Beginning Again

It's been over six years since the last post I made here at OnTrack Economics. Whether this post is the beginning of a new series, we'll have to see, but if it is here's what I hope to accomplish:

1. Explain what has happened to monetary policy options since my last post in 2009.

2. Explain the box the Fed now finds itself trapped within.

3. Explain the theory of monetary policy that the Fed abandoned.

4. Describe a better, strong form theory of monetary policy that should be used instead.

5. Attempt to explain how the former monetary policy control levers might be restored, in time. 

Changes in Monetary Policy Since 2009

Taking point #1 as the remainder of this post, the Federal Reserve essentially abandoned the normal means of controlling total reserves and the money supply when it

a) started paying interest on reserves,

b) allowed the fed funds rate to go to essentially zero percent, and

c) instituted the process of Quantitative Easing that goes by the acronyms QE1, QE2, and QE3.

Interest on Reserves

When the Fed started paying banks interest on the reserves they hold to back deposits, they in effect disabled their ability to generate controlled monetary growth. Prior to doing so, a small change in the balance of excess reserves in the banking system, on the order of a few hundred million dollars, always affected the amount of money in the banking system. Today, the existence around $2.5 trillion of excess reserves in the banking system clearly indicates that the system no longer reacts to the level of excess reserves.

Driving the Funds Rate to Zero

The Fed, and many monetary economists as well, assume that there is a zero boundary problem that crops up whenever the economy will not support a positive interest rate. When, no matter how low the Fed drives the fed funds rate, the money supply and economy fail to improve, zero is eventually reached, according to this thinking. And at the zero boundary it is no longer possible to drive rates lower, so the Fed loses it's ability to grow the economy by driving an increase in the money supply.

Side note: In fact, after several years of zero rates now, some central banks have indeed learned that rates can drop below zero with the proper inducements, such as charging a fee for holding deposits, rather than paying interest. This is a novel concept, sort of a new and improved mattress, if you will. That is, don't put that billion dollars under your mattress where you could lose it. Instead, deposit it with us and we will ensure that you get at least 99.5% of it back in one year's time. Well, a billion is a lot to mess with, so some institutions have done just that.

And still, monetary policy has been frustrated. What to do?

Enter the QE's, #1, #2, and #3

Finally, the powers that be at the Federal Reserve decided that if you can't get the economy revived with a zero short rate, then they should get to work on long rates. The net result is that the Fed's portfolio now contains trillions of dollars in long maturity debt including the lion's share of most long maturity U.S. Treasury issues.

But while Quantitative Easing has done wonders for the stock market, the bond market, the art and other collectible markets, and has even got houses selling like it's 2006 again, the economy remains soft and inflation shows no sign of accelerating, thereby giving the Fed little reason to raise rates under its monetary model.

Conclusion

Unable to justify a continual transfer of the bulk of the long treasury market to the Fed's portfolio given the failure of three such episodes to generate economic growth, and unable therefore to justify a return to a more normal level of fed funds, the Fed just sits and waits, promising that a tiny rate increase will be due soon. (The definition of "soon" is apparently somewhat loose at today's Fed, however.)

The next post will explain the box that the Fed now finds itself trapped within, and why "soon" really means "not until we really have to."

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?