Macroeconomics – Page 9 – 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.

Stock Valuations: Micro and Macro

Posted on 24 July 2015 by David Merkel

From a friend who is a client:

Here are a couple of things I have been pondering.

Market capitalization is pretty fictitious. It assumes that all the shares of a company are worth the price at which the last block sold. However, if you tried to sell all of the shares of a large company (hypothetically), the price would drop to almost zero.

It seems to me the primary reason the stock market goes up over time is because the money supply increases. To put it another way, if the money supply did not increase the stock market could only increase in value by increasing the % percentage of the money supply spent on stocks, which is obviously limited.

My views here might be somewhat naive. Comments/criticism/feedback welcome.

Dear Friend,

Ben Graham used to talk about the stock market being a cross between a voting machine and a weighing machine. ?On any given day, economic actors vote by buying and selling shares, and in the short run, the?trades happen at the levels dictated by whether the buyers or sellers are?more aggressive. ?That is the voting machine of the market. ?In the short run, values can be pretty senseless if one side or the other decides to be aggressive in their buying or selling.

What arrests the behavior of the voting machine is the weighing machine. ?The price of a stock can’t get too low, or it will get taken over by a competitor, a private equity firm, a conglomerate, etc. ?The price of a stock can’t get too high, or valuation-sensitive investors will sell to buy cheaper shares of firms with better prospects. ?Also, corporate management will begin thinking of how they could buy up other firms, using their stock as a currency.

I’ve written more on this topic at the article?The Stock Price Matters, Regardless. ?Within a certain range, the market capitalization of a company is arbitrary. ?Outside the range?of reasonableness, financial?forces take over to push the valuation to be more in line with the fundamentals of the company.

Macro Stock Market Measures

Every now and then, someone comes along and suggests a new way to value the stock market as a whole. ?I’ve run across the idea that the stock market is driven by the money supply before. ?The last time I saw someone propose that was in the late 1980s. ?I think people were dissuaded from the idea because money supply changes in the short run did not correlate that well with the movements in stock indexes over the next 25 years.

Now, in the long run, most sufficiently broad macroeconomic variables will correlate with levels of?the stock market. ?Buffett likes to cite GDP as his favorite measure. ?It’s hard to imagine how over the long haul the stock market wouldn’t be correlated with GDP growth. ?(Why do I hear someone invoking Kalecki in the background? ?Begone! 😉 )

There are other popular measures that get trotted out as well, like the Q-ratio, which compares the stock market to its replacement cost, or the Shiller Cyclically Adjusted P/E ratio [CAPE]. All of these have their merits, but none of them really capture what drives the markets perfectly. ?After all:, various market players note that the market varies considerably with respect to each measure, and they try to use them to time the market.

The best measure I have run into is a little more complicated, but boils down to estimating the amount that Americans have invested in the stock market as a fraction of their total net worth. ?You can find more on it here. (Credit @Jesse_Livermore) ?Even that can be used to try to time the market, and it is very good, but not perfect.

But in short, the reason why any of the macro measures of the market don’t move in lockstep with the market is that market economies are dynamic. ?For short periods of time, our attention can fixate on one item or group of items. ?In my lifetime, I can think of periods where we focused on:

Monetary aggregates
Inflation
Unemployment
Housing prices
Commercial Mortgage defaults
Japan
China
High interest rates
Low interest rates
Bank solvency

Profit margins rise and fall. ?Credit spreads rise and fall. ?Interest rates rise and fall. ?Sectors of the economy go in and out of favor. ?The boom/bust cycle never gets repealed, and economists that think they can do so eventually get embarrassed.

That’s what keeps this game interesting on a macro level. ?You can’t tell what the true limits are for market valuation. ?We can have guesses, but they are subject to considerable error. ?It is best to be conservative in our judgments here, in order to maintain a margin of safety, realizing that we will look a little foolish when the market runs too hot, and when we seem to be catching a falling knife in the bear phase of the market. ?Take that as my best advice on what is otherwise a cloudy topic, and thanks for asking — you made me think.

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.

Sixteen Implications of “The Phases of an Investment Idea”

Posted on 2 July 2015 by David Merkel

My last post has many implications. I want to make them clear in this post.

When you analyze?a manager, look at the repeatability of his processes. ?It’s possible that you could get “the Big Short” right once, and never have another good investment idea in your life. ?Same for investors who are the clever ones who picked the most recent top or bottom… they are probably one-trick ponies.
When a manager does well and begins to pick up a lot of new client assets, watch for the period where the growth slows to almost zero. ?It is quite possible that some of the great performance during the high growth period stemmed from asset prices rising due to the purchases of the manager himself. ?It might be a good time to exit, or, for shorts to consider the assets with the highest percentage of market cap owned as targets for shorting.
Often when countries open up to foreign investment, valuations are relatively low. ?The initial flood of money in often pushes up valuations, leads to momentum buyers, and a still greater flow of money. ?Eventually an adjustment comes, and shakes out the undisciplined investors. ?But, when you look at the return series analyze potential future investment, ignore the early years — they aren’t representative of the future.
Before an academic paper showing a way to invest that would been clever to use in the past gets published, the excess returns are typically described as coming from valuation, momentum, manager skill, etc. ?After the paper is published, money starts getting applied to the idea, and the strategy will do well initially. ?Again, too much money can get applied to a limited factor (or other) anomaly, because no one knows how far it can get pushed before the market rebels. ?Be careful when you apply the research — if you are late, you could get to hold the bag of overvalued companies. ?Aside for that, don’t assume that performance from the academic paper’s era or the 2-3 years after that will persist. ?Those are almost always the best years for a factor (or other) anomaly strategy.
During a credit boom, almost every new type of fixed income security, dodgy or not, will look like genius by?the early purchasers. ?During a credit bust, it is rare for a new security type to fare well.
Anytime you take a large position in an obscure security, it must jump through extra hoops to assure a margin of safety. ?Don’t assume that merely because you are off the beaten path that you are a clever contrarian, smarter than most.
Always think about the carrying capacity of a strategy when you look at an academic paper. ?It might be clever, but it might not be able to handle a lot of money. ?Examples would include trying to do exactly what Ben Graham did in the early days today, and things like Piotroski’s methods, because typically only a few small and obscure stocks survive the screen.
Also look at how an academic paper models trading and liquidity, if they give it any real thought at all. ?Many papers embed the idea that liquidity is free, and large trades can happen where prices closed previously.
Hedge funds and other manager databases should reflect that some managers have closed their funds, and put them in a separate category, because new money can’t be applied to those funds. ?I.e., there should be “new money allowed” indexes.
Max Heine, who started the Mutual Series funds (now part of Franklin), was a genius when he thought of the strategy 20% distressed investing, 20% arbitrage/event-driven investing and 60% value investing. ?It produced great returns 9 years out of 10. ?but once distressed investing and event-driven because heavily done, the idea lost its punch. ?Michael Price was clever enough to sell the firm to Franklin before that was realized, and thus capitalizing the past track record that would not?do as well in the future.
The same applies to a lot of clever managers. ?They have a very good sense of when their edge is getting dulled by too much competition, and where the future will not be as good as the past. ?If they have the opportunity to sell, they will disproportionately do so then.
Corporate management teams are like rock bands. ?Most of them never have a hit song. ?(For managements, a period where a strategy improves profitability far more than most would have expected.) ?The next-most are one-hit wonders. ?Few have multiple hits, and rare are those that create a culture of hits. ?Applying this to management teams — the problem is if they get multiple bright ideas, or a culture of success, it is often too late to invest, because the valuation multiple adjusts to reflect it. ?Thus, advantages accrue to those who can spot clever managements before the rest of the market. ?More often this happens in dull industries, because no one would think to look there.
It probably doesn’t make sense to run from hot investment idea to hot investment idea as a result of all of this. ?You will end up getting there once the period of genius is over, and valuations have adjusted. ?It might be better to buy the burned out stuff and see if a positive surprise might come. ?(Watch margin of safety…)
Macroeconomics and the effect that it has on investment returns is overanalyzed, though many get the effects wrong anyway. ?Also, when central bankers and politicians take cues from the prices of risky assets, the feedback loop confuses matters considerably. ?if you must pay attention to macro in investing, always ask, “Is it priced in or not? ?How much of it is priced in?”
Most asset allocation work that relies on past returns is easy to do and bogus. ?Good asset allocation is forward-looking and ignores past returns.
Finally, remember that some ideas seem?right by accident — they aren’t actually right. ?Many academic papers don’t get published. ?Many different methods of investing get tried. ?Many managements try new business ideas. ?Those that succeed get air time, whether it was due to intelligence or luck. ?Use your business sense to analyze which it might be, or, if it is a combination.

There’s more that could be said here. ?Just be cautious with new investment strategies, whatever form they may take. ?Make sure that you maintain a margin of safety; you will likely need it.

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.

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.

On Human Fertility, Part 4

Posted on 2 April 2015 by David Merkel

I write about this every now and then, because human fertility is falling faster then most demographers expect. Using the CIA Factbook for data, the present total fertility rate for the world is 2.425 births per woman that survives childbearing. That is down from 2.45 in 2013, 2.50 in 2011, and 2.90 in 2006. At this rate, the world will be at replacement rate (2.1), somewhere between 2025 and 2030. That?s a lot earlier than most expect, and it makes me suggest that global population will top out at 8.5 Billion in 2050, lower and earlier than most expect.

Have a look at the Total Fertility Rate by group in the graph above. The largest nations for each cell are listed below the graph. Note Asian nations to the left, and African nations to the right.

Africa is so small, that the high birth rates have little global impact. Also, AIDS consumes their population, as do wars, malnutrition, etc.

The Arab world is also slowing in population growth. When Saudi Arabia is near replacement rate at 2.17, you can tell that the women are gaining the upper hand there, which is notable given the polygamy is permitted.

In the Developed world, who leads in fertility? Israel at 2.62. Next is France at 2.08 (Arabs), New Zealand at 2.05, and the US at 2.01,?slightly below replacement. We still grow from immigration, as does France.

Most of the above is a quick update of my prior piece, which has some additional crunchy insights. ?This evening, I would like to highlight two articles that I saw recently — one on troubles with municipal pensions, and one on how some areas of China are dying. ?They are at root the same story, but with different levels of potency.

Let me start with the?amusing question where?Arnold Schwarzenegger asks Buffett via CNBC what can be done to solve the municipal defined benefit pension problem, which Becky Quick then asks Buffett. ?For the next 80 seconds, Buffett says it is a messy problem created by politicians that voted for high municipal pensions, because future generations would pay the bill, and not current taxpayers. ?The politicians that voted for them are long gone. ?Buffett offers no solutions, and I don’t blame him because all of the solutions are ugly. ?Here they are:

If state law allows, terminate the current plans and replace them with Defined Contribution plans, or reduce the rates of future accrual. ?If those can’t be done, create a new Defined Contribution plan for all new employees, who will no longer participate in the?Defined?Benefit plans. ?Even the last of these will be fiercely resisted by municipal unions.
Cancel the cost of living adjustment, if you can do so legally.
Raise taxes — I’m sure younger people will enjoy paying for past services of municipal employees.
Impose excise (or something like that) taxes on municipal pension payments, and rebate the money back to the plans.
Declare or threaten bankruptcy if you can legally do it, and try to extract concessions from the representatives of pensioners.
Amend the state constitution to change the status of pension benefits, including adding an?exception adding legality to adjust benefits after the fact. (ex post facto)

Don’t get me wrong. ?I don’t think the radical solutions could/would ever be done, and the National government would probably slap down any state that actually tried something draconian. ?Remember, states are practically administrative units of the national government. ?States’ rights is a nice phrase, but often very empty of power.

Here are some non-solutions:

Float pension bonds — just a form of leverage, substituting a fixed liability for a contingent liability, and assuming that you can earn more than the?rate paid on the pension bonds.
Invest more aggressively. ?Sorry, taking more risk won’t do it. ?Returns are only weakly related to risk, and often taking high risks leads to lower returns. ?The returns you are likely to get depend mostly on the entry prices you pay for the underlying cash flow streams in question.
Invest in alternative assets. ?Sorry, you are late to the game. ?Alternatives offer little more than conventional assets at present, and they carry high fees and illiquidity.
Adjust the discount rate, or salary increase rate assumption. ?That may make the current problem look smaller, but it doesn’t change the underlying benefits to be paid, or the returns the assets will earn. ?If anything, the assumptions are too aggressive now, and plan assets are unlikely to return much more than 4%/year over the next 10 years.

Buffett gave one cause for the problem, but there is one more — if the US population were growing rapidly, there would be a larger base of taxpayers to spread the taxes over. ?Diminished fertility feeds into the problems in the states, as well as other social insurance schemes, like Social Security and Medicare. ?You could loosen up immigration to the US, particularly for younger, wealthy, and or/skilled people, but that has its controversial aspects as well.

Here’s another way of phrasing it — it’s difficult to create workers out of thin air. ?Governments would like nothing better than to?have more working age people magically appear. ?It would solve the problem. ?Alas, those decisions were largely made 20-40 years ago also. ?There is even competition now for the best immigrants.

That brings me to the article on China. Rudong, a city in China where the one-child policy began, is now an elderly place with few younger people to take care of the elderly. ?Kind of sad, even if the problem was partially self-inflicted, and partially inflicted by conceited elites who thought they were doing a good thing.

A few?quotations from the article:

?China will see more places like Rudong very soon,? said Wang Feng, a professor of sociology at the University of California at Irvine. ?It?s a microcosm of the rapid demographic and economic transformation China has been experiencing the last decades. There will be more ghost villages and deserted or sleepy towns.?

also:

?China is quickly turning gray on an unprecedented scale in human history, and the Chinese government, even the whole Chinese society, is not prepared for it,? Yi said. ?In many places, including my hometown in western Hunan, it?s hard to find a young man in his 20s or 30s.?

and also:

What?s different in China is that the one-child policy accelerated the process, removing hundreds of millions of potential babies from the demographic pool. China?s old-age dependency ratio ? a measure of those age 65 or over per 100 of working age ? is set to triple by 2050, to 39.

The one-child policy created possibly the sharpest demographic shift in the world. ?It is largely irreversible; once women as a culture stop having children, they don’t start having more when benefits are offered or penalties are lowered. ?It would take a big change in mindset in order to get that to shift, like a religious change, or the aftermath of a big war.

The Christians are growing in China, and many of them would have larger families, but even if Christianity?gets a lot bigger, and the Party tolerates it, that won’t come fast enough to deal with the problems of the next 30 years, but it could help with the problems after that.

In closing, there is enough pity to go around. ?Pity for the elderly that will not get taken care of to the degree that they would like. ?Pity for those younger who cannot afford the time or monetary costs of taking care of the elderly.

I think the only solution to any of this would be shared sacrifice, where everyone gets hurt somewhat. ?My question would be what places in the world have the requisite maturity to?achieve such a solution. ?Optimistically, the answer would be many, but only after a lot of sturm und drang.

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.