Category: Public Policy

Too Much Debt

Posted on by David Merkel

Photo Credit: Steve Rotman || As Simon and Garfunkel sang, “The words of the prophets are written on the subway walls…”

Debt-based economies are unstable. Economies with a lot of short-term debt are more unstable. The Fed is like Johnny One-Note, or Fat Freddie with a hammer. They only know one tool, and it will solve all problems.

Are there problems from too much debt? More debt will solve the problem. Shift debts from the private to the public sector. Don’t let the private market solve this on its own.

Though the bed debt is not in the same place as the last crisis, we are once again trying to play favorites through the Federal Reserve and rescue entities that took too much risk.

My view is let them fail. The whole system is not at risk, and the COVID-19 crisis will pass in two weeks. The great risk is not from the disease, but from the ham-handed response from policymakers who are short-sighted, and highly risk averse to the point of not wanting to cross the street for fear of dying.

Have we become like the Chinese, who bail out their banks and non-banks regularly? Who can’t bear to see any significant institution fail?

(Yes, I know they are getting more willing to see entities fail in China, but why are we getting less that way in the US? Let market discipline teach companies to not have so much debt.)

Here are three things to consider:

  1. Bond ETFs Flash Warning Signs of Growing Mismatch — The Fed now think its purview extends to managing the discounts of bond ETFs? Let the system work, and let profit seeking institutions and individuals benefit from artificially high yields. Let insurance companies do what I did: purchase a cheap package of bonds in an ETF, and convert it into the constituent bonds, and sell those that you don’t want for a profit. (Losses from ETFs premiums and discounts are normal, and it is why the dollar weighted returns are lower than the time-weighted returns.)
  2. The same applies to repo markets. As I have said before, the accounting rules need to be changed. Repo transactions should not be treated as a short-term asset, but as a long asset with a short-term liability, because that is what it is. With Residential Mortgage-Backed SecurIties in trouble, the market should be allowed to fail, to teach those who take too much risk to not do that. This failure will not cascade.
  3. The same applies to the crony of Donald Trump — Tom Barrack. He pleads his own interest, seeking for the Fed or the Treasury to bail him out, and those who are like him. Let him fail, and those who are like him.

Market participants need to know that they are responsible for their own actions, particularly in a small and short-lived crisis as this one. COVID-19 as a systemic crisis will be gone within weeks.

My statement to all of those listening is “When will we set up a more rational system that discourages debt?” We could made dividends tax-exempt, and deny interest deductions for non-financial corporations, including financial subsidiaries of non-financial corporations. Of course we would grandfather prior obligations.

Are we going to wait for the grand crisis, where the Fed will continue to extend credit amid roaring inflation, or where extend no credit amid a tanking economy? This is what eventually faces us — there is no free lunch. The Fed can’t create prosperity via loose monetary policy, and Congress cannot create prosperity via loose fiscal policy.

The bills eventually come due. The USA might get the bill last after the failure of China, Japan, and the EU, but it will eventually get the bill.

As such, consider what you will do as governments can’t deal with the economic and political costs of financing the losses of the financial system.

The Worst Policies are Made During Crises

Posted on by David Merkel

Photo Credit: Mike Licht || As a culture, we are very much “live for the moment.” But what happens when buyers of Treasuries decide that it’s not worth it anymore?

I am not a fan of the Democrats or of Big Government Republicans like Bush Jr. and Trump. In general, I think we need to shrink our government, decentralize, and de-lever our economy such that we make debt a smaller component of how we finance our lives. The Democrats talk about inequality, but they don’t really mean it. Increasing marginal tax rates is good show, but the real game is how income is calculated, and they won’t touch that, because their richest donors find ways to hide their income — the same as donors to the Republicans.

That’s why I call the governing elite in DC “The Purple Party.” A blend of red and blue, with just enough difference to get politically motivated donors to give, but practically doing the same thing, serving wealthy elites.

I’m going to make a post on COVID-19 next week, but my last post on the topic was too optimistic. That said, the politicians, particularly governors, are being scaremongers. They are vastly overestimating the size of the crisis.

What really bugs me are the foolish ideas being propounded by the Fed and politicians. Let me talk about a few of them.

1) Don’t close the stock or bond markets. Closing the markets does not eliminate volatility. It only hides it. Practically, it makes the price of securities to be zero for those who want to sell them. And, for those who left some cash on the side, it denies them the opportunity to profit from their wisdom.

2) The Fed should only hold short government debt. That is a neutral asset. Anything else makes the Fed play favorites in what they buy, whether it is mortgage-backed securities, municipal bonds, or corporates. Don’t let the Fed become a political institution, creating ad hoc policy by whose debt they do and don’t buy.

3) Don’t close businesses. Let all businesses set their own policies. They don’t want their workers to infect others. Let them operate.

The idea that there are “necessary businesses” is foolish. The “necessary businesses” rely on other businesses to be their suppliers.

What would be better would be to have extensive testing for COVID-19, and to quarantine those who are infected, and those who are not tested who had contact with those who are infected. Leave the rest of society free. Don’t close firms down, and then give some lame amount of government assistance to them. We do best when we are working. People staying at home lack the healthy stress that working provides.

4) Now, if you have to give assistance, giving it to people directly is the best way. I advocated for that in the last financial crisis. But you should give it to all Americans equally, to avoid favoritism. Now, there is the issue of those who buy US Treasury debt objecting to the concept, and I can respect that. Why else do you think that the yield on 30-year Treasury Bonds has risen 0.8% over the last ten days?

There is no such thing as a free lunch, and with all those advocating excessive deficit spending, I would say “Yes, the past efforts have not disrupted the markets, but if you read economic history closely, no one can tell what will make the paradigm shift. Are you feeling lucky?”

Summary

From my reading of the data, I don’t see how this crisis lasts past the end of April. Yet there are governors of states foolishly shutting down businesses, and thinking that they are doing something good. “Shelter in place” is a recipe for turning all Americans into lawbreakers in the same manner as is with highway speed limits. Do you really want to ruin our culture via overly strict laws?

What of the poor people running out of money? What of the small businesses that go broke? Governments should focus on testing for the virus, and quarantining those who have it and those who have had contact and are untested.

In closing, I would encourage all readers to vote all incumbents out of office. They are not serving the interests of average Americans well. They are cowards who listen to scaremongers, and that includes Trump.

PS — some people might suggest that I am not kind to those that are hurting. It’s not true. I give over 10% of my income to charity each year. Beyond that, I would challenge people to consider Venezuela. Many small to medium-sized actions by Chavez and Maduro slowly robbed the country of economic vitality. The wealthiest nation in South America became the poorest.

The same could happen here. Economic disasters often spring from something small — remember Ben Bernanke saying that the risk from subprime mortgages was “well contained?” Yes, subprime mortgages were small, but they represented the marginal buyers of residential real estate, so when they failed, so did property prices. Like dominoes, they fell.

Thus I am saying to urge the government to not engage in policies that increase its deficits. You can’t tell when the last bit of debt will be the straw that breaks the back of the camel.

The S-Curve, Once More, with Feeling

Posted on by David Merkel

Photo Credit: Lars Plougmann || Indeed, this seems like a race, and the S-Curve is a major challenge to drive through

This will be brief, because I am still working on it, but it is my weak conviction that as far as the markets are concerned, the COVID crisis will largely be over by next Friday. How certain am I? Not very — I give it a probability value of around 30%.

If my thesis is correct, reported new cases of COVID-19 in the US will peak by Friday of this week, and will be 90% complete by next Friday. I will be watching how many new cases are reported. New cases tend to peak when total cases increase at a mid-teens percentage rate over the prior day. Because reporting is noisy, you don’t see that so easily, but the inverse logistic curves I am estimating are consistent on that figure for all the countries I have modeled so far.

I’ve run models for South Korea and Italy as well, and I’ll run them for a few more countries tomorrow. They are all pretty consistent with each other. Italy’s new cases should peak tomorrow, if they haven’t already.

I know everything is dark and gloomy now. Even if my modeling is wrong, which is a significant likelihood (I am extrapolating), I find it difficult to believe that we will still be in crisis mode by tax day.

So, cheer up. The number of COVID-19 cases is unlikely to be overwhelming, and we are all likely to survive this. The markets will revive, though maybe not energy stocks for six months. Those are a separate issue.

And if new cases track my estimates, I will put more money into the market. That’s all for now.

The Effect of Democratic Delegate Allocation Rules

Posted on by David Merkel

Photo Credit: Gage Skidmore || Unless things change, Democratic Party Elites should get comfortable with Sanders being their nominee for President

This is a rare post on politics at Aleph Blog. I am not taking a position on any candidate here, nor their effect on the economy. As an applied mathematician, I want to point out the implications of three factors:

  • Bernie Sanders is getting roughly 30% of votes in the primaries/caucuses, and the next five split the rest in an uneven way.
  • These Democratic contests typically award delegates based on the vote in each area as defined by a state, and the state as a whole. The delegates get split pro-rata to a candidate’s share of the vote in each area if the candidate gets over 15%. It’s a little more complex than that if no one gets more than 15% of the vote, but that’s not likely to happen in 2020.
  • If Sanders gets over 35% of all the pledged delegates, it will get increasingly ugly to not give him the nomination the nearer his delegate total gets to 50% of pledged delegates. No one wants a convention where over 1/3 of the delegates feel cheated. If you need examples where there wasn’t cheating, but there were sure a lot of hard feelings, you can think of Ford/Reagan in 1976, Carter/Kennedy in 1980, and Clinton/Sanders last election.

Add in one more bit of data — in an internet age, it is easy to keep a campaign on life support. Candidates with low funds can nominally hold on for a long time subsisting off of what free media and a skeleton staff can give them.

I ran a few simple simulations yesterday. With six main candidates altogether, if Sanders gets 30% of the vote on average, and the other five split the rest in a lopsided way, on average Sanders will end up with roughly 45% of all of the delegates. But suppose one of Sanders’ opponents drops out, and the other assumptions remain similar — Sanders would get 36% of the delegates. If one more opponent drops out, the effect is a lot smaller — Sanders would get 33% of the delegates.

The most unlikely assumption not to change is that Sanders doesn’t pick up support from voters when opponents of his drop out, particularly if the ones dropping out would be Warren or Buttigieg. I would expect that Sanders might pick up more support if one of them dropped out, as opposed to Biden, Bloomberg or Klobuchar.

But the main effect going on here is with so many opponents to Sanders splitting the remaining votes, few of them get above the 15% threshold, and Sanders gets a decidedly higher allocation of delegates than what he got in the popular vote — not as big of a difference as in the GOP’s winner-take-all primaries, but this is still a considerable advantage unless one of his challengers breaks out of the pack.

Thus, when I read an article like No,?You?Drop Out: Why Bernie?s Rivals Are All Stubbornly Staying in the Race I realize that most of Sanders’ opponents would like others to drop out of the race, but no one sees a decent reason to do so. Everybody thinks it’s nice to get more cars off the crowded highway, as long as it is not them.

Thinking back to 2012 when I wrote Searching for the Not-Romney, I noted how virtually every GOP candidate had had a surge and fall versus Romney. After each surge, there wasn’t a second surge. Voters had given them a limited window of time when they reviewed them — they weighed them in the balance, and found them wanting. No second chances.

I don’t think that’s a perfect paradigm. Second chances ARE possible for the opponents of Sanders, but I think they are unlikely. The candidate would have to give voters a reason to think, “Huh, I guess I didn’t understand him right the first time.” Getting a lot of people to change their minds is difficult after a first impression is made. Thus in the present state of matters, I assume that Sanders will be the nominee of the Democrats.

And, since I can’t resist making at least one comment regarding the economic implications of that, yesterday the market went down hard because of the coronavirus, something that I think is transitory, and should have little effect. Perhaps the drop was due to Sanders’ convincing win in Nevada. That would certainly have more effect on the economy, particularly profits, for a longer period of time.

It might be wise to check your risk position, and ask yourself whether you feel comfortable given an increased likelihood of Sanders being the next President of the USA.

All for now.

Greenspan’s Pathology

Posted on by David Merkel

Photo Credit: The Aspen Institute || His shadow still affects central banking today…

At Aleph Blog, I will argue for things that are against my short term interests. After all, the higher stock and bond prices go, the higher my income goes in the short-run. In the long-run, that’s not sustainable.

I am here this evening to criticize the philosophy of Alan Greenspan that had the FOMC doing the bidding of the stock, bond, and futures markets.

  • Don’t disappoint the markets.
  • Give the markets what they want, and everything will work out well.
  • Flag the markets to tell what your intentions are.

None of those are the province of the Fed. The Fed is supposed to care for:

  • Low inflation
  • Low labor unemployment
  • Moderate long-term interest rates
  • (and indirectly) A healthy banking system, because the levers of Fed policy depend on it.

All of these things are going well at present, AND the yield curve has normalized. So why loosen again? Well, Fed funds futures indicate a igh probability of a cut… so give the market what it wants, right?

Ah, bring back Volcker and Martin, who would follow their statutory mandate, and not just mention it to excuse policy errors.

I write this partly after reading this article at Marketwatch. The article is a mix of different opinions, but the ones that get me are the ones that say that the Fed has to listen to the markets.

Well, that’s what Greenspan, Bernanke, and Yellen did, and it led us into a low interest rate morass because they never let recessions do their work and eliminate entities with low marginal efficiencies of capital.

Recessions are not always bad, and lower interest rates are not always good. Just as fires are good for forests in the long run, so are recessions that clear away marginal economic ideas.

It may not come this week. It may not come in the next few years, but eventually the Fed will be willing to offend the markets again. When it does, the jolts will be considerable, but it may lead to a better economy in the long-term.

Improving Liquidity for Small Cap Stocks

Posted on by David Merkel

Picture Credit: OTA Photos || This is easier said than done!

The SEC is seeking ideas on how to make small cap stocks more tradable. Let me quote the closing of an article from the Wall Street Journal:

In soliciting the proposals, the SEC laid out a number of possible approaches, without endorsing any of them.


One such approach would limit trading in low-volume stocks to the exchange where they are listed. Nasdaq Inc. has promoted a similar plan, arguing that it would create deeper markets for small-cap stocks by concentrating the trading of their shares on one venue. But critics, including some rival exchanges,?have attacked Nasdaq?s plan?as anticompetitive, saying it would benefit big exchanges like Nasdaq.

In another approach floated by the SEC, trading in low-volume stocks would take place in periodic auctions, separated by discrete time intervals, instead of continuously throughout the trading day.

SEC Seeks Ideas For Improving Trading in Small-Cap Stocks

I’m not sure that any of these proposals will work. Longtime readers know that I think that liquidity is hard to permanently increase, or decrease for that matter.

By nature, small cap stocks have smaller floats. There’s less information about them Many accounts and managers have mandates that don’t allow them to purchase small cap stocks. Bid-ask sizes and spreads tend to be smaller and larger respectively than those of large caps. That’s largely a function of floating market cap and the underlying riskiness of the company in question. Market structure plays less of a role.

The composition of investors does matter. It typically doesn’t change that much; it is cyclical. Horizons shorten as volatility rises, and vice-versa.

The more buy-and-hold investors there are, the more liquidity decreases. The more traders with short time horizons there are, the more liquidity increases. Commissions declining will possibly make time horizons a little shorter for day-traders, but I can’t imagine that the effect will be that big.

As a smaller investor, I do like the concept of a central order book that would have a monopoly on trading a stock, because it would remove an informational edge that high-frequency traders [HFT] have. I don’t think it would increase liquidity much though. It would change where the trades happen, and perhaps who makes the trades. I think that some less technologically inclined investment advisors would be willing to put up larger bids and asks in such a context, but they would mostly replace lost volume from HFT.

I also think that having more auctions during the day would be a good idea, say like one every half hour. I don’t think it would increase liquidity, though. Trading would become more sparse away from the auctions.

I own four illiquid stocks for my stock strategy clients, and one less liquid closed-end fund for my bond clients. I can trade them if I need to. I just have to be more patient with those securities, and break trades up into bite-size pieces.

For me, trading is a way of implementing changes to the portfolio. If any of the proposed changes happened, my trading would not change much at all. I suspect that would be true for all but the investors with the shortest time horizons, but I think that could go either way. We have lower commissions on one hand, and disadvantages for HFT on the other. Could be a wash.

Enough rambling. I don’t see a lot of likely change here, and liquidity should not be the highest priority at the SEC. Rather than facilitating more secondary trading, it would be nice to see more private firms going public. SEC efforts on that would get my attention.

Post 3000 — I’m glad to be back!

Posted on by David Merkel

Photo Credit: Stephan Caspar || In Roman numerals 3000 is MMM… and thus the yummy picture that will make some people go “mmm….” As for me Mmm… I’m glad to be back.

Every 100 posts (except that I did not do it at the 2900 milestone), I take a moment to reflect. I started blogging back in February of 2007. I was 46 years old then; I am 58 now.

I resisted starting a blog for some time. When my editor at RealMoney asked me (she was asking all the contributors) “Are you going to start a blog?” I answered, “RealMoney, particularly the Columnist Conversation is my blog.”

I loved writing for RealMoney, but in some ways I was not the best fit for RM. I wrote more about theory, and less about actionable ideas. My main reason for that was that beyond holding a CFA charter, and at the time, a dues-paying life actuary, I have a code of ethics in addition to those from CFAI and the SOA. Aside from that, feedback is lopsided, like on Yelp. You get disproportionate feedback when you make a mistake, but little praise when you get something right.

But the reason I decamped from RealMoney was that I wanted more editorial freedom. It is the same reason that I tried writing for The Balance, and gave it up because I needed more freedom to write what I was thinking. (Also, writing for The Balance involved rewriting old articles, many of which were average for the web, but way below my standards. Rewriting those took a lot of time, and did not satisfy the other requirement of writing new articles on topics the the editors wanted, most of which were decidedly niche.)

How Aleph Blog Changed Over Time

When I began, I was writing two small articles per night. I morphed into writing articles that were relatively long, and one per night. I had a goal: to express all of the main ideas that I had come to regarding finance, economics and investment. A major part of that was The Rules posts, which mostly stemmed from insights I had between 1999 and 2003. There were a few that came after that, but not many. When I finished the last of the original Rules posts, I breathed a sigh of relief, because one of the major goals of the blog was complete. I had written an article on all of the “Rules.”

Now, one other thing that changed was the financial crisis. During the crisis, I resolved to write about all of the issues that I thought my distinct view could help explain. But I did not want to be a “crisis blogger.” There are some bloggers that are locked into writing about disaster, which is problematic when we have been in a very long though shallow recovery. Some commenters criticized me for not being like Zero Hedge back in 2009 or so. I ignored it because I want to be an “All Weather” blogger. I will write when the sun shines. I will write when it rains.

I do want to make one comment from the crisis era, when I was one of the bloggers invited to the first US Treasury / Blogger summit. In my 7-part coverage of the event, I never mentioned what I said during the main portion of the event. I was not the most outspoken at that event. Those that were “crisis bloggers” dominated the conversation.

There were only two things I got to say during the meeting. The first was my telling them that they could learn something from the way Canada regulates their banks, and also that the US state-regulated insurance companies were regulated better than the depository institutions in the US, especially for solvency.

The second thing that I said was that the US should lengthen maturities for Treasury issuance, and issue fifties, centuries, and consols. Also, they should issue floating rate debt. I told them that the US government would face a crisis when there is too much debt to roll over, so stagger the maturities, and pay up to borrow longer.

Back to the Present

I wrote a lot of book reviews in the past. I am unlikely to write a lot more of them, though there will be some. Part of that is Amazon favoring reviewers that bought their books at Amazon. I got most of mine from the publishers.

I have maybe 40 article ideas to work on now. Many of them will require significant work. Many of my best articles required that level of work, but it will mean that my output will slow down. If you have something you would like me to write about, send me an email. My address is on the Contact Me page. I don’t guarantee that I will write about it, but reader letters have led to more articles at my blog than most others.

Thanks to my Readers

There is one post that is especially dear to me, the one entitled Learning Leadership. It describes a time when I effected a huge change in the business that I worked for, and got little to no reward for doing so.

I thank all of my readers for reading me, wherever you are. One-third of my readers are outside of the US. I try to write for a global audience, but living in the US, I know that it will be somewhat US-centric. All the same, I invite those outside the US to write me and ask me questions.

And with that, I close this piece. Not that I will answer every question, but I will read everything that is written to me. My readers help make my blog better. Keep writing to me and helping me; I appreciate it.

Issue Longer Treasury Debt

Posted on by David Merkel

Picture credit: DonkeyHotey || Should bonds get longer?

When I visited the US Treasury during the first Treasury/Blogger summit I encouraged the US Treasury to issue debts longer than 30 years, and also floating rate debt. I said the insurance companies, pension funds and endowments would be willing buyers, and that it would be cheaper than issuing 30-year bonds. I thought that the yields on (say) 50-year bonds would be lower than 30-year bonds, because the yield curve for most of my life (at that point) had the yield curve peaking out at around 22 years or so. 30-year bonds usually yielded less than 20-year bonds.

The case for issuing longer debt was easy when 30-year bonds yielded less than 20-year bonds. That is no longer true, and has not been true since the financial crisis. In a low interest rate environment, 30-year bonds yield more than 20–year bonds. In a higher interest rate environment, the relationship flips.

So, should the US treasury issue 50-year, 100-year, or perpetual bonds? I still think the answer is yes, and for three reasons.

1) It’s an experiment. The market doesn’t always know what it wants until you offer an option to it. No degree of discussion with the advisory committee can beat an actual offering to the market. There used to be callable T-notes, and even a Treasury note denominated in Swiss Francs. Experiments are worth trying on a small level just to see what happens. Knowledge is a valuable thing — theory is worth less than tangible data.

2) Rates are low. Why not lock in the low rates? Even if 50-year bonds have a premium yield to 30-year bonds, those yields are likely lower than what you might get when interest rates are high.

3) It would be genuinely useful for life insurance companies and pension funds to have a benchmark for 50-year bonds, which would encourage the corporate market to issue debt as well. Those who make long promises need others who will make similarly long fixed commitments.

Then there are the speculators, who I don’t care much about. They would appreciate longer debt as well, as it would give them a greater place to speculate.

My advice to the US Treasury is this: issue longer debt as an experiment. If there is additional cost in the short-run, see if it is cheaper in the long run. There is a market for longer debt, even if your advisory committee thinks differently.

Always Late

Posted on by David Merkel

Photo Credit: Brendan Ross || When policy is late it becomes procyclical. Better to do nothing.

Start with four premises.

1) One of the things everyone acknowledges about monetary policy is that it works with long and variable lags. It’s kind of like dealing with an unmanned space vehicle a long way away. You have to make choices taking into account the lag for the signal to get there, and the lag for the craft to send back data on what is happening. Fortunately with this the length of the lags are known.

2) Another thing that most economists acknowledge is that employment is a trailing indicator of the economy as a whole. Thus employment can misrepresent the strength of the economy. The economy can be strengthening rapidly, and employment has barely budged, or like now, the economy can be weakening and employment can seem really strong.

3) Then there is the Fed’s dual mandate, which means the Fed must try to aim for low consumer price inflation and low labor unemployment.

4) Further confusing matters here is the Phillips Curve, which posits negative correlation between consumer price inflation and labor unemployment. The key assumption of the Phillips Curve is that there is a fixed relationship between wage increases and price inflation. It is dubious that this theory ever worked. If it ever worked, it was during an era when closed economy macroeconomics was a reasonable approximation for how the US economy worked. This might have been true in the 20 years following WWII.

In an open macroeconomy like today, as the US economy strengthens, labor can be sought in many other countries than the US. The key assumption of the Phillips curve is wrong. Whatever modest effects exist are likely accidental and not structural.

I’m no fan of stimulating the economy. If you regulate the banks tightly to keep them solvent, the economy will largely self-correct. Booms and busts will still be there, but not as big.

But that’s not the way our culture views things. They want the government to manage the macroeconomy, even if that management won’t work so well. They want to believe in Oz. (Which, given that Oz was about the so-called failure of the gold standard, this has come full circle.)

Here’s how Oz can function better. The Fed can focus on GDP rather than employment, arguing that by focusing on GDP employment will follow for the most part — and that where it doesn’t follow so well, tell the truth that the Fed doesn’t have much influence over employment.

The opposite of this argument is like this article in the Wall Street Journal, where it says:

Referring to the latest Fed two meetings, Ms. George said, ?with moderate growth, record-low unemployment and a benign inflation outlook, maintaining an unchanged setting for policy would have been appropriate, in my view.?

Fed?s George: U.S. Economy Is in ?Good Place?

George is driving through the rearview mirror. GDP looks a little further forward, and the yield curve looks more forward still. The yield curve is a discounting mechanism, and predicts future movements in lending, GDP and employment, in that order.

So long as the controlling members of the Fed say things like “We couldn’t need to loosen, the economy or employment is strong,” amid an inverted yield curve, or ” “We couldn’t need to tighten, the economy or employment is weak,” amid a steep yield curve, it will always be late, and exacerbate booms and busts.

The Fed likes to trumpet its independence, but more than fearing Trump or Congress, they fear public opinion, and don’t want to take right moves that have bad optics. They would rather get there late, and pretend that the heroes have arrived on time. Going back to Oz, the Fed is a mishmash of the scarecrow and the lion.

Summary

My solution is that the Fed should look at forward-looking indicators, and educate the press and public about what they are doing. If they do that, policy will work better until the forward looking indicators lose their value. Oh well… search for new ones.

Postlude

I know some people tire of my musings on Central Banking. Personally, I hope this is my last post on it for a long time.

Easy In, Hard Out (IV)

Posted on by David Merkel

Photo Credit: Fabricio Olivetti || Beware situations where some governmental entity thinks that they have unlimited power…

This is the fourth in a series of posts regarding the Fed’s balance sheet, and quantitative easing. Unlike the first three, I’m not going to do the graphs of the composition of the Fed’s balance sheet that I did before, because I’m not sure it’s relevant to the present argument.

I want to quote a few passages from prior articles, because it has been so long. From the conclusion of article 3:

My main point is this: even with the great powers that a central bank has, the next tightening cycle has ample reason for large negative surprises, leading to a premature end of the tightening cycle, and more muddling thereafter, or possibly, some scenario that the Treasury and Fed can?t control.

Easy In, Hard Out (III)

The main thing that I got wrong in the prior parts of this series was assuming longer interest rates would rise, leading to a tightening of short-term interest rates. I expected my scenario 2 ( Growth strengthens and inflation rises), and we got scenario 3 ( Growth weakens and inflation remains low). Regarding scenario 3, I said:

3) Growth weakens and inflation remains low.? This would be the main scenario for QE4, QE5, etc.? We don?t care much about the Fed?s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.

Easy In, Hard Out (Updated)

I also thought that the Fed would have a hard time taking back the policy accommodation:

But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the ?policy accommodation.?? That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.

Easy in, Hard out

Back to the Present

The hullabaloo over raising the fed funds rate over 3% has passed. A debt-laden economy slowed down faster than expected, leading long rates to fall, and the yield curve inverted. The Fed has been loosening amid an economy that is middling-to-weak, grudgingly, because unlike most other loosening cycles, nothing has blown up yet.

(An aside: The Fed could have fought back via a balance sheet-neutral swap of all their bonds longer than 10 years for an equal amount of T-bills,and short T-notes. That would have steepened the yield curve.)

But we are in an environment where the Fed is trying to deal with everything, like an overworked superhero. Repo markets having trouble? Flood the short-term lending markets with liquidity, and reverse the shrinkage of the Fed’s balance sheet.

By removing risk from the repo markets, it incents players there to get more aggressive, because they know the Fed has their backs. Better to let the players know that the repo market is subject to considerable volatility. They need to consider liquidity conditions like any other prudent investor, realizing that losses are indeed possible.

Summary

The Fed needs to return to the days of Volcker and Martin, where they let risk markets go their own way, and focus on the real economy only. They won’t do that, because past Fed easy accomodation has led to a lot of debts, both public and private.

Monetary policy accommodation is “easy going in, but hard going out.” The financial markets now think of low rates and ample liquidity as a birthright, not a temporary accomodation, partially because servicing the debt in a low interest rate environment is a lot easier. It is also partially because rates were so low for so long that expectations have adjusted.

I don’t see how the Fed gets out of this situation. Sitting and waiting, swapping away the long Treasuries would not be the worst idea in the world. But when there is a lot of debt, it tends not to get paid down in a orderly way during a recession. Defaults will come cheaper by the dozen.

I don’t think avoiding financial fragility at this time is the best long-term option. The banks are in decent shape, despite the repo market. Corporate bonds and loans and low-end consumer loans will bear most of the losses in the next recession. Best to take the hit, and let everyone know that the Fed does not exist to facilitate speculation, but to restrain inflation, and promote labor employment.

Then maybe, post recession, we can get a growing economy, a normal-shaped yield curve, and a less-indebted economy… excluding the indebted US and municipal governments, which truly are hopeless.

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