Stock Vigilantes to the Rescue

During President Clinton's terms of office we had the Bond Vigilantes. They rode herd on the government by raising interest rates whenever spending plans threatened to get out of hand. Today, with interest rates on U.S. Treasuries near record lows, the Bond Vigilantes have been overwhelmed by a desperate flight to safety by millions of frightened investors. But a new vigilante group has arisen to take over, the Stock Vigilantes.

For several weeks, it seemed that every time President Obama opened his mouth to explain a new, far-reaching government program he was planning, the stock market would take another 100 to 200 point dive. On the off days, Pelosi or Reid would add their thoughts and stocks would dive again. Then a strange thing happened. President Obama's poll numbers started first to fall, and then to plummet.

What we now have is a President frightened by his popularity dropping and realizing that millions of Americans, and not a few foreigners, are blaming his policy pronouncements for each additional 2, 3 or 4% daily drop in their retirement plans. That is, the Stock Vigilantes have taken control from the Bond Vigilantes.

It's no coincidence that President Obama recently decided he needed to hedge somewhat on the implementation of "Cap and Trade" legislation. Every time he raised the issue, the Stock Vigilantes took another chunk out of our retirement plans. When word surfaced that he was becoming ambivalent about pushing the most far-reaching restructuring of the American economy since FDR's New Deal, we finally had the best market rally of the year.

This President wants to take America down a far-left socialist road. Of that there can now be little doubt given his policy pronouncements since Inauguration Day. And it's unlikely that a drop in the polls will stop him. But Congress has another election day scheduled in a year and a half, and campaigning will begin soon. The Stock Vigilantes don't have the power to turn President Obama into a moderate, but they do have the power to scare moderate Democrats, and probably even a few liberal ones, into reining in the president's more radical aspirations, each of which promises to drive the American economy further southward.


Economic Forecast

As I said on December 2, the economy would hit bottom by March and certain leading numbers including retail sales and durable goods orders would rebound first. Employment would lag by a month or two, but would be the number that ultimately convinces the markets that the economy is turning upward. So far, both January and February's retail sales figures have come out stronger than expected. Though January's figure failed to ignite any enthusiasm, when the February decline of .1 percent (versus an expected decline of .5 percent) was reported along with a significant upward revision to January on March 12th, the market added to the rally it began on Monday, March 10th.

Durable goods orders, on the other hand, were still plummeting as of the January number, reported on February 26th. The February number to be reported near the end of March should begin to show a turnaround, however. The employment number remains dreary, and will not show strength until the numbers for March are reported in early April, or possibly even a month later. Nonetheless, the economy appears now to me to be turning on schedule, as I wrote in early December. Interestingly enough, a poll at CNN on when the economy would recover offered no option for "soon" or "now" and only 22% of respondents even chose the "later this year" option. The other 78% are looking for the recession to last until the end of this year at least.

The Bond Market

Rates plunged to absurdly low levels after my December 2nd forecast with the 10-year note yield falling to nearly 2 percent from the 2.70% rate in early December. That rate was unsustainable and 10-year rate is now back up near 3%, fluctuating between 2.75% and 3% lately. The long bond dropped from the early-December number of 3.25% to a low of near 2.5% in late December and is now back up, trading between 3.5% and 3.75% for the past month or so. As the signs of a strengthening economy mount, long term government securities are going to be slaughtered, especially given the massive borrowing that is going to be required to finance recent spending bills. And this is before inflation becomes a major concern, a factor that will likely come into play later in the year depending on Federal Reserve actions over the next several months.

The Stock Market

My December forecast on the stock market failed to account for the willingness of President Obama to destroy wealth by jettisoning the capitalist system, or at least expressing his intentions to do so, at the first opportunity. Otherwise, it's likely the lows made last November, which were then tested in January, would have held. Instead, investors lost all hope that the economy would be managed for growth and the market plumbed new lows. Only in the last week, when President Obama expressed a sentiment, and only a sentiment, that perhaps some of his ideas might have to wait for the economy to recover, did the stock market put in a convincing rally. However, this president has shown a remarkable ability to be able to say one thing while doing the opposite but not getting called to account for doing so. It remains to be seen what he actually does next, but my money would be on further attempts at wealth destruction. As I said at the outset of this piece, only the Stock Vigilantes are likely to be able to bring this process under control, and then only by scaring moderate Democrats facing re-election in 2010.

We should have seen a significant stock market rally by this point, and maybe we still will. However, this president and this Congress are not the investor's friends. Forecasting a bull market, however much the fundamentals will justify one (and they will) is a fool's game with the present crew in charge. At least that's how I see it.

The Housing Market

Face it, housing has been beat up beyond most people's (though not my own) expectations. While it might have further to drop, and while inventories remain plentiful, it's probably time to start picking and choosing if one is looking to get into a house near the bottom. Housing markets are local, and some markets no doubt still have much farther to fall, but in general if a potential buyer puts in exceptionally low bids on several houses over the next few months, and ends up buying one, I suspect he will be satisfied with his purchase a couple of years later. This will be particularly true if the Fed lets the recent monetary burst remain in the system.

The Federal Reserve and Money Supply

The massive injection of funds into the banking system in September of last year resulted in over a 50% growth in demand deposits over the four months through December (from $300 bn in August to $465 bn in December.) That injection is now being wisely withdrawn and the February number came in at $397 bn. If monetary policy is not to generate a 25% or so increase in the general price level over the next few years, the Fed must draw down demand deposits to close to the $300 bn level over the next few months. If they do this over the summer, a historically weak period for the stock market, the process could be hard on stock prices. Nevertheless, it must be done if inflation is to be held at bay.

As I said in early December, the massive reflation by the Fed could "turn on a dime" and so it did. Within a month they had taken action that significantly contracted demand deposits. As a reminder, for a reader to fully understand this process, you must read and understand the seven "priority" posts on this site.

Another Note to Business Leaders

I asked in December if it would be useful to know that the economy would be turning up by the second quarter of this year. You now have a huge advantage over market participants. This is because you can see your own sales trends and how your customers are acting. If the economy is indeed picking up, you will see it in your sales (unless, again, you build houses.) The problem is that given all the gloom and doom talk, including that coming from the White House, you might not believe what you're seeing. Let me tell you this. If your customers are starting to show signs of perking up, it's real. The time to batten down the hatches has passed. Don't sail into an economic recovery with a shrunken sales force and with your manufacturing operations unprepared to ramp up production, or you'll be caught unprepared yet again. Trust what you're seeing in your own operations, not what you're being told by outside economists because they will miss the turn by several months.

Forecasting Markets and the Economy

This is the first post here concerned only with forecasting. As such, it is labeled "forecast" at the end of the post. If you're interested in the theory underlying the forecasts, read the seven initial posts labeled "priority."

NBER Declares a New Recession

Yesterday, the National Bureau of Economic Research stated that economic activity peaked in December of 2007 and that we then entered a recession. I refer readers back to the following statement on my post of October 10, 2008:

Note how the consumer expenditures in the GDP figures have started to be revised downward all the way back to the fourth quarter of 2007, revisions that are completely consistent with a monetary contraction beginning around the second quarter of 2007. Note also the reversal of the commodity bubbles around the world, the continuing fall in housing prices, and the steady rise in the stock market came to an end by the third quarter of 2007. All of this is consistent with a monetary contraction beginning in the second quarter of 2007, as explained in the monograph.

Finally, note the carnage in the stock market, the contraction of global credit and the sudden strengthening in the dollar over the past several weeks as the world's investors come to grips with the reality that we are deflating, rather than inflating.

While it was obvious that we were already in recession when I wrote the above in October, what was not obvious was that the recession started at the beginning of the year. In fact, there was very little talk of a recession until mid-year and even then the majority of forecasters seemed to be hoping that the travails of the housing market would be overcome by strong international activity.

The Proverbial Water Over the Dam

I bring up the past "forecast" (which I never made on a timely basis in a public forum and therefore it can hardly be called a forecast) merely to illustrate that the theory I set forth in the seven priority posts correctly fit the past activity. In that sense, it does little good. It is indeed water over the dam.

What should be learned by those of you reading these posts is that the bulk of public opinion during the past two years alleging that the Fed was being too easy was wrong. In fact, the Fed was being far too restrictive. Again, you really do need to read the monograph referred to in the earlier posts, and dissect those posts carefully if you are to understand the underlying mechanism that drives my conclusions.


Implications for the Future

What now? Given the massive injection of reserves into the system, many economists would naturally wonder whether the Fed has successfully eased. However, they remain concerned that the Fed is merely "pushing on a string" and that the injected reserves will remain unused. This is not the case, however, because demand deposits skyrocketed at an historic rate as soon as the reserve injection was initiated.

Under past operating procedures, this would always have happened due to the "hot potato" theory of monetary policy that I've explained in the monograph. Now, however, those operating procedures have changed and it becomes much more important to determine whether the Fed is indeed "pushing on a string." Right now, it appears they are not, because demand deposits have grown apace. They will bear close watching over the next several months though, to ensure that the present levels are sustained.

The Economy

With the demand deposit burst occurring in September of 2008, it is reasonably certain that the economy will begin to rebound soon and that by March of 2009 (exactly six months after the money burst) signs of that rebound will have become evident. These signs will include accelerating retail sales, durable goods orders and finally employment numbers. If the past is any guide, the first signs will be complete surprises to market participants, will temporarily move markets, but will then be overwhelmed by other (lagging) published information. Typically, the statistic that finally convinces the doubters, who will be legion to the very end, will be the employment number. Even then, it will take as long as two or even three quarters of recovery before the NBER declares the end of the recession.

The Bond Market

Again, if the past is any guide, interest rates will fall until the first signs of a recovery and then will begin a rapid rise that will be sustained for a long period. The caveat to this forecast is that interest rates, particularly on longer maturity treasuries, are already at ridiculously low levels that might not be sustainable for another three to four months. The carnage in the bond markets in the second quarter of 2009, if present rates hold until then, will be something to behold.

The Stock Market

I've found that the stock market reacts rapidly to a change in demand deposits, so by March of 2009 we will likely have experienced a significant recovery in stock prices. The Fed was executing an extremely tight, even deflationary, policy until the third week of September after which the sudden increase in demand deposits occurred in response to the massive injection of reserves. Unfortunately, by that time the stock market had already started its severe decline, a decline which essentially was wrung out by the second week of October. Presently the market is trying to put in a bottom around current levels, an effort that should prove successful.

The Housing Market

This is a market that got about 80-100% too high relative to general prices and it did so in a near-deflationary environment besides. The implications are that the rise was the result of a herd mentality (assisted by the nearly-insane lending standards fostered upon the industry by Congress--let's put the blame where it really belongs here) and that to reach equilibrium housing must fall, relative to other prices, by 40 to 50% over the next few years. In other words, no near-term recovery in housing is likely and, in fact, housing prospects are likely to continue to deteriorate. The only possible way to forestall this is to induce a sharp, sudden inflation.

The Inflation Picture

Which brings us to inflation. If the present burst in the money supply is sustained, then inflation will indeed reassert itself. However, since the Fed has effectively relinquished most of the power it once had over the level of the money supply with its recent (and accelerated) change in treatment of excess reserves (See the previous post for an explanation,) it is anything but clear what present policy will yield. If you understand the content of the priority posts on this website, they you will realize that just because the Fed tries to effect an easing in policy doesn't mean that they will be successful, even if it appears that they are. After all, Japanese authorities tried for years to ease following their real estate and stock market debacles of the 1980's and yet remained mired in a ten-year deflationary environment.

Right now, though, it would appear that the Fed is finally managing to reflate, and on a grand scale at that. This could turn on a dime, however, and bears watching.

A Word to Business Leaders

Would it have been useful to know in the fourth quarter of 2007 that the risks of an imminent recession had grown substantially? Look at your own forecasts at that time and decide. Now examine your present forecasts and ask yourself if it would be useful to learn that the economy will begin accelerating soon and that the recession should be behind us by the second quarter of 2009? I'm reasonably certain that this will be the case and that you should be making plans on that basis unless you are depending upon a recovery in the housing market as well.

You've got real money on the line, so if this economic forecast proves accurate, you might even want to consider adding me to your list of consultants. Have the ones you've been relying upon been doing all that well recently?

Paying Banks to Hold Excess Reserves - Huge Mistake, Huge!

At the conclusion of the previous post I said that I would next explain how the Fed was getting ready to convert their control of monetary policy from what I claim is currently an "iron bar" to that limp "string" that many economists claim the Fed is always pushing on.

Fed Accelerates Plan to Pay Interest on Excess Reserves

In this press release, the Federal Reserve announced its intention to begin paying interest, for the first time ever, on excess reserves held by banks. One of the expressed reasons for doing so is cited at the end of the 7th paragraph: "Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector."

Unfortunately, it is that very opportunity cost that created the "iron bar" of monetary policy discussed in the previous post. As of October 1, 2008, that "iron bar" has been converted into a "limp string" and I fear the Federal Reserve has now lost control of monetary policy without even realizing they've done so.

Read the Monograph!

In nearly every post I refer to A Monograph on Monetary Policy, an unpublished paper that I wrote several years ago to explain how monetary policy has worked in this country for decades. If you've read it and actually understand it then you will also understand that it was the "opportunity cost of holding required reserves" that the Fed has just set out to "essentially eliminate" which gave the Fed tremendous power over the economy in the short run, and over inflation levels in the long run.

Now the Fed has relinquished a large part of that power. I say "a large part" because they still have a 75 basis point (0.75%) penalty rate that they impose, but that will likely not be enough to prevent banks from just holding onto excess reserves at the end of the two-week reserve calculation period. In the past, banks treated such reserves essentially as toxic waste and circulated them aggressively in an effort to drive their "opportunity cost" down to the minimum possible.

Again, as explained in the monograph, this "toxic waste" treatment resulted ultimately in the "iron bar." That is, even a modest provision of excess reserves would result in money growth. Conversely, a modest withdrawal of reserves, resulting in negative excess reserves would cause banks to have to scramble to find reserves, a process that resulted in an almost immediate contraction of the banking system as measured by demand deposit balances (with all the caveats discussed in the monograph applicable here.)

Japan, Again?

This country has been on a Japanese trajectory for over 20 years now. Japan had their stock market mania, then their real estate bust and then their lost decade, a decade when the Japanese monetary authorities could not get their money supply to expand. The reason for that failure was that they made the mistake of allowing the equivalent of their fed funds rate to go to nearly zero. This removed the "opportunity cost" that our own Fed is so concerned about, resulting in converting their iron bar of policy to the limp string so often discussed. The result was that for years they were indeed attempting to run the monetary policy of Japan by "pushing on a string."

This is why Bernanke was justified in being so concerned about deflation in the early part of this decade, a time when our Fed Funds rate was headed dangerously close to zero (though I doubt, given the recent decision, that he was concerned for the right reason.)

Now, we have doubled the reasons to be concerned. We are once again pushing the interest rate on federal funds to near zero, thereby risking the emulation of Japan's policy that created their "lost decade," and we have gone them one better by paying interest on excess reserve balances, thereby creating a situation where even at higher interest rates the Fed will have no power (or a much reduced power) to reverse a decline in the money supply.

What to Conclude?

Assuming the Fed has relinquished its power to easily and forcefully affect policy, in the sense that they could easily adjust reserves and thereby force money supply to increase or decrease accordingly (and quickly), force the economy to adjust accordingly (within a relatively short span of just six months) and force the inflation rate to adjust as well (over a much longer span of several years,) then we have entered, as they say, interesting times.

My advice, to myself as well as others, is to pay close attention to the level of demand deposits. They have ballooned since mid-September at an unprecedented rate. (Note that this process began several weeks before the Fed implemented the new policy of paying interest on excess reserve balances incidentally, indicating that the massive provision of excess reserves at that time had an immediate effect on the money supply.) Now, if the world works as laid out in the monograph, in almost exactly six months from mid-September, i.e., in about mid-March, the economic statistics will start looking up. Retail sales will have already rebounded, durable goods orders will also have begun turning up and the March (or possibly April) unemployment report will provide the final confirmation that the worst has passed. During that time, the stock market will have rebounded as well, greased by easy money and leading the economy, as usual, by several months. (A side forecast: When this happens, falling gasoline prices will get most of the credit.)

The Caveat

All of this is more or less baked in the pie already unless the Fed's new policy of paying interest on excess reserve balances results in their relinquishing control of monetary policy, as would be evidenced by a steady decline of the level of demand deposits over the next several months in spite of massive reserve provision by the Fed. The entire point of this post is that this might indeed happen. If it does, it would be nice if someone besides me actually understood why it was happening.

This concludes what I have to contribute to the theoretical discussion surrounding monetary policy and reserve management. I might add one further post that lays out what I believe a sensible reserve regulation regimen should look like, but if I never do that, simply going back to the 1950's policy would be an excellent beginning. This is not to say that we should run policy as we did in the 50's, 60's and 70's, because even then the Fed did not fully understand their potential power. But the 1950's reserve regulations gave them exactly the powers they need today, powers they have now all but relinquished.