant slower economic growth.  After all, the country did hide its banking problems for a decade.  Despite a shrinking workforce, it doesn’t allow immigration.  Its laws cement the management practices of twenty year ago–and most times the actual managers–in place and defends them from virtually all attempts at change. Iconoclasts risk social censure, or worse.

Sounds a lot like the Eurozone, doesn’t it–one currency, but keep the local power brokers in place?


Without substantial structural pro-growth reforms, what’s likely to happen?

For a while, nothing much.  The character of the stock market will continue to change, as investors shift away from smaller, counter-culture secular growth stocks to larger, older exporters.  But for foreign investors, a large part of any local currency gains will be erased by currency losses.  So it will be even harder to make money in Tokyo than before.

The strategy, however, seems to me to be playing with longer-term fire.  The central government has piled up a huge amount of debt, which it can continue to service both because interest rates are extremely low and because–lacking other investment alternatives–Japanese citizens continue to buy tons of government bonds.  Reemergence of inflation will mean, at the very least, rising nominal interest rates, and therefore rising debt service for the government.  In addition, in an all too rigid economy, inflation may spread relatively quickly and begin to have negative effects on the value of Japanese assets.  If so, Japanese investors may shift their money away from government bonds and toward inflation-protection vehicles, like real assets or foreign securities.  That might lead to further currency weakness and compound the government’s funding problem.  So a sovereign debt crisis, while not imminent, may be ultimately waiting in the wings.

what I’m doing in response

I own two Japanese stocks, DeNA and Gree.  I like them both, although each has taken its lumps as the market orients toward exporters.  I’m certainly not going to add new money to Japan.  And I’ve got to consider whether I lessen my exposure.  If DeNA and Gree didn’t have substantial businesses outside their domestic market, I’d be doing that already.



employment in the US: the November Employment Situation and JOLTS

The Labor Department’s Bureau of Labor Statistics released its Employment Situation report for November last Friday. The headline numbers, a 9.8% unemployment rate and the addition of 39,000 jobs vs. the 140,000 that the consensus of economists had predicted, caused a furor both in Washington and in the news media.  Wall Street, however, shrugged the news off, after a brief morning dip.

the Employment Situation

There are, as usual, a couple of quirks in the November report, but nothing that alters the headline number significantly.  The 39,000 gain in jobs breaks out into a boost of 50,000 to private payrolls and a drop of 11,000 in government employees.  Given the parlous state of government finances it seems to me this is a trend that will continue, despite the penchant for elected officials to increase spending no matter what.

The retail sector lost 28,100 jobs, at a time when holiday hiring should be increasing.  Retailers have been announcing that they are in fact adding to their staffs, but a lower rate than in prior years.  So the apparent loss of jobs could well be a function of the way the Labor Department makes its seasonal adjustments to data.  At some point, this should correct itself.

As you may know, the monthly numbers are revised twice after the initial report, as more survey respondents check in.  The September figures, for example, initially reported a loss of 159,000 government jobs (mostly teachers) and a gain of 64,000 in the private sector.  The final tally announced in the November report is a gain of 112,000 private sector positions and a loss of 136,000 in government.  That’s a net gain of 81,000 jobs.

The October report has also gained 21,000 jobs in its initial revision.


The Labor Department also produces a periodic Job Openings and Labor Turnover survey.  The next one comes out at 10am New York time today, a few hours after this is published.  The report will likely show that there are about 3 million unfilled job openings in the US, up by about 800,000 from the recession low.

No one really knows why these available jobs aren’t immediately filled.  The two leading causes posited are:  the jobs require technical skills that the currently unemployed generally don’t have; or the unemployed owe more in mortgages on their houses than the houses are worth, so people are unwilling/unable to move.

the real issue

It’s possible that the November jobs numbers will be revised up to approach the consensus forecasts in the upcoming December and January revisions.  And it is true that there are almost a million more Americans employed today than at the low point for employment in December 2009.

But about 100,000 new workers on average enter the labor force each month, mostly as they complete school or technical training.  In a sense, then the first 100,000 new jobs created in the economy each month go to absorb these new workers.

Let’s say that the economy is really generating about 200,000 new jobs a month–far above what the official figures say– right now, only we don’t know it yet.  How would that affect the unemployment rate or the roughly 8 million workers who lost their positions during the recession?

If so, that number would be enough to take care of all the new workers entering the labor force, plus reduce the number of unemployed by 100,000 a month.  That’s 1.2 million a year.

How many years at this level of job creation until the 8 million who lost their jobs are reabsorbed into the workforce?  Six years and eight months. In other words, at a very generous estimate of the way the economy is now expanding, we won’t have full employment until the second half of 2018.

That’s the real problem.

At first glance, this is purely a domestic political/social problem, not an investment one.  The work force is expanding.  Consumer confidence is rising.  Foreign tourism is on the rise.  And over half of Wall Street’s profits come from sources outside the US.  So S&P earnings will likely continue to rise at a healthy clip, even if unemployment declines at only a snail’s pace.

A key question for investors, however, is whether unemployment will remain an issue of secondary concern.  One could argue that the Fed is carrying out quantitative easing for purely social, not economic, reasons–even at the risk of negative economic effects.  It remains to be seen if this is the last action either the Fed, or Congress, decides to take.

Quantitative easing II: pros and cons

It looks like the US Federal Reserve will start a second round of Quantitative Easing (dubbed QE II) later this week.

what it is

conventional policy

Under normal circumstances, the Fed–or any other national monetary authority–conducts it money policy by controlling the price of the overnight loans it provides to commercial banks.  When it wants to slow the economy down, it raises the price of such loans (meaning the interest rate it charges for them) ; when it wants to boost economic activity, it lowers the price.

What happens, though, when the price hits zero–in effect, where it is now?  In theory, by this time the Fed has done all it can.  If this isn’t enough, it steps aside and the country looks to the president and congress to introduce fiscal stimulus (that is, temporarily boost government spending or lower taxes) to get activity moving at a more rapid clip.

But what if Washington is dysfunctional and can’t get it together to do anything?

an analogy

A doctor sees a man lying on the side of the road, bleeding.  He stops, administers first aid and calls for an ambulance.

Two ambulances show up.  The crew of one says the best thing to do for the ailing man is to leave him there to heal himself.  The crew of the other says the best thing is to arrange for insurance that will cover him in the case of a future accident.  A fist fight between the two crews breaks out.

What should the doctor do?

unconventional policy action

The doctor probably doesn’t walk away.  He probably does something unusual, something that substitutes for the ambulances and that he thinks will help the person lying by the side of the road.

This is the position the Fed believes itself to be in.

what to do

What it has decided to do is to buy longer-dated fixed income securities that the banks have on their balance sheets.  This will put even more money into the hands of banks to lend to customers.  This is QE II because the Fed has already done this once during the early days of the financial crisis, buying up, in particular, highly illiquid bonds whose presence on banks’ balance sheets was thought to have paralyzed their new lending departments.

In theory, QE II would also tend to lower longer-term interest rates and possibly weaken the currency.  And in fact, after the Fed first said it stood ready to start QE II operations several months ago, the interest rates on longer-dated Treasury securities has declined and the US$ has fallen by about 10%.

why the Fed feels comfortable

Maybe “comfortable” isn’t quite the right word.  “Willing” might be better.  It thinks there’s a need for faster economic growth to reduce the unemployment rate.  It knows Washington won’t do anything.  It understands that if it pumps too much money into the system and keeps it there for too long, inflation will result.  But it doesn’t see inflation as a threat anytime soon.  In fact, it would like a little more inflation than we have now, because it thinks deflation is a greater possibility.  And deflation is always the greater threat.

In short, the Fed would probably prefer not to use unconventional means, but it sees no near-term downside.

why not everyone else is

Bond fund managers are very clearly opposed.  The head of PIMCO, the largest such organization in the US, calls QE II “somewhat of a Ponzi scheme.”  Why?  QEII may well help accelerate an anemic domestic economy.  If not, it will at least raise the worry that inflation will resurface in a way the Fed doesn’t expect and can’t easily control.  Neither is good for bond prices, nor for their management fees.

Some economists fear that because unconventional measures are just that, they are poorly understood.  They may have unintended negative consequences.  Even conventional Fed measures can have unintended negative consequences, they point out, in the way that too loose money policy in the early part of the decade led to a housing bubble with devastating consequences for the US.  Others worry that the Fed may leave money too loose for too long, either because it makes a mistake or because it feels political pressure.

So is China.  For bond funds, the worry is that the marketing promise of an economic moonscape–bereft of economic growth or inflation for as far as the eye can see–that will keep their shareholders from ever losing money will prove to be a pipe dream.

For China, on the other hand, where everything is part of political struggle, QE II will likely be seen, not as the result of Washington’s ineptitude but the conclusion of a Machiavellian scheme to create inflation.  The point of doing so?  –to reduce the real value of the trillions of dollars in treasury securities the Middle Kingdom holds.

my thoughts

QE II is on the way, whether we like it or not.  This forces us as investors to be sharply on the alert for signs of either inflation or of a pickup in economic growth.  Both run counter to the Fed’s suppositions.  They would signal a potential sea change in the character of the financial markets that would require portfolio reorientation.

Stay tuned.