Fed Policy – Page 9 – The Aleph Blog

Redacted Version of the March 2015 FOMC Statement

Posted on 18 March 2015 by David Merkel

Comments

I will still argue that this was a nothing-burger. The patience language was eliminated, but what were left in its place were contingent conditions that are subject to a wide degree of interpretation.
Pretty much a nothing-burger. Few significant changes.? The FOMC has a weaker view of GDP 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 continued to fall.
Equities rise and long bonds rise. 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 FOMC actually chops out ?dead wood? from its statement. Brief communication is clear communication.? If a sentence doesn?t change often, remove it.
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.

Talking About Value Investing and Fed Policy

Posted on 30 January 2015 by David Merkel

Here is the second part of my interview on RT Boom/Bust. It was recorded while the FOMC was releasing its statement, so I had no idea at that time as to what the announcement had been.

The interview covers my view of Apple (not one of my strong points), Fed Policy, and what should value investors do in this low interest rate environment. Note that not all of my opinions are strong ones, and that in my opinion is a good thing. Often the best opinions are not controversial.

If you are interested in these topics, or listening to me, then please enjoy the above video. My segment is about seven minutes long.

Redacted Version of the January 2015 FOMC Statement

Posted on 29 January 2015 by David Merkel

Comments

Pretty much a nothing-burger. Few significant changes.? The FOMC has a stronger view of GDP and Labor, and deems the weak global economy to be a reason to wait.
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 flattened out.
Has the FOMC seen how low the 30-year T-bond yield is?
Equities fall and long bonds rise. Commodity prices 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 FOMC need to chop out more ?dead wood? from its statement. Brief communication is clear communication.? If a sentence doesn?t change often, remove it.
In the past I have said, ?When [holding down longer-term rates on the highest-quality debt] doesn?t work, what will they do? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.? The Fed is playing with forces bigger than themselves, and it isn?t dawning on them yet.
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.

Redacted Version of the December 2014 FOMC Statement

Posted on 17 December 2014 by David Merkel

Photo Credit: International Monetary Fund

Comments

Pretty much a nothing-burger. Few significant changes, if any.? The only interesting thing is that they have given up on inflation getting anywhere near 2% for now.
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 flat and long bonds rise. Commodity prices 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 FOMC chops some ?dead wood? out of its statement. Brief communication is clear communication.? If a sentence doesn?t change often, remove it.
In the past I have said, ?When [holding down longer-term rates on the highest-quality debt] doesn?t work, what will they do? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.? The Fed is playing with forces bigger than themselves, and it isn?t dawning on them yet.
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.

Redacted Version of the October 2014 FOMC Statement

Posted on 29 October 2014 by David Merkel

September 2014	October 2014	Comments
Information received since the Federal Open Market Committee met in July suggests that economic activity is expanding at a moderate pace.	Information received since the Federal Open Market Committee met in September suggests that economic activity is expanding at a moderate pace.	No change. This is another overestimate by the FOMC.
On balance, labor market conditions improved somewhat further; however, the unemployment rate is little changed and a range of labor market indicators suggests that there remains significant underutilization of labor resources.	Labor market conditions improved somewhat further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources is gradually diminishing.	Shades their view of labor use up.? More people working some amount of time, but many discouraged workers, part-time workers, lower paid positions, etc.
Household spending appears to be rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.	Household spending is rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.	Shades up household spending a little.
Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.		Finally dropped this bogus statement.
Inflation has been running below the Committee’s longer-run objective. Longer-term inflation expectations have remained stable.	Inflation has continued to run below the Committee’s longer-run objective. Market-based measures of inflation compensation have declined somewhat; survey-based measures of longer-term inflation expectations have remained stable.	Shades their forward view of inflation down.? TIPS are showing slightly lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.35%, down 0.18% from September.
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 and inflation moving 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 and inflation moving toward levels the Committee judges consistent with its dual mandate.	No change.? They can?t truly affect the labor markets in any effective way.
The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced and judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year.	The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. Although inflation in the near term will likely be held down by lower energy prices and other factors, the Committee judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year.	CPI is at 1.7% now, yoy.? They shade up their view down on inflation?s amount and persistence.
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.	The Committee judges that there has been a substantial improvement in the outlook for the labor market since the inception of its current asset purchase program.	No change.
In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in October, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $5 billion per month rather than $10 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $10 billion per month rather than $15 billion per month.	Moreover, the Committee continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability. Accordingly, the Committee decided to conclude its asset purchase program this month.	Finally ends QE, for now.
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.	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.	No change
The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.	This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	Maintains reinvestment of long-term securities, which does little to hold interest rates down, assuming that is a desirable goal.
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.		Finally ends a useless paragraph.
If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will end its current program of asset purchases at its next meeting.		Deletes sentence
However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.		Deletes sentence
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.? In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, 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 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 developments.	Highly accommodative monetary policy is gone ? but a super-low Fed funds rate remains.? Policy normalizes, sort of, but no real change.
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.	The Committee anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.	No change.? Its standards for raising Fed funds are arbitrary.
	However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.	Tells us what we already knew.
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.	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.	No change.
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.	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.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Narayana Kocherlakota; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.	Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Loretta J. Mester; Charles I. Plosser; Jerome H. Powell; and Daniel K. Tarullo.	Fisher and Plosser dissent.? Finally some with a little courage.
Voting against the action were Richard W. Fisher and Charles I. Plosser. President Fisher believed that the continued strengthening of the real economy, improved outlook for labor utilization and for general price stability, and continued signs of financial market excess, will likely warrant an earlier reduction in monetary accommodation than is suggested by the Committee’s stated forward guidance. President Plosser objected to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for “a considerable time after the asset purchase program ends,” because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee’s goals.	Voting against the action was Narayana Kocherlakota, who believed that, in light of continued sluggishness in the inflation outlook and the recent slide in market-based measures of longer-term inflation expectations, the Committee should commit to keeping the current target range for the federal funds rate at least until the one-to-two-year ahead inflation outlook has returned to 2 percent and should continue the asset purchase program at its current level.	Send Mr. Kocherlakota a chill pill, and ask him to review how badly the FOMC forecasts, and how little effectiveness monetary policy has had for the good in the US.? He just wants to create another bubble, along with the rest of the doves.

Comments

Pretty much a nothing-burger. Few significant changes, if any.? Yes, QE ends, but who didn?t expect that?
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 flat and long bonds rise. Commodity prices are down.? 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 FOMC chops some ?dead wood? out of its statement. Brief communication is clear communication.? If a sentence doesn?t change often, remove it.
In the past I have said, ?When [holding down longer-term rates on the highest-quality debt] doesn?t work, what will they do? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.? The Fed is playing with forces bigger than themselves, and it isn?t dawning on them yet.
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.

The Butterfly Machine

Posted on 23 October 2014 by David Merkel

Photo Credit: whologwhy || Danger: Butterfly at work!

There’s a phenomenon called the Butterfly Effect. ?One common quotation is “It has been said that something as small as the flutter of a butterfly’s wing can ultimately cause a typhoon halfway around the world.”

Today I am here to tell you that for that to be true, the entire world would have to be engineered to allow the butterfly to do that. ?The original insight regarding how small changes to complex systems occurred as a result of changing a parameter by a little less than one ten-thousandth. ?Well, the force of a butterfly and that of a large storm are different by a much larger margin, and the distances around the world contain many effects that dampen any action — even if the wind travels predominantly one direction for a time, there are often moments where it reverses. ?For the butterfly flapping its wings to accomplish so much, the system/machine would have to be perfectly designed to amplify the force and transmit it across very long distances without interruption.

I have three analogies for this: the first one is arrays of dominoes. ?Many of us have seen large arrays of dominoes set up for a show, and it only takes a tiny effort of knocking down the first one to knock down the rest. ?There is a big effect from a small initial?action. ?The only way that can happen, though, is if people spend a lot of time setting up an unstable system to amplify the initial action. ?For anyone that has ever set up arrays of dominoes, you know that you have to leave out dominoes regularly while you are building, because accidents will happen, and you don’t want the whole system to fall as a result. ?At the end, you come back and fill in the missing pieces before showtime.

The second example is a forest fire. ?Dry conditions and the buildup of lower level brush allow for a large fire to take place after some small action like a badly tended campfire, a cigarette, or a lightning strike starts the blaze. ?In this case, it can be human inaction (not creating firebreaks), or action (fighting fires allows the dry brush to build up) that helps encourage the accidentally started fire to be a huge one, not merely a big one.

My last example is markets. ?We have infrequently?seen volatile markets where the destruction?is huge. ?A person?with a modest knowledge of statistics will say something like, “We have just witnessed a 15-standard deviation event!” ?Trouble is, the economic world is more volatile than a normal distribution because of one complicating factor: people. ?Every now and then, we engineer crises that are astounding, where the beginning of the?disaster seems disproportionate to the end.

There are many actors that take there places on stage for the biggest economic disasters. ?Here is a partial list:

People need to pursue speculation-based and/or debt-based prosperity, and do it as a group. ?Collectively, they need to take action such that the prices of the assets that they pursue rise significantly above the equilibrium levels that ordinary cash flow could prudently finance.
Lenders have to be willing to make loans on inflated values, and ignore older limits on borrowing versus likely income.
Regulators have to turn a blind eye to the weakened lending processes, which isn’t hard to do, because who dares oppose a boom?? Politicians will?play a role, and label prudent regulations as “business killers.”
Central bankers have to act like hyperactive forest rangers, providing liquidity for the most trivial of financial crises, thus allowing the dry tinder of bad debts to build up as bankers use cheap funding to make loans they never dreamed that they could.
It helps if you have parties interested in perpetuating the situation, suggesting that the momentum is unstoppable, and that many people are fools to be passing up the “free money.” ?Don’t you know that “Everybody ought to be rich?” [DM: then who will deliver the pizza? ?Are you really rich if you can’t get a pizza delivered?] ?These parties can be salesmen, journalists, authors, etc. whipping up a frenzy of speculation. ?They also help marginalize as?”cranks” the wise critics who point out that the folly eventually will have to end.

Promises, promises. ?And all too good to be true, but it all looks reasonable in the short run, so the game continues. ?The speculation can take many forms: houses, speculative companies like dot-coms or railroads, even stocks themselves on sufficient margin debt. ?And, dare I say it, it can even apply to old age security schemes, but we haven’t seen the endgame for that one yet.

At the end, the disaster appears out of nowhere. ?The weak link in the chain breaks — vendor financing, repo financing, a run on bank deposits, margin loans, subprime loans — that which was relied on for financing becomes recognized as a short-term?obligation that must be met, and financing terms change dramatically, leading the entire system to recognize that many assets are overpriced, and many borrowers are inverted.

Congratulations, folks, we created a black swan. ?A very different event appears than what many were counting on, and a bad?self-reinforcing cycle ensues. ?And, the proximate cause is unclear, though the causes were many in society pursuing an asset boom, and borrowing and speculating as if there is no tomorrow. ?Every individual action might be justifiable, but the actions as a group lead to a crisis.

In closing, though I see some bad lending reappearing, and a variety of assets at modestly speculative prices, there is no obvious crisis facing us in the short-run, unless it stems from a foreign problem like Chinese banks. ?That said, the pension promises made to those older in most developed countries are not sustainable. ?That one will approach slowly, but it will eventually bite, and when it does, many will say, “No one could have predicted this disaster!”

Mantra: Interest Rates Have to Rise, Interest Rates Have to…

Posted on 16 October 201416 October 2014 by David Merkel

Photo Credit: Beto Vilaboim || No, you are not crazy -- it *is* hopeless — Photo Credit: Beto Vilaboim || No, you are not crazy — it *is* hopeless

I thought of structuring this post like a fictional story, but I couldn’t figure out how to make it good enough for publication. ?Well, truth is often stranger than fiction, so have a look at this Bloomberg article pointing at a 37% loss in the?ProShares UltraShort 20+ Year Treasury (TBT).

A few points to start with: shorting is hard. ?Leveraged shorting is harder. ?I think I have reasonable expertise in much though not all of investing, and I put most shorts in the “too hard pile.”

That said, I have taken issue with the “interest rates can only go up” trade for 8-9 years now. ?It is not a major theme of mine, but I remember a disagreement that I had with Cramer over it back when I was writing for RealMoney. ?(I would point to it now, but almost all content at RealMoney prior to 2008 is lost.)

Many bright investors (usually not professional bond investors) have taken up the?”interest rates can only go up” view because of the loose monetary policy that we have experienced, and thanks to Milton Friedman, we know that “Inflation is always and everywhere a monetary phenomenon,” or something like that.

Friedman may or may not be right, but when banks do not turn the proceeds of?deposits into loans, inflation doesn’t do much. ?As it is, monetary velocity is low, with no signs of imminent pickup.

At least take time to read the views of those who are long a lot of long Treasuries, and have been that way for a long time — Gary Shilling and Hoisington Management. ?Current economic policies are not encouraging growth, and that is true over most of the world. ?We have too much debt, and the necessary deleveraging inhibits growth.

Think of this a different way: we have a lot of people thinking that they will retire over the next 10-30 years. ?To the extent that you can live with the long-run volatility, I accept the idea that you can earn 6-8%/year in stocks over that period, so long as there isn’t war on your home soil, or a massive increase in socialism.

But what if you are running a defined-benefit plan, investing to back long-dated insurance products, or just saying that you need some degree of nominal certainty for?some of your assets. ?The answer would be debt claims against institutions that you know will be around to pay 10-30 years from now.

In an era of change, how many institutions are you almost certain will be here 10-30 years from now? ?Personally, I would be comfortable with most government, industrial and utility bonds rated single-A or better. ?I would also be comfortable with some municipal and financial company bonds with similar ratings.

If followed, and this has been followed by many institutional bond investors, this would result in falling long-term yields, particularly now when economic growth is weak globally.

Now, rates have fallen a great deal over 2014. ?Can they fall further from here? ?Yes, they can. ?Is it likely? ?I don’t know; they have fallen a lot faster than I would have expected.

I would encourage that you watch bank lending, and to a lesser extent, inflation reports. ?The time will come to end the high quality long bond trade, but at present, who knows? ?Honor the momentum for now.

Full Disclosure: Long TLT for my fixed income clients and me (it’s a moderate?part of a diversified portfolio with a market-like duration)

Numerator vs Denominator

Posted on 11 October 201411 October 2014 by David Merkel

Every now and then, a piece of good news gets announced, and then something puzzling happens. ?Example: the GDP report comes out stronger than expected, and the stock market falls. ?People scratch their heads and say, “Huh?”

A friend of mine who I haven’t heard from in a while, Howard Simons, astutely would comment something to the effect of: “The stock market is not a futures contract on GDP.” ?This much is true, but why is it true? ?How can the market go down on good economic news?

Some of us as investors use a concept called a discounted cash flow model. ?The price of a given asset is equal to the expected cash flows it will generate in the future, with each future cash flow?discounted to reflect to reflect the time value of money and the riskiness of that cash flow.

Think of it this way: if the GDP report comes out strong, we can likely expect corporate profits to be better, so the expected cash flows from equities in the future should be better. ?But if the stock market prices fall, it means the discount rates have risen more than the expected cash flows have risen.

Here’s a conceptual problem, then: We have estimates of the expected cash flows, at least going a few years out but no one anywhere publishes the discount rates for the cash flows — how can this be a useful concept?

Refer back to a piece I wrote earlier this week. ?Discount rates reflecting the cost of capital reflect the alternative sources and uses for free cash. ?When the GDP report came out, not only did come get optimistic about corporate profits, but perhaps realized:

More firms are going to want to raise capital to invest for growth, or
The Fed is going to have to tighten policy sooner than we?thought. ?Look at bond prices falling and yields rising.

Even if things are looking better for?profits for existing firms, opportunities away from existing firms may improve even more, and attract capital away from existing firms. ?Remember how stock prices slumped for bricks-and-mortar companies during the tech bubble? ?Don’t worry, most people don’t. ?But as those prices slumped, value was building in those companies. ?No one saw it then, because they were dazzled by the short-term performance of the tech and dot-com stocks.

The cost of capital was exceptionally low for the dot-com stocks 1998-early?2000, and relatively high for the fuddy-duddy companies. ?The economy was doing well. ?Why no lift for all stocks? ?Because incremental dollars available for finance were flowing?to the dot-com companies until?it became obvious that little to no cash would ever flow back from them to investors.

Afterward, even as the market fell hard, many fuddy-duddy stocks didn’t do so badly. ?2000-2002 was a good period for value investing as people recognized how well the companies generated profits and cash flow. ?The cost of capital normalized, and many dot-coms could no longer get financing at any price.

Another Example

Sometimes people get puzzled or annoyed when in the midst of a recession, the stock market rises. ?They might think: “Why should the stock market rise? ?Doesn’t everyone?know that business conditions are lousy?”

Well, yes, conditions may be lousy, but what’s the alternative for investors for stocks? ?Bond yields may be falling, and inflation nonexistent, making money market fund yields microscopic… the relative advantage from a financing standpoint has?swung to stocks, and the prices rise.

I can give more examples, and maybe this should be a series:

The Fed tightens policy and bonds rally. (Rare, but sometimes…)
The Fed loosens policy, and bonds fall. (also…)
The rating agencies downgrade the bonds, and they rally.
The earnings report comes out lower than last year, and the stock rallies.
Etc.

But perhaps the first important practical takeaway is this: there will always be seemingly anomalous behavior in the markets. ?Why? ?Markets are composed of people, that’s why. ?We’re not always predictable, and we don’t predict?better when you examine us as groups.

That doesn’t mean there is no reason for anomalies, but sometimes we have to take a step back and say something as simple as “good economic news means lower stock prices at present.” ?Behind that is the implied increase in the cost of capital, but since there is nothing to signal that, you’re not going to hear it on the news that evening:

“In today’s financial news, stock prices fell when the GDP report came out stronger than expected, leading investors to pursue investments in newly-issued bonds, stocks, and private equity.”

So be aware of the tone of the market. ?Today, bad news still seems to be good, because it means the Fed leaves interest rates low for high-quality short-term debt for a longer period than previously expected. ?Good news may imply that there are other places to attract money away from stocks.

Ideas for this topic are welcome. ?Please leave them in the comments.

When Will the FOMC Tighten the Fed Funds Rate?

Posted on 10 October 2014 by David Merkel

Photo Credit: Moon Lee || When is this train going to arrive?

There are several ways to gauge the Federal Open Market Committee wrong. I am often guilty of a few of those, though I hope I am getting better. ?Don’t assume?the FOMC:

Shares your view of how economies work.
Cares about the politics of the situation.
Knows what it really wants, aside from magic.
Won’t change its view by the time an event arrives that was previously deemed important for monetary policy.
Cares about the reasoning of dissenters on the committee.
Understands what is actually happening in the economy, much less what its policy tools will really do.

But you can assume the FOMC:

Cares about the health of the banks, at least under extreme conditions
Wants to do something good, even if their minds are poisoned by neoclassical economics
Will err on the side of saying too much, rather than too little, when it feels that its policies are not having the impact?desired on the markets and economy.
Will act in the manner that most protects its continued existence and privileges.

So if we want to guess when the FOMC will tighten, we can do three things:

Look at market opinion
Look at the FOMC’s own opinions, or
Something else 😉

Let’s start with market opinion. ?At present, Fed funds futures have the Fed funds rate rising to 0.25% in the third quarter of 2015, and 0.50% in the fourth quarter. ?Now, market opinion has tended to be ahead of the actual actions of the FOMC on tightening policy, so maybe that will be true in the future as well. ?So far, those betting for tightening in the Fed funds futures market have been losing over the last few years along with those shorting the long Treasury bond, because rates have to go up.

Okay, so what does the FOMC think? ?Starting back in January of 2012, they started providing forecasts to us, and here is a quick summary of their efforts:

In general, they have been overly optimistic about growth in the US economy. ?They probably still are too optimistic.

They have been better at forecasting the unemployment rate, even as it has become less useful as an indicator of how strong labor conditions are because of discouraged workers and more lower wage jobs.

In general, they have expected inflation to perk up in response to their policies a lot faster than it has happened.

And as a result, like the market, they have expected to tighten in the past a lot sooner than they are presently projecting, which is not all that much different than the view of the market. ?Also like the market, you can’t simply take an average of their views as representative of where Fed Fund will be. ?Since the FOMC relies on voting, the median view would be more representative than the average Fed funds rate forecast, and that has remained at a relatively consistent “tightening will happen sometime in 2015” since September 2012. ?The median estimate of where Fed funds would be at the end of 2015 has also been 0.75-1.00% over that same period, which is higher than the current market estimate of 0.60%, but lower than the FOMC’s own estimate of 1.1%.

So, where does this leave us, but with a view that the FOMC will tighten policy next year. ?But what if the monetary doves on the FOMC remain dominant? ?After all, those that are permanent voting members are more dovish than the average participant tossing out an estimate. ?That leaves me with this, which reflects the influence of the doves better:

This graph is based on the average forecast, which includes a decent number of outlier views from some of the doves, which at present suggests tightening in January of 2016, but if you take into account the time drift of views since September 2012, it augurs for tightening in August of 2016.

The drift has happened because the economy has not strengthened the way the FOMC expected it would. ?If we muddle along at the average rate of growth over the last two years, the FOMC may very well sit on its hands and not tighten as quickly as presently expected. ?After all, labor conditions are soft, and inflation as they measure it is not roaring ahead. ?(Please ignore the asset price inflation that aids the non-existent wealth effect.)

As it is, statements from the FOMC have been noncommittal, only saying that they are ending QE. ?They are still waiting for their grand sign to act on Fed funds, and it has not come yet.

Summary

Current expectations from the market and the FOMC suggest that the Fed funds rate will rise in 2015. ?Prior expectations of FOMC action have signaled much earlier action than what has actually happened. ?From my vantage point, it is more likely that the FOMC moves later than the third quarter of 2015 versus?earlier than then. ?The FOMC has been slow to remove policy accommodation; it is more likely that they will remain slow given present economic conditions.

Inevitable Ineffective Banking Regulation

Posted on 1 October 20141 October 2014 by David Merkel

I am mystified at why people might be outraged or surprised that the Federal Reserve does a poor job of overseeing banks. ?The Fed is an overstaffed bureaucracy. ?Overstaffed bureaucracies always tend toward consensus and non-confrontation.

I know this from my days of working as an actuary inside an overstaffed life insurance company, and applying for work in other such companies. ?I did not fit the paradigm, because I had strong views of right and wrong, and strong views on how to run a business well, which was more aggressive than the company that I worked for was generally willing to do. ?Note that only one such company was willing to hire me, and I nearly got fired a couple of times for proposing ideas that were non-consensus.

This shouldn’t be too surprising, given the past behavior of the Fed. ?In 2006, the Fed made a few theoretical noises about residential real estate loan quality, but took no action that would make the lesser regulators do anything. ?It’s not as if they didn’t have the power to do it. ?One of the great canards of financial reform is that regulators did not have enough power to stop the bad lending. ?They most certainly did have enough power; they just didn’t use it because it is political suicide to oppose a boom. ?(Slide deck here.)

As a result, I would not have enacted Dodd-Frank, because I like my laws simple. ?Instead, I would have fired enough?of the regulators to make a point that they did not do their jobs. ?How many financial regulators were fired in 2008-2009? ?Do you hear the crickets? ?This is the #1 reason why you should assume that it is business as usual in banking regulation.

You won’t get assiduous regulation unless regulators are dismissed for undue leniency. ?I have heard many say in this recent episode with Goldman Sachs, the New York Fed, and?Carmen Segarra that those working for the Fed are bright and hard-working. ?I’ll give them the benefit of the doubt; my own dealings with those that work for the Fed is that most of them, aside from bosses,?are quiet, so you can’t tell.

Being quiet, and favoring the powerful, whether it is bosses, politicians, or big companies that you regulate is the optimal strategy for advancement at the Fed over the last 30 years. ?It doesn’t matter much how bright you are, or how hard you work, if it doesn’t have much impact on the organization’s actions.

I try to be an optimistic kind of guy, but I don’t see how this situation can be changed without firing a lot of people, including most of the most powerful people at the Fed, lesser banking regulators, and US Treasury.

And if we did change things, would we like it? ?Credit would be less available. ?I think that would be an exceptionally good thing, but most of our politicians are wedded to the idea that increasing the availability of credit is an unmitigated good. ?They think that because they don’t get tagged for the errors. ?They take credit for the bull market in credit, and blame everyone except themselves and voters for the inevitable bear market.

Also, if we did fire so many people, where would we find our next crop of regulators? ?Personally, I would hand banking regulation back to the states, and end interstate branching, breaking up the banks in the process.

Remember, the insurance industry, regulated by the states, is much better regulated than the banking industry. ?State regulators are much less willing to be innovative, and far more willing to say no. ?State regulation is simple/dumb regulation, which is typically good regulation.

But whether you agree with my policy prescription or not, you should be aware that things are unlikely to change in banking regulation, because it is not a failure of laws and regulations, but a failure of will, and we have the same sorts of people in place as were there prior to the financial crisis.

Postscript

I would commend the articles cited by Matt Levine of Bloomberg regarding this whole brouhaha:

A bit more on Carmen Segarra.

Apparently the place to discuss regulatory capture is on Medium. Here is Dan Davies:

Regulated institutions generally have better contacts and relationships with the top central bankers than their supervisors do. And for whatever reason, top central bankers never developed the necessary knee-jerk aggressive response to any attempts to make use of these relationships to affect the behaviour of supervisors.
So banks never need to listen to their line-level regulators because they can always get those regulators’ bosses’ bosses’ bosses to overrule them. Here is Felix Salmon, mostly agreeing. And here is Alexis Goldstein with a litany of Fed enabling of banks. Elsewhere, Martien Lubberink explains the transaction that got so much attention in the Fed tapes, in which Goldman agreed to hang on to some Santander Brasil stock for a year before delivering it to Qatar. He thinks it was pretty vanilla. And Adam Ozimek has a good point:

This American Life ep should lower avg est corruption belief. Goldman and NY Fed secretly taped & all u get is in non-confrontational nerds?