Fed Policy – Page 4 – The Aleph Blog

Thinking About Monetary Policy: A Counterfactual

Posted on 8 October 20169 October 2016 by David Merkel

Photo Credit: Daniel Mennerich || A bridge described in fiction to bridge me to the counterfactual argument of this post

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I received an email from a longtime reader:

David, here is a (possibly useless) thought experiment.

In 2005, PIMCO’s Paul McCulley was begging Ben Bernanke to halt the on- going quarter-point raises in the Fed Funds rate at 3.5 percent. I forget his exact reasoning, but he clearly thought that the financial markets couldnot accommodate short-term rates above 3.5 percent without substantial disruptions.

Suppose that Bernanke had listened to McCulley and capped the Fed Funds rate at 3.5 percent until it was clear how the markets would fare at that level. Would that alone have been sufficient to postpone or even avert the housing crisis? Or would it have made the crash even worse?

According to FRED, the Funds rate reached 3.5 percent in August 2005, and as we know housing prices nationally peaked about one year later, just as the Funds rate was topping out at 5.25 percent. Question is, did the additional 1.75 percent of increases serve to tip the housing market into decline, or was the collapse inevitable with or without the last seven quarter-point raises?

Any thoughts?

Here was my response:

I proposed the same thing at RealMoney, except I think I said 4%.? My idea was to stop at a yield curve with a modestly positive slope.? It might have postponed the crisis, and maaaaybe allowed banks and GSEs to slowly eat up all of the bad loan underwriting.

I had Googlebots tracking housing activity daily, and August 2015 was when sales activity peaked.? I announced it tentatively at RealMoney, and confirmed it two months later.? From data I was tracking, housing prices flatlined and started heading down in 2006.? The damage was probably done by 2005 — maybe the right level for Fed funds would have been 3%.

The trouble is, hedge funds and other entities were taking risk every which way, and a mindset had overwhelmed the markets such that we had the correlation crisis in May 2005, and other bits of bizarre behavior.? Things would have blown up eventually.? Speculative frenzy rarely cools down without the bear phase of the credit cycle showing up.

So, much as it would have been worth a try, it probably wouldn’t have worked.? The housing stock was already overvalued and overleveraged.? But it might have taken longer to pop, and it might not have been as severe.

But now for the fun question.? Is the Fed trying to do something like that now?? Are they so afraid of popping any sort of asset bubble that they have to be extra ginger in raising rates?? It seems any market “burp” takes rate rises off the table for a few months.

I don’t know.? I do know that the FOMC has only 1% of tightening to play with before the yield curve gets flat.? Also, obvious speculation is limited right now.? There is a lot that is overvalued, but there is no frenzy… unless you want to call nonfinancial corporation and government borrowing a frenzy.

Thanks for writing.

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The FOMC is Afraid of its own Shadow

If I were the Fed, I would end the useless jabbering that they do. ?I would also end the quarterly forecasts and press conference. I would also end publishing the statement and the minutes, and let people read the transcripts five years later. We would go back to the pre-Greenspan years, when monetary policy was managed better. ? Before I did that I would say:

The Fed has three responsibilities: controlling inflation, promoting full employment, and regulating the solvency of the banking system. ?We are not responsible for the health and well-being of financial markets. ?The ‘Greenspan Put’ is ended.

We will act to limit speculation within the banks, such that market volatility will have minimal impact on them. ?We want our pursuit of limited inflation and full employment to not be hindered by looking over our shoulder at the boogeyman that could affect the banking system. ?To that end, please realize that we will not care if significant entities lose money, including countries that may get whipped around by our pursuit of monetary policy in a way that benefits the American people.

We are not here as guarantors of prosperity for speculators. ?Really, we’re not here to guarantee anything except pursue a stable-ish price level, and to the weak extent that monetary policy can do so, aid full employment.

We hope you understand this. ?We do not intend to use our “lender of last resort” authority again, and will manage bank solvency in a way to avoid this. ?We may get called ‘spoilsports’ by the banks that we regulate, but in the end we are best served as a nation if solvency concerns dominate over the profitability of the banking industry.

As it is, the present FOMC fears acting because it might derail the recovery or spark a bear market in risky assets. ?Going beyond the mandate of the Fed has led to bad results in the past. ?It will continue to do so in the future.

The best way for the Fed to maintain its independence is to act independently and responsibly. ?Don’t listen to outside influences, particularly when hard things need to be done. ?Be the adult in the room, and tell the children that the medicine that you give them is for their good. ?Recessions are good, because they clear away bad uses of capital from the ecosystem, and make room for new more productive ideas to use the capital instead.

As it is, the Fed is afraid of its own shadow, and will not take any hard actions. ?That will either end with inflation, or an asset bubble that eventually affects the banks. ?A central bank like that does not follow its mandate does not deserve its independence. ?So Fed, if you won’t act for our long-term good, will you act to preserve your existence in your?present form?

Redacted Version of the September 2016 FOMC Statement

Posted on 21 September 2016 by David Merkel

Comments

The FOMC tilts closer to tightening, though they changed their risk statement to neutral.
Interesting to see such a large dissent. That is a relatively rare occurrence.
Policy continues to stall, as the economy muddles along.
But policy should be tighter. Savers deserve returns, and that would be good for the economy.
The changes for the FOMC?s view are that GDP and labor indicators are stronger. The FOMC has groupthink and confirmation bias, and thus interpret noise as signal.
Equities and bonds rise. Commodity prices rise and the dollar falls.? Everything is a little looser.
The FOMC says that any future change to policy is contingent on almost everything.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up much, absent much higher inflation, or a US Dollar crisis.

Redacted Version of the July 2016 FOMC Statement

Posted on 27 July 2016 by David Merkel

Comments

This statement was a nothing-burger.
Policy continues to stall, as the economy muddles along.
But policy should be tighter. Savers deserve returns, and that would be good for the economy.
The changes for the FOMC?s view are that labor indicators are stronger, and GDP and household spending are weaker.
Equities and bonds rise a little. Commodity prices rise and the dollar falls.? Everything is a little looser.
The FOMC says that any future change to policy is contingent on almost everything.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up much, absent much higher inflation, or a US Dollar crisis.

In Human Affairs “Never Say Never”

Posted on 5 July 2016 by David Merkel

Picture Credit Bloomberg — Picture Credit: Bloomberg

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Rates can go lower from here. ?For as long as I can remember, I have been told by many experts that rates can’t go lower, or, that they must go up — there is no way they can go lower. ?I have argued with that idea, as has Hoisington (Lacy Hunt), Gary Shilling and a few others.

Note also that the Fed and most central banks have been on the wrong side of this as well. ?They keep saying that inflation will come, economic activity will pick up,?and that interest rates will rise.

The Fed keeps saying that they will tighten policy. ?I’ll tell you this — with only 0.82% between the yields on 10- and 2-year Treasuries, the Fed is not tightening.

WIth debt levels as high as they are (both government and private), trying to influence economic activity though interest rates is a dumb idea. ?Incenting borrowers to borrow more is difficult, aside from the government — and they rarely do anything with the money that helps produce opportunities for greater economic activity.

We would be better off without “policymakers” trying to “stimulate” the economy, “manage” it, “stabilize” it, etc. ?(But where is the political will to change things — the populace wants easy prosperity, and who is there to tell them to accept a rough world where work and competition is tough, and there is no “Big Daddy” to make life easy? ?The people are the problem. ?The politicians are only a symptom.)

There is one thing that could change this, but it would lay bare the intellectual and moral bankruptcy of what policymakers have been trying to do, which is try to maintain the real value of debt claims while still trying to “stimulate” the economy. ?They could burn away the value of debt claims through an inflation greater than that of the 1970s.

So far, they aren’t willing to do that. ?But their existing policies will prolong the stagnation.

And as such, rates can fall further — with a lot of noise/variation around it.

Brexit Boogeyman Bellows “Boo!”

Posted on 24 June 2016 by David Merkel

Picture Credit: Peanuts Reloaded || Perhaps today Brexit; Monday an exit from Italy or Spain; [then] Europe dismantles — Picture Credit: Peanuts Reloaded || Roughly: “Perhaps today Brexit;?Monday an exit from Italy or Spain; [then]?Europe dismantles”

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At a time like this, when the Brexit Boogeyman goes “Boo!” it’s time to take stock of the situation amid panic.

Though the UK will face some political unrest as the Prime Minister resigns, and article 50 is likely but not certainly invoked, the nature of political discourse hasn’t shifted in full. ?Though an important question, it is only one question, and more things will remain stable than change.

At least that is most likely. ?If you think of “real options” theory, you could say, “Okay, a door opened today that was previously locked. ?What new doors beyond that one could be opened?” ?Other countries could leave the EU and/or?Eurozone [EZ]. ?The EU/EZ could dissolve. ?The odds of other countries leaving isn’t that high. ?For the EU or EZ to dissolve would take a lot of doing, and the odds of that happening is very low, though higher than the odds yesterday.

As I said a week ago:

Governments are smaller than markets; markets are smaller than cultures.

What I am saying is that almost everything affecting the needs of people will get done when there is sufficient freedom. ?If Brexit occurs, the UK will negotiate some agreement that is mutually beneficial to the UK and the EU, and most things will go on as they do today. ?Even with a subpar agreement,?perfidious Albion is very effective at getting what they need completed. ?This is especially true of their very effective and creative financial sector in the City of London without which most effective international ~~secrecy, taxation avoidance and regulatory avoidance~~ business could not be done.

Whatever happens, it will happen slowly. ?Leaving a complex multinational group like the EU takes two years at least. ?How it all works out in detail is not predictable.

I can say that human systems tend toward stability. ?People act to preserve the things that they like. ?Only under severe conditions does that cease to be true, and even then typically only for short periods of time.

I can also say something a little more controversial. ?Wealth, assets, and money [WAM] act like they are alive and have more votes than people do under most conditions. ?Why am I saying this?

Governments come in, and go out, but for the most part, the same things get done. ?Those thinking that radical change will come are usually deeply disappointed. ?WAM tend to maintain the status quo, not because their owners ~~bribe politicians and suborn regulators~~ pay political action contributions, ?but because people want the streams of goods and services that help make WAM valuable. ?Only a genuine crisis at least as large as?the Great Depression or the Civil War can create truly radical change that reshapes the basic desires of most of the people in a nation.

Capitalist democracies that respect the rule of law (e.g., the government is also governed by?a higher law) are usually pretty stable; systems that don’t have significant capitalism or democracy may last a couple generations, but tend to fall apart.

All that said, there is significant economic pressure to do two things after the Brexit:

Rethink the single currency and common laws
Maintain a free-ish trade zone in goods and services

The Eurozone does not allow for the necessary economic adjustments across nations in a fiat?monetary system. ?Nations need their own currencies, central banks, etc. ?They also need to govern themselves via their local culture, not someplace far away with misguided idealists who think they know what’s best for all.

Free-ish trade maintains most of what is needed?for human needs. ?The European Union is a political construct meant to prevent war from ever recurring in Europe. ?The best way to do that is through trade. ?Severe wars rare start between nations that rely on each other and interact through commerce.

My view is that ten years from now, the goods and services that people want will get delivered, regardless of the governmental structures in Europe. ?I will invest accordingly.

Practical Implications

Things will be rocky in the short run, and there will be more bumps along the road as the Brexit negotiations go on. ?I will be resisting panic and euphoria in modest ways. ?This isn’t the sum total of my strategies, but I expect that profitable business will continue, and that people and nations will pursue generally intelligent long-term self-interest as events unfold.

When I say modest, I tweak my portfolios at the edges. ?Brexit does not comprise more than 5% of what I would do with assets. ?As with any investment idea, spread your bets, diversify, don’t bet the farm.

And, I would say the same even to governments — if you don’t have contingency plans for the possibility of the EU shrinking or even disappearing, you are not truly prepared for all contingencies. ?As Warren Buffett once said (something like) “We’re paid to think about the things that ‘can’t happen.'”

In closing, many thought that Brexit could not happen. ?Now, what else “can’t happen?” 😉

The Collapse of FOMC Expectations

Posted on 17 June 201617 June 2016 by David Merkel

When do you admit that you are wrong? ?Do you do it publicly? ?Do you hide it?

Do you hide it plain sight?

When I look at the graph for Fed funds for 2017 and later, I think the FOMC is admitting that they were wrong for a long time, and now hide that in plain sight.

They don’t admit that they were wrong. ?They don’t admit that the economy has proven to be a lot weaker than they ever expected, and that they now expect that to persist for a while.

That’s what the graphs for Fed funds and GDP say.

But what does the FOMC say in its statement? ?It expresses confidence in future GDP robust growth, even though their expectations have collapsed to 2% real growth as far as they care to opine.

Look at the above graph, and see how it has all converged to 2%.

PCE Inflation? They assume it will be 2% before the year starts, and then they adapt to incoming data.

There’s no model here, just a disappointed ideology that says they wish to ?produce a 2% PCE inflation rate, dubious as that goal is.

The only thing more dubious there is their ability to achieve their ideology.

Remember after the financial crisis? There were those who said unemployment would never return to 5% — that the natural rate of unemployment was permanently higher.

I may have been among them.

Well, now the FOMC has a new consensus. ?Unemployment below 5%?as far as they care to opine.

When I look at these graphs, particularly the ones for Fed funds and GDP growth, I see a paradigm shift where Bayesian priors have been dragged kicking and screaming by the data to No Man’s Land.

Grudgingly they acknowledge the data in the graphs, but they don’t have a theory to go along with it, so their statements and minutes sound the same.

Nothing is changed. ?Soon our policies will restore robust real GDP growth, produce inflation and then we will tighten policy and restore normalcy.

Well, that’s what their minutes and statements say.

But who are you going to believe? ?The FOMC and their words, or your lying eyes looking at their graphs?

PS — modified to reflect Bullard’s lack of a vote on long-term Fed funds rate.

Redacted Version of the June 2016 FOMC Statement

Posted on 15 June 2016 by David Merkel

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Comments

The FOMC meets too frequently. Often the economic signals at one meeting get reversed at the next meeting, as was true this time.? Rather than hyper-interpreting every wiggle, maybe the FOMC should meet every six months, with the proviso that the chairman could call an interim meeting if the situation demanded it.
That this is true regarding economic aggregates has been known since the ?50s. For a variety of reasons, it is difficult to distinguish signal from noise over periods of less than a year.
Then again, maybe the FOMC meets to make it look like they are doing something. 😉
This statement was a nothing-burger.
Policy continues to stall, as the economy muddles along.
But policy should be tighter. Savers deserve returns, and that would be good for the economy.
The changes for the FOMC?s view are that labor indicators are weaker, and GDP and household spending are stronger.
Equities fall and bonds rise a little. Commodity prices rise and the dollar falls.
The FOMC says that any future change to policy is contingent on almost everything.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up much, absent much higher inflation, or a US Dollar crisis.

The Fed Minutes are Noise

Posted on 20 May 2016 by David Merkel

Photo Credit: duncan c || It wasn't my intent initially to compare the words of the FOMC with the scrawlings of a vandal, but ya know some things are surprise fits — Photo Credit: duncan c || It wasn’t my intent initially to compare the words of the FOMC with the scrawlings of a vandal, but ya know, some things are surprise fits

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I wasn’t surprised to hear in the FOMC minutes that members of the committee thought:

For these reasons, participants generally saw maintaining the target range for the federal funds rate at 1/4 to 1/2 percent at this meeting and continuing to assess developments carefully as consistent with setting policy in a data-dependent manner and as leaving open the possibility of an increase in the federal funds rate at the June FOMC meeting.

and

Participants agreed that their ongoing assessments of the data and other incoming information, as well as the implications for the outlook, would determine the timing and pace of future adjustments to the stance of monetary policy. Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June. Participants expressed a range of views about the likelihood that incoming information would make it appropriate to adjust the stance of policy at the time of the next meeting. Several participants were concerned that the incoming information might not provide sufficiently clear signals to determine by mid-June whether an increase in the target range for the federal funds rate would be warranted. Some participants expressed more confidence that incoming data would prove broadly consistent with economic conditions that would make an increase in the target range in June appropriate. Some participants were concerned that market participants may not have properly assessed the likelihood of an increase in the target range at the June meeting, and they emphasized the importance of communicating clearly over the intermeeting period how the Committee intends to respond to economic and financial developments.

I was surprised to see some of the markets take it seriously. ?Here’s why:

1)?The FOMC loves to talk hawk and them be doves. ?They don’t think the?costs to waiting are significant, particularly given how low measured inflation and and implied future inflation are. ?Five-year inflation, five years forward implied from TIPS spreads is?not high at present as you can see here:

2) The FOMC is well known for giving with the right hand and taking with the left. ?They would like if possible to have the best of both worlds — gentle movement of what they view as key variables, while usually not dramatically changing the forward estimates of those

3) The FOMC’s natural habitat is wishful thinking. ?Their GDP forecasts are usually high, and they suspect their policy tools will move the economy the way they want and quickly, and it’s just not true.

4) LIBOR rates have done a better job of the FOMC at estimating future policy, and they have barely budged since the FOMC minutes came out.

5) The FOMC always has more doves than hawks, and that is the way the politicians who appoint and approve the board members like it. ?They will live with inflation. ?That was yesterday’s problem. ?Today’s problem is stagnant median incomes — and looser monetary policy will help there, right?

Well, no, but I’m sure they clapped when Peter Pan asked them to save Tinkerbell. ?There is no link between inflation and faster real growth over the long haul. ?There may be measurement errors in the short run.

6) They don’t like moving against foreign rates, but that’s not a big factor.

7) GDP isn’t showing much lift at all.

Summary

Unless we have a change in management at the Fed, where they are?not trying to manipulate markets through their words, but maybe one that said little and acted quietly, like the pre-1986 FOMC, they really aren’t worth listening to. ?They act like politicians. ?Let them study Martin and Volcker, and learn from when the FOMC was more effective.

PS — I’m not saying they can’t tighten in June. ?I’m just saying it’s unlikely, and to ignore the comments in the FOMC minutes. ?What the FOMC says is of little consequence. ?It’s what they do that counts. ?They are like a little dog that barks a lot, but rarely bites.

Goes Down Double-Speed (Update 3)

Posted on 30 April 20162 May 2016 by David Merkel

S&P 500 at turning points — Data Credit: Ed Yardeni

This is the fourth article in this series, and is here because the S&P 500 is now in its second-longest bull market since 1928, having just passed the bull market that ended in 1956.? ? Yeah, who’da thunk it?

This post is a little different from the first three articles, because I got the data to extend the beginning of my study from 1950 to 1928, and I standardized my turning points using the standard bull and bear market definitions of a 20% rise or fall from the last turning point. ?You can see my basic data to the left of this paragraph.

Before I go on, I want to show you two graphs dealing with bear markets:

As you can see from the first graph, small bear markets are much more common than large ones. ?Really brutal bear markets like the biggest one in the Great Depression were so brutal that there is nothing to compare it to — financial leverage collapsed that had been encouraged by government policy, the Fed, and a speculative mania among greedy people.

The second graph tells the same story in a different way. ?Bear markets are often short and sharp. ?They don’t last long, but the intensity in term of the speed of declines is a little more than?twice as fast as the rises of bull markets. ?If it weren’t for the fact that bull markets last more than three times as long on average, the sharp drops in bear markets would be enough to keep everyone out of the stock market.

Instead, it just keeps many people out of the market, some entirely, but most to some degree that would benefit them.

Oh well, on to the gains:

Like bear markets, most bull markets are small. ?The likelihood of a big bull market declines with size. ?The current bull market is the fourth largest, and the one that it passed in duration was the second largest. ?As an aside, each of the four largest bull markets came after a surprise:

(1987-2000) 1987: We knew the prior bull market was bogus. ?When will inflation return? ?It has to, right?
(1949-56) 1949: Hey, we’re not getting the inflation we expected, and virtually everyone is finding work post-WWII
(1982-7) 1982: The economy is in horrible shape, and?interest rates are way too high. ?We will never recover.
(2009-Present) 2009: The financial sector is in a shambles, government debt is out of control, and the central bank is panicking! ?Everything is falling apart.

Sometimes you win, sometimes you lose... — Sometimes you win, sometimes you lose…

Note the two dots stuck on each other around 2800 days. ?The arrow points to the lower current bull market, versus the higher-returning bull market 1949-1956.

Like bear markets, bull markets also?can be short and sharp, but they can also be long and after the early sharp phase, meander upwards. ?If you look through the earlier articles in this series, you would see that this bull market started as an incredibly sharp phenomenon, and has become rather average in its intensity of monthly returns.

Conclusion

It may be difficult to swallow, but this bull market that is one of the longest since 1928 is pretty average in terms of its monthly average returns for a long bull market. ?It would be difficult for the cost of capital to go much lower from here. ?It would be a little easier for corporate profits to rise from here, but that also doesn’t seem too likely.

Does that mean the bull is doomed? ?Well, yes, eventually… but stranger things have happened, it could persist for some time longer if the right conditions come along.

But that’s not the way I would bet. ?Be careful, and take opportunities to lower your risk level in stocks somewhat.

PS — one difference with the Bloomberg article linked to in the first paragraph, the longest bull market did not begin in 1990 but in 1987. ?There was a correction in 1990 that fell just short of the -20% hurdle at -19.92%, as mentioned in this Barron’s article. ?The money shot:

The historical analogue that matches well with these conditions is 1990. There was a 19.9% drop in the S&P 500, lasting a bit under three months. But the damage to foreign stocks, small-caps, cyclicals, and value stocks in that cycle was considerably more. Both the Russell and the Nasdaq were down 32% to 33%. You might remember United Airlines? failed buyout bid; the transports were down 46%. Foreign stocks were down about 30%.

And then Saddam Hussein invaded Kuwait.

That might have been the final trigger. The broad market top was in the fall of 1989, and most stocks didn?t bottom until Oct. 11, 1990. In the record books, it was a shallow bear market that didn?t even officially meet the 20% definition. But it was a damaging one that created a lot of opportunity for the rest of the 1990s.

FWIW, I remember the fear that existed among many banks and insurance companies that had overlent on?commercial properties in that era. ?The fears led Alan Greenspan to encourage the FOMC to lower rates to… (drumroll) 3%!!! ?And, that experiment together with the one in 2003, which went down to 1.25%, practically led to the idea that the FOMC could lower rates to get out of any ditch… which is now being proven wrong.

Redacted Version of the April 2016 FOMC Statement

Posted on 27 April 201627 April 2016 by David Merkel

Caption from the WSJ: Regulators don?t think it is the place of Congress to second guess how they size up securities. Fed Chairwoman Janet Yellen said recently that legislation would ?interfere with our supervisory judgments.? PHOTO: BAO DANDAN/ZUMA PRESS — PHOTO CREDIT: BAO DANDAN/ZUMA PRESS

Comments

Policy continues to stall, as the economy muddles along.
But policy should be tighter. Savers deserve returns, and that would be good for the economy.
The changes for the FOMC?s view are that labor indicators are stronger, and GDP and household spending are weaker.
Equities rise and bonds rise. Commodity prices flat and the dollar falls.
The FOMC says that any future change to policy is contingent on almost everything.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up much, absent much higher inflation, or a US Dollar crisis.