Wednesday, January 25, 2012

More fiscal and monetary stimulus means more slo-flation

The Law of Unintended Consequences, coupled with a contrarian mindset, is often the best way to understand the impact of government policies on the economy: whatever the government is trying hardest to do, expect the opposite. At the very least, remain very skeptical.

Today the FOMC reminded us that they are trying really, really hard to stimulate the economy by keeping short-term interest rates very, very low, "at least through late 2014." Notably missing in today's FOMC statement was boilerplate which promises that the FOMC will keep its eye on the evolution of inflation and inflation expectations. The Fed is trying to be bold, but even they realize that "a highly accommodative stance for monetary policy" is only likely to foster more inflation rather than more growth. Rising inflation expectations sap some of the economy's vitality by steering resources to speculative activities (e.g., buying gold and stockpiling commodities, buying other currencies), rather than taking on real risk by investing in new plant and equipment and creating new jobs.

Last night, in his SOTU speech, Obama reminded us that he is willing to do just about anything to help the economy grow—except to give the private sector more room to work its growth magic. That would expose the fatal conceit of those, like him, who believe that nothing good can come if it does not originate in Washington. It's not enough to just lower the corporate tax rate to a more competitive level and eliminate loopholes and tax subsidies. He'd rather punish corporations that "export" jobs overseas, and reward those who bring them back, as if the federal government or mere politicians knew better how to manage a business like Apple than Tim Cook. Unfortunately, the more changes to the tax code designed to create politically-favored outcomes, the more distortions this introduces to the economy and the less growth we are likely to get.

Today's market reaction to the SOTU speech and today's FOMC news was consistent with this interpretation: thanks to myopic fiscal and monetary policies, we're likely to see somewhat more inflation, and only modest real growth. Call it slo-flation, rather than stagflation.


The 10-30 Treasury spread is the only part of the yield curve that is more or less immune to Fed ministrations. By pledging to keep short-term rates very low for years, the Fed can dominate interest rates out to the 10-yr maturity area. But they have very little control over interest rates beyond 10 years. The 10-30 spread has been widening since last October, in line with the rise in forward-looking inflation expectations, as shown in the above chart. Both jumped today because the bond market is getting nervous about the prospects for inflation.


Gold shot up by $43 in the wake of the FOMC announcement. This makes perfect sense, since extremely low borrowing costs locked in for a long time make it easier and safer for speculators to bet on rising gold prices, and extremely accommodative monetary policy promised for as far as the eye can see only undermines the outlook for the dollar's purchasing power, thus boosting the demand for tangible assets.

The S&P 500 inched higher, up only 0.5% as of this writing. The trailing PE ratio of the S&P 500 is still less than 14, substantially lower than its long-term average of 16.6, and Apple's trailing PE of 12.75 and expected PE of 11.21 is hardly what one would expect to see for a rapidly-growing company. Low PE ratios—especially in today's environment of super-low interest rates—can only mean that the market is highly skeptical about the prospects for future growth.

Equity and high-yield debt prices are rising—reluctantly—mainly because the risk of deflation is disappearing, and rising inflation means faster nominal growth and that is good for corporate cash flows. But PE ratios remain depressed, since the promise of true growth remains elusive.

19 comments:

Benjamin said...
This comment has been removed by the author.
Benjamin said...

Obama, and the Dems in general, need to be more pro-business, I think there is little dispute about that. And fiscal stimulus is perhaps meaningless, except it builds up debts on future taxpayers.

But I contend Scott Grannis is incorrect regarding the Fed.

The Fed has a proper role in stimulating an economy teetering on deflation, 13 percent below GDP trend, in which unit labor costs are falling and real estate is selling for half off. The DJIA is still below 1999 levels. There is not the slightest hint of worrisome rates of inflation.

In such a scenario, Fed stimulus is proper, and should be very aggressive. We do not want to do a Japan. That is by far the biggest threat today.

The Fed should announce and transparently define nominal GDP growth targets, and the QE and interest rates they will use to get us to those growth targets. The Fed is instead following the Japan model.

It saddens me that the right-wing has not grasped the promise of Market Monetarism to promote growth without inflation or federal deficits.

The hoary encrusted shibboleths of yesteryear have not aged well. Tight money is not a panacea, anymore than fiscal deficits are. The Keynesians and the tight-money crowd are both wrong--but deeply fixed into their peevish and resentful pathways.

BTW, Friedman was not for tight money per se, and in fact advocated Japan engage in aggressive and sustained QE to solve its recessionary-deflationary economy.

Japan did not listen, and they have paid the price. The USA is not listening either.

Public Library said...
This comment has been removed by the author.
Donny Baseball said...

and longer dated yields dipped briefly on the news but started rising again - the market has to realize sooner or later that the Ben Bernanke's easy money combined with Obama's animal spirits-crushing administration equals stagflation. But in order to come to grips with this, the bond market has to swallow some supply side lessons - phillips curve is bunk, as is demand side pump priming - which it is reluctant to do. But in the end, the market will figure out where this policy mix leads.

Public Library said...

Scott,

Question: What do you think about all the discussion now (and in the past) about the Fed becoming more transparent with communications?

IMHO this provides the opposite of the intended consequences. If the Fed was opaque about ultimate decision making, then the market would maintain a healthy level of fear with regards to risk taking.

I do believe the Fed should provide more visibility into actions on an ex-post basis (if we have a Fed), but ex-ante guidance may prove costly.

Scott Grannis said...

The Fed is just a group of fallible humans, no different from the rest of the professionals that study the market and the economy. Having them publish their individual forecasts of rates, inflation, and the economy (which are ultimately derived from basic assumptions that everyone has to make) adds little to the world's knowledge, or to the world's confusion.

Public Library said...

Scott: Not sure I fully agree and your post seems to allude to the same thing. For example, if the Fed communciates its on-hold @ .25bps for 2,3 5 years, speculators can/will employ carry trades without a worry on the short end.

Benji: from the mises. This is what you relaly need to know about money printing.

"Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer. The state of the demand for money cannot alter the amount of goods produced, that is, it cannot alter the so-called real economic growth. Likewise a change in the supply of money doesn't have any power to grow the real economy."

Scott Grannis said...

The Fed can announce that it expects to keep rates low until at least the end of 2014, but that is not a guarantee. If the economy behaves better than their assumptions, and/or inflation rises more than they feel comfortable with, it would be astonishing (and quite destructive I might add) for them to hold to their pledge. Any market participant needs to understand this.

But what the FOMC collectively believes does carry more weight than what any group of individuals in the market might believe, since the FOMC has the power to enforce its beliefs. So on the margin, today's FOMC statement promising more time for low rates probably does convince some additional speculators to join the gold-buying party.

Benjamin said...

Public Library-

I like Mises, I like Friedman, but most of all I like the new Market Monetarism.

The gold rally? There was a much more important rally today on the DJIA. The DJIA is closing in on 13k. That is good news.

Even the gold rally may be bullish. If people have more disposable income, they will buy more gold. It is a luxury good; the bulk of demand is for jewelry in China and India. The USA has become a secondary market, despite the braying you hear on talk radio.

So gold's rally may be a verification that better times are ahead---but really, I read nothing into gold prices, which seem to come from the Moon and go to Mars. It is a lulu investment and still down, in inflation-adjusted terms, from the 1980s.

Benjamin said...

Public Library-

On Mises.

Okay, I produce a perfect set of 10 counterfeit Ben Franklins. I ask you buy paint and paint my house, just to be nice to me.

You say no.

I ask you to buy paint and paint my house for $1000. You say yes.

Economic activity, output and wealth is increased.

Why do you accept the paper money. As perfect counterfeits you can pay taxes with them, or the next guy you give them to can do the same. They are accepted.

Money is the lubricant for an economy. I am not recommending counterfeiting or printing too much money. But you gotta print enough to keep the economy humming. Bernanke is not.

Benjamin said...

BTW, one of the "unintended consequences" is that the DJIA was by 80 today, closing on 13k.

I hope for such unintended consequences every day of my life.

Mark Gerber said...

Isn't this Fed statement just paving the way for QE3? In other words, the Fed can now say they have done everything they can short of another round of QE?

John said...

If the Administration needs to be more "pro-business" and instead engages in "animal-spirit crushing," why are corporate profits so strong?

Donny Baseball said...

John
Corporate profits are strong because 1) corporations laid people off in 2008 and 2009 and have not rehired them so they are much leaner and meaner doing base level business, 2) financing costs are very low thx to bernanke, most cos have refied down to much lower interest costs, and 3) companies are reigning in growth capex. I talk to CEOs and cfos everyday, they are minting money today off the world economy and a relative return to normalcy in the US, but nobody is in a growth mindset, and they will ALL tell you sotto voce it is due to Washington DC and this administration.

John said...

DB wrote: "but nobody is in a growth mindset, and they will ALL tell you sotto voce it is due to Washington DC and this administration."

I don't buy it. If they're not in a growth mindset they should lose their jobs. I'd fire their butts. Here is a link to a list of 50 top growth companies:

http://money.cnn.com/magazines/fortune/fortune500/2011/performers/companies/fastgrowprofits/5yr.html

John said...

Looks like the link above got cut off. Try again.
http://money.cnn.com/magazines
/fortune/fortune500/2011/performers/companies
/fastgrowprofits/5yr.html

Donny Baseball said...

John,
You may not buy it, but I can assure you that in corporate board rooms, these CEOs are safe. Some are active buying distressed assets but without that opportunity the imperative across corporate America is 1) preserve "right-sized" status, 2) you cannot have a strong enough balance sheet 3) wait to see what happens in Nov.
This is all coming straight from Boardrooms. A company's timeline is perpetuity, this President's timeline is somewhere between 11 months and five years - trust me, they can wait. Unduly risky growth, is not the growth anybody wants.

Mark Gerber said...

I wouldn't suppose it has anything to do with the fact that in 2008 the biggest age cohort, namely the baby boomers, crossed over the prime age of 50 and started their decent into what we call retirement? Naw ... that's too simple minded of an explanation. Why look at the people that make up the economy when we have hundreds of stats and economic theories to consider.

Scott Grannis said...

Mark: there is no way that demographics can change so much in such a short period. Demographics change very slowly over many years. Besides, I really doubt that there was a surge in the number of baby boomers retiring after the disastrous stock market of 2008. If anything, baby boomers on average are going to be retiring much later than they or anyone else expected.