Fed Policy – Page 8 – The Aleph Blog

Redacted Version of the July 2015 FOMC Statement

Posted on 29 July 2015 by David Merkel

Photo credit: jonesylife || Oh look, a dozen doves flying at the FOMC!

June 2015	July 2015	Comments
Information received since the Federal Open Market Committee met in April suggests that economic activity has been expanding moderately after having changed little during the first quarter.	Information received since the Federal Open Market Committee met in June indicates that economic activity has been expanding moderately in recent months.	No real change.
Growth in household spending has been moderate and the housing sector has shown some improvement; however, business fixed investment and net exports stayed soft.	Growth in household spending has been moderate and the housing sector has shown additional improvement; however, business fixed investment and net exports stayed soft.	No real change. Swapped places with the following sentence.
The pace of job gains picked up while the unemployment rate remained steady. On balance, a range of labor market indicators suggests that underutilization of labor resources diminished somewhat.	The labor market continued to improve, with solid job gains and declining unemployment. On balance, a range of labor market indicators suggests that underutilization of labor resources has diminished since early this year.	No real change. Swapped places with the previous sentence.
Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports; energy prices appear to have stabilized.	Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports.	No real change.
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.	Market-based measures of inflation compensation remain low; survey?based measures of longer-term inflation expectations have remained stable.	No change.? TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.10%, up 0.07% from April.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	No change. Any time they mention the ?statutory mandate,? it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.	The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate	No real change.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.	The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.	CPI is at +0.2% now, yoy.? No change in language.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	No change.
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.	The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.	No real change. No rules, just guesswork from academics and bureaucrats with bad theories on economics.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	No change.? Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.	When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.	No Change. ?Balanced? means they don?t know what they will do, and want flexibility.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.	Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.	No change, sadly. We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.

Comments

This FOMC statement was another great big nothing. No significant changes.
Don?t expect tightening in September. People should conclude that the FOMC has no idea of when the FOMC will tighten policy, if ever.? This is the sort of statement they issue when things are ?steady as you go.?? There is no hint of imminent policy change.
Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.? Wage growth is weak also.
Equities and long bonds rise. Commodity prices and the dollar are flat.
The FOMC says that any future change to policy is contingent on almost everything.
Don?t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
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, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
We have a congress of doves for 2015 on the FOMC. Things will continue to be boring as far as dissents go.? We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.

Asset-Liability Mismatches and Bubbles

Posted on 9 July 2015 by David Merkel

There’s a lot of talk about the Chinese stock market falling. I look at it as an opportunity to talk about why bubbles develop in markets, and why governments don’t take steps to avoid them until it is too late — also, why they try to prop the bubbles up, even though it is hopeless. ?But first an aside:

Three weeks ago, I was interviewed on RT/America Boom/Bust. ?Half of the interview aired — the part on domestic matters. ?The part on Greece and China didn’t air, and what a pity. ?I argued that China today was very much like Japan in the late ’80s, where the Japanese had a hard time investing abroad, and had an expansive monetary policy. ?People had a hard time figuring out where to put their money. ?Savings and fixed income didn’t offer much. ?Real Estate was great if you could afford it. ?The stock market was a place for putting money to work — and it had a lot of momentum behind it.

China has the added complexity of wealth management products which are opaque and many are Ponzi schemes. ?Also, the fixed income markets in China are not as mature as Japan’s markets 30 years ago. ?Both have the difficulties that they are too big for some of the indexes that international investors use.

Another reason for the bubbly behavior was use of margin, both formal and informal, and, the tendency for stock investors to have very short holding periods. ?Short-termism and following momentum is most of what creates bubbles. ?Ben Graham’s voting machine dominates, until the weighing machine takes over, and the voting machine votes the opposite way.

Long term assets like stocks should be financed with equity, or at worst, long-term debt. ?Using a lot of margin debt to finance equity leads to a rocket up, and a rocket down. ?When the amount of equity in the ?account gets too low, more assets have to be added, or stocks will have to be liquidated to protect the margin loan that the broker made. ?When enough stocks in margin accounts are forced to be sold, that can drive stock prices down, leading to a self-reinforcing cycle, until the debt levels normalize at much lower levels. ?This is a part of what happened in the Great Depression in the US.

Now governments never argue with bubbles when they expand, because no one dares to oppose a boom. ?(Note: that article won a small award. Powerpoint presentation here.) ?The powers that be love effortless prosperity, and no one wants to listen to a prophet of doom when the Cabaret is open.

Now, the prosperity is mostly?fake, because all of the borrowing is temporarily pulling future prosperity into the present. ?When the bubble pops, that will revert with a vengeance, leaving behind bad debts.

Despite the increase in debts, and speculative changes in economic behavior, most policymakers will claim that they can’t tell whether a bubble is growing or not. ?Their bread is buttered on the side of political contributions from financial firms.

But when the bubble pops, and things are ugly, governments will try to resist the deflating bubble — favoring relatively well-off asset owners over not-so-well-off taxpayers. ?In China at present, they are closing down markets for stocks (if it doesn’t trade, the price must not be falling). ?They are trying to be more liberal about liquidating margin debt. ?They are limiting share sales by major holders. ?They are postponing IPOs. ?They are inducing institutions to buy stock.

China thinks that it can control and even reverse the deflating bubble. ?I think they are deluded. ?Yes, they are relatively more powerful in their own country than US regulators and policymakers. ?But even if their institutions were big enough to suck up all of the stock at existing prices, it would merely substitute on problem for another: the institutions would be stuck with assets that have?low forward-looking returns. ?If you use those to fund a defined benefit pension plan, you will likely find that you have embedded a loss in the plan that will take years to reveal itself.

As a result, since China is much larger than Greece, its problems get more attention, because they could affect the rest of the world more. ?For Western investors without direct China exposure, I’m not sure how big that will be, but with highly valued markets any increase in volatility could cause temporary indigestion.

The one bit of friendly advice I might offer is don’t be quick to try to catch a falling knife here. ?It might be better to wait. and maybe buy stocks in countries that get unfairly tarred by any panic coming out of China, rather than investing in China itself. ?Remember, margin of safety matters. ?More on that coming in a future post.

Redacted Version of the June 2015 FOMC Statement

Posted on 17 June 2015 by David Merkel

April 2015	June 2015	Comments
Information received since the Federal Open Market Committee met in March suggests that economic growth slowed during the winter months, in part reflecting transitory factors.	Information received since the Federal Open Market Committee met in April suggests that economic activity has been expanding moderately after having changed little during the first quarter.	Shades GDP up. ?Why can?t the FOMC accept that the economy is structurally weak?
The pace of job gains moderated, and the unemployment rate remained steady. A range of labor market indicators suggests that underutilization of labor resources was little changed.	The pace of job gains picked up while the unemployment rate remained steady. On balance, a range of labor market indicators suggests that underutilization of labor resources diminished somewhat.	Shades labor use up.
Growth in household spending declined; households’ real incomes rose strongly, partly reflecting earlier declines in energy prices, and consumer sentiment remains high. Business fixed investment softened, the recovery in the housing sector remained slow, and exports declined.	Growth in household spending has been moderate and the housing sector has shown some improvement; however, business fixed investment and net exports stayed soft.	Shades up their view of household spending.? Drops a comment on consumer sentiment (that only lasted one month).
Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports.	Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports; energy prices appear to have stabilized.	Notes stable prices of energy, even though prices have risen over the last two months.
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.	Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.	No change.? TIPS are showing lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.03%, down 0.07% from April.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	No change. Any time they mention the ?statutory mandate,? it is to excuse bad policy.
Although growth in output and employment slowed during the first quarter, the Committee continues to expect that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.	The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.	No real change.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.	The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.	CPI is at -0.1% now, yoy.? No change in language.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	No change.
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.	The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.	No change. No rules, just guesswork from academics and bureaucrats with bad theories on economics.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	No change.? Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.	When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.	No Change. ?Balanced? means they don?t know what they will do, and want flexibility.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.	Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.	No change, sadly. We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.

Comments

This FOMC statement was a great big nothing. No significant changes.
People should conclude that the FOMC has no idea of when the FOMC will tighten policy, if ever. This is the sort of statement they issue when things are ?steady as you go.?? There is no hint of imminent policy change.
The FOMC has a stronger view of GDP, energy prices and labor use.
Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.? Wage growth is weak also.
Equities rise and long bonds are flat. Commodity prices rise and the dollar falls.? The FOMC says that any future change to policy is contingent on almost everything.
Don?t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
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, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
We have a congress of doves for 2015 on the FOMC. Things will continue to be boring as far as dissents go.? We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.

At RT/America’s Boom/Bust

Posted on 16 June 2015 by David Merkel

I had the fun today of taping a segment with Ameera David on RT Boom/Bust. The above video covers the first half of the session, and lasts about seven minutes. We covered the following topics (with links to articles of mine, if any are applicable):

Bond Market Illiquidity
Stock Market Valuations
The Slowness of the FOMC
Why?many retail investors get skunked by the market
How to invest in this environment
Potential?Equity Market Sector Picks

The second half, should it make it onto the show, deals mostly with international issues. ?Enjoy the video, if you want to.

On Bond Market Illiquidity (and more)

Posted on 4 June 201524 June 2015 by David Merkel

Photo Credit: Moyan Brenn || What's more illiquid than the desert? — Photo Credit: Moyan Brenn || What’s more Illiquid than the desert?

I’ve read a lot of articles about bond market illiquidity, and I don’t think it is as big of an issue as many are making it out to be. ?The bond market often runs hot and cold, and when prices and yields are moving, it is difficult to get off trades at levels you might like unless you are resisting the trend. ?And if you are resisting the trend, will you like the trade one week later, when the trade might look poor in hindsight?

Part of the difficulty is that the buy side has gotten more concentrated. ?Bigger players by their nature can’t move in and out of positions without moving the market against their interests. ?Illiquidity is a rule of life for them. ?They may as well become market makers to some degree — offering bonds they want to keep at prices at which only the desperate would want to buy. ? Also, they could bid for bonds at levels at which only the desperate would want to sell.

Add into that the amount of bonds tucked away in ETFs. ?The ETFs may seem to offer liquidity at no cost, but retail investors tend to panic more rapidly than institutional investors. ?If retail investors run away from any part of the market, the ETFs in that part of the market will be among the managers selling into a falling market, and there is a cost to that, at least for those slower to sell the ETFs in question.

But away from that, current monetary policy leaves many on pins and needles waiting for short rates to rise. ?Now, there is no guarantee that short rates will rise in 2015. ?The Fed has shown itself to be extra slow to act in this cycle, and the current FOMC has no hawks — not that the hawks matter — their views are not a part of current monetary policy.

But even if short rates rise, there is no guarantee that long rates will follow. ?In the last tightening cycle, long rates stayed the same with a lot of noise that included falling long yields in the early phases. ?The global economy isn’t that strong, and interest rates in the middle of the curve tend to track nominal GDP growth (with a lot of noise).

You can position yourself for rising short rates, but you have to give up a lot of income (carry) to do so. ?How long can you bear to earn very little, particularly if you are earning a management fee?that eats up a lot of the income?

Situations like this are naturally twitchy, because things are unclear, but as things clarify, there may?be many who will want to sell longer bonds to buy?shorter bonds where rates will rise. ?If long rates do rise along with short rates, who pray tell will be the philanthropist that holds onto the long bonds and eats losses for clients that want positive (or at least small?negative) total returns?

There is a price for almost every asset, but there is no guarantee of being able to sell a lot of long bonds if rates are rising, and certainly not without offering a large price concession. ?That’s illiquidity, which naturally happens if you try to trade against a large trend in the bond market.

That brings me to my main point:

Bonds should be illiquid now. ?Why should you expect otherwise?

No one is out to do you voluntary favors in the markets. ?Why should markets have narrow bid-ask spreads when there is significant policy uncertainty, and large players that hold a large fraction of the total bond market? ?At a time like this, I would?only?want to make a market if the compensation was significant.

Two unrelated notes before I sign off. ?First, I sold my position in long Treasuries about a month ago, when 30-year yields crossed 2.80%. ?I had owned the long bonds for quite a while and had decent profits on them. ?I felt the current selloff might have legs, which may be true (or not). ?So, I am below market duration at present, and earning ~4% off of a variety of short investment grade corporates, bank loans, junk bonds, TIPS, and foreign bonds… so far so good, but I can’t express any significant confidence that this strategy will be a winner. ?It’s my best guess for now, as I don’t see many immediate credit risks. ?After all, look how little damage the energy sector took on even with oil prices that fell hard. ?There is a lot of money looking around for bargains.

Second, if I were a large corporate bond issuer, I would look to form a consortium with my fellow large issuers to set up an auction market for the new issuance of bonds, and bypass Wall Street. ?Why? ?Because the new issue yield premiums are large. ?Why should large money managers benefit from the new issue market? ?Yes, I know that offering liquidity should receive some reward, but not as large as it is at present.

This is a modern era, and the need for intermediaries in the IPO market for bonds is less needed. ?Let the buy side, which is starved for new bonds and yield, pay up for the privilege of receiving the bonds. ?Who knows? ?Maybe the issuers might borrow a little more as a result.

Hey, CFOs of large bond issuers! ?This is your chance to become a hero. ?Grab the opportunity, and issue your bonds with your peers through a mutually owned central auction house. ?Who knows? ?One day you could spin it off, and it could become… an investment bank. 😉

Redacted Version of the April 2015 FOMC Statement

Posted on 29 April 2015 by David Merkel

Photo credit: jonesylife || Oh look, there are twelve doves flying!

Comments

With this FOMC statement, people should conclude that they have no idea of when the FOMC will tighten policy, if ever. This is the sort of statement they issue when things are ?steady as you go.?? There is no hint of imminent policy change.
The FOMC has a weaker view of GDP, labor use, household spending, business fixed investment and exports.
Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.? Wage growth is weak also.
Forward inflation expectations have reversed direction and are rising, and the twitchy FOMC did not note it.
Equities rise and long bonds rise. Commodity prices fall and the dollar rises.? The FOMC says that any future change to policy is contingent on almost everything.
Don?t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
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, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
We have a congress of doves for 2015 on the FOMC. Things will be boring as far as dissents go.? We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.

On Negative Interest Rates

Posted on 21 April 201521 April 2015 by David Merkel

Photo Credit: Alcino || What is the sound of negative one hand clapping?

As with many of my articles, this one starts with a personal story from my insurance business career (skip down four paragraphs to the end of the story if you want):

25 years ago, when it was still uncommon, I wanted?to go to an executive course at the Wharton School for actuaries that wanted to better understand investment math and markets. ?I went to my boss at AIG (a notably tight-fisted firm on expenses) and asked if the company would pay for me to go… it was an exclusive course, and very expensive compared to any other conference that I would ever go to again in my life. ?I tried not to get my hopes up.

Lo, and behold! ?AIG went for it!

A month later, I was with a bunch of bright actuaries at the Wharton School. ?The first thing I noticed was aside from the compound interest math, and maybe some bond knowledge, the actuaries were rather light on investment knowledge, and I would bet that all of them had passed the Society of Actuaries investment course. ?The second thing I noticed were some of the odd investments described in the syllabus: it was probably my first taste of derivative instruments. ?At the ripe old age of 29, I was learning a lot, and possibly more than the rest of my classmates, because I had spent a lot of time studying investments already, both on an academic and practical basis.

I had already studied the pricing of stock options in school, so I was familiar with Black-Scholes. ?(Trivia note: an actuary developed the same formula for valuing optionally terminable reinsurance treaties six years ahead of Black, Scholes and Merton. ?That doesn’t even take into account Bachelier, who derived it 73 years earlier, but no one knew about it, because it was written in French.) ?At this point, the professor left, and a grad student came in to teach us about the pricing of bond options. ?At the end of his lesson, it was time for the class to have a break. ?I went down to make a comment, and it went like this:

Me: You said that we have to adjust for the fact that interest rates can’t go negative.

Grad student: Of course.

Me: But interest rates could go negative.

GS: That’s ridiculous! ?Why would you ever lend money and accept back less than you gave them, and lose the time value of money?!

Me: Almost of the time, you wouldn’t. ?But imagine a scenario where the demand for loanable funds leaves interest rates near zero, but the times are insecure and violent, leaving you uncertain that if you stored your cash privately, you would run too large of a risk of having it stolen. ?You need your cash in the future for a given project. ?In this case, you would pay the bank to store your money.

GS: That’s an absurd scenario! ?That could never happen!

Me: It’s unlikely, I admit, but I wouldn’t say that you can never have negative interest rates.

GS: I will say it again: You can NEVER have negative interest rates.

Me: Thanks, I guess.

Well, so much for the distant past. ?Here is why I am writing this: yesterday, a friend of mine wrote me the following note:

Good evening.? I trust you had a blessed Lord’s Day in the new building.?

Talking bonds today with my Econ class.? Here’s our question. Other than playing a currency angle why would anyone buy European debt with a negative yield?? The Swiss and at least one other county sold 10 year notes with a negative yield.? Can you explain that?? No interest and less principle [sic] at the end.

Now, I didn’t quite get it perfectly right with the grad student at Wharton, but most of it comes down to:

Low demand for loanable funds,?with low measured inflation, and
Security and illiquidity of the funds invested

The first one everyone gets — inflation is low, and few want to borrow, so interest rates are very low. ?But that doesn’t explain how it can go negative.

Things are different for middle class individuals and large financial institutions. ?Someone in the middle class facing negative interest rates from a checking or savings account could say: “Forget it. ?I’m taking most of my money out of the bank, and storing it at home.” ?Leaving aside the inconvenience of currency transaction reports if the amount is over $10,000, and worries over theft, he could take his money home and store it. ?Note that he does have to run a risk of theft, though, so bringing the money home is not costless.

The bank has the same problem, but far larger. ?If you don’t invest the money, where would you store it? ?Could you even get enough currency delivered to do it? ?if you had a vault large enough to store it, could you trust the guards? ?Why make yourself a target? ?If you don’t have a vault large enough to store it, you’re in the same set of problems that exist for those that warehouse precious metals, but with a far more liquid commodity.

Thus in a weak economic environment like this, with low inflation, banks and other financial institutions that want certainty of payment in the future are willing to pay interest to get their money back later.

Part of the problem here is that the fiat currencies of the world exist only to be?units of account, and not stores of value. ?Thus in this unusual environment, they behave like any other commodity, where the prices for futures are often higher than the current spot price, which is known as backwardation. ?(Corrected from initial posting — i.e. it costs more to receive a given cash flow in the future than today, thus backwardation, not contango.) ?The rates can’t get too negative, though, or some institutions will bite the bullet and store as much cash as they can, just as other commodities get stored.

To use another analogy, a while ago, some market observers couldn’t get why anyone would accept a negative yield on Treasury Inflation Protected Securities [TIPS]. ?They did so because they had few other choices for transferring money to the future while still having inflation protection. ?Some people argued that they were locking in a loss. ?My comment at the time was, “They’re trying to avoid a larger loss.”

Thus the difficulty of managing cash outside of the bond/loan markets in a depressed economy leads to negative interest rates. ?The financial institutions may lose money in the process, but they are losing less money than if they tried to store and protect the money, if that could even be done.

Opinions on the Market, Redux

Posted on 31 March 2015 by David Merkel

Here’s the second half of my most recent interview with Erin Ade at RT Boom/Bust. [First half located here.] We discussed:

Stock buybacks, particularly the buyback that GM is doing
Valuations of the stock market and bonds
Effect of the strong dollar on corporate earnings in the US
Effect of lower crude oil prices on capital spending
Investing in Europe, good or bad?

Seven minutes roar by when you are on video, and though taped, there is only one shot, so you have to get it right. ?On the whole, I felt the questions were good, and I was able to give reasonable answers. ?One nice thing about Erin, she doesn’t interrupt you, and she allows for a few rabbit trails.

The Bond Market Tells The Fed What To Do, Not Vice-Versa

Posted on 28 March 201529 March 2015 by David Merkel

Photo Credit: Tulane Public Relations || James Carville wants to be "reincarnated" as the bond market, to scare everyone -- boo! — Photo Credit: Tulane Public Relations || James Carville wants to be “reincarnated” as the bond market, to scare everyone — boo!

I was reading this article at Reuters, and musing at how ludicrous it is?for the Fed to think that it can control the reaction of the bond market to tightening Fed policy, should it ever happen. ?The Fed has never been able to control the bond market, except on the short end, and only with the highest quality paper.

The long end is controlled by the economy as a whole, and its rate of growth, while lower quality bonds and loans also respond more to where the credit cycle is. ?The Fed has never been able to tame the credit cycle — the boom and the bust. ?If anything, they make the booms and busts worse.

Now they think that their new policy tools will enable them to control the bond market. ?The new tools are nothing astounding, and still mostly affect short and high quality debts.

One thing is certain — when the Fed starts tightening, some levered parties will blow up. ?Even the mention of the taper caused shock waves in the emerging bond markets. ?And when something big blows up, the Fed will stop tightening. ?It always happens, and they always do.

So please give up the idea that the Fed?can do what it wants. ?It looks like it can in the short-run, but in the long run markets do what they want, and the Fed has to respond, rather than lead.

Deeds, not Words? Or, Say Less and Mean More

Posted on 19 March 2015 by David Merkel

There was a lot of hoopla yesterday over the FOMC removing the word “patient” from its statement. ?But when you read the sentence that replaced the sentence containing the word patient, you shouldn’t think that much has changed:

Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.

There are two contingencies here, which are both subject to considerable latitude in interpretation:

Seeing further improvement in the labor market
Being?reasonably confident that inflation will move back to its 2 percent objective over the medium term

I have long argued that the FOMC doesn’t have a strong theory for what they are doing, and have designed their language in speaking to the markets to maximize their flexibility. ?It has not been the obfuscation of the overly confident Greenspan era, but the endless blather that comes from trying to be “transparent” and drown the market in communications, because they never quite understand us properly.

Now, for the first time in a while, the FOMC statement shrank, and for that, I thank the FOMC. ?It should shrink further, and it would be better if the FOMC said nothing, and went back to pre-Greenspan practices, and let the actions of the Open Markets Desk at the New York Fed do the talking. ?Deeds, not words.

Now, data isn’t the same as deeds, and they aren’t always as clear as words, but the FOMC gave us a release of the forecasts of its members yesterday. ?The graphs in this piece reflect the central tendency of their estimates, giving proper weight to the dominant views, as well as less weight to the views from the?outliers.

Start with the graph at the top of this article. ?The average of all of the views suggests tightening in September. ?Now, with 15 favoring a move in 2015, a move will likely happen this year. ?If you look back through their data releases, a preponderance of opinion has pointed to 2015 since September of 2012, with never fewer than 12 members pointing to a move in 2015 since then.

But what of the shift in opinions regarding the level of the Fed Funds rate over time? ?What happened to that with the removal of the “patient” language?

My but they got more dovish... — My but they got more dovish…

Look at the reduction in the expected end of year Fed Funds rate — down 0.35% in 2015 (to 0.77%), 0.51% in 2016, 0.32% in 2017, and 0.12% in the long run. ?That last number is significant, because of the change in composition of those giving opinions, and it indicates a more generally dovish group.

But the downward moves in values indicate fewer tightening moves for 2015 — at present the estimate would be 2-3 quarter-percent moves. (And five more eaches in 2016 and 2017, for those who dream that savers might get some compensation, and that the government’s budget works at higher levels of interest rates)

A big reason for the shift is the move in views on PCE inflation:

Still behind the deflationary curve... — Still behind the deflationary curve…

That’s a 0.59% move down in PCE inflation estimates for 2015. Odds are, it will be lower than that. The FOMC as forecasters always chase trends, and rarely get ahead of them. They also believe in the power of monetary policy to produce inflation, and more perversely, growth. As it is, their actions have produced little of either.

It does explain why their estimates for 2016 and beyond are so high. Would any of the members dare to break from the lockstep, and concede that monetary policy does not have significant power to affect the economy for good?

Here is the real GDP graph:

Note the continued move down in estimates for all future periods. Interesting to see the pessimistic shift.

Finally, the unemployment rate graph:

Discouraged workers of the world unite, you have nothing to lose but... — Discouraged workers of the world unite, you have nothing to lose but…

There are many jobs to be had, if people will search for them, and if they think the wages are worth taking, versus alternatives of leisure, working in unreported labor markets, etc…

Conclusion

Looking at the data, the FOMC certainly isn’t hawkish at present. That is consistent with the change in language in the statement, which left timing for any future hikes in the Fed Funds rate vague, and subject to interpretation. This explains the fall in the US Dollar, and the rise in the prices of stocks, long bonds, and commodities. The markets viewed it all as continued monetary lenience, and given the composition of voting members on the FOMC, that should come as no surprise at all.

Until something breaks, expect the FOMC to continue to err on the side of monetary lenience… it’s the only thing they know.