Monday, October 27, 2014

How I see things

A quick recap of how I see the current state of markets and the economy:

Inflation: Contrary to the expectations of many monetarists, including myself, inflation remains subdued. This can only mean that monetary policy has not, contrary to what most believe, been "stimulative." Inflation happens when the supply of money exceeds the demand for it; that we haven't seen higher inflation is proof that the Fed has not been printing money, as I've long argued. Quantitative Easing has been all about swapping bank reserves (T-bill substitutes) for notes and bonds. Demand for safe assets like T-bills and short-term notes has been intense, and the Fed has effectively accommodated the market's demand for safe assets. It's been a very risk-averse recovery, and had the Fed not engaged in QE, there would have been a severe shortage of the things the market has most wanted.

Growth: It's been a sub-par recovery, despite massive fiscal "stimulus." Actually, it's more correct to say that it's been a sub-par recovery because of too much government spending. Government spending, which has been dominated by transfer payments, wastes money and creates perverse incentives. It's also been a sub-par recovery because the world has been so risk-averse. Corporate profits have been abundant, but businesses have been reluctant to invest those profits due to persistent risk aversion. The U.S. economy has grown mainly because of its inherent dynamism and ability to overcome adversity, and because most people here naturally want to improve their lot in life by working harder, saving, investing, and taking risk.

The dollar: Until recently, the dollar has been very weak against virtually all currencies. This was the by-product of 1) the Fed's QE policy (which many thought would severely debase the dollar), 2) the government's massive deficit-financed spending (which increased expected tax burdens, thus depressing investment and growth), and 3) the huge increase in regulatory burdens (think Obamacare and Dodd-Frank) which have also depressed growth and investment. The dollar has improved of late because 1) the economy has done better than dismal expectations, 2) the U.S. economy is outperforming the Eurozone economy, and 3) the policy outlook is improving as elections approach and the Obama administration's agenda (which consists of a relentless effort to expand government's power and influence over the economy, which in turn dims the prospects for healthy growth) shrinks to near-nothingness.

Interest rates: It should now be abundantly clear that QE was not about lowering interest rates, and low interest rates do not stimulate growth. Interest rates have actually risen during each episode of QE. Monetary policy cannot fine-tune economic growth, and it cannot create growth out of thin air. Low interest rates may be good for borrowers, but not for lenders; in a sense, the Fed's attempts to manipulate interest rates proved to be a zero-sum game (at best). Today's low interest rates are symptomatic of the persistence of risk aversion: zero interest rates on high-quality risk-free securities reflect intense demand for those securities and that safety. In a booming economy, cash is a drag; in today's economy, cash is a refuge from uncertainty.

Equities: The stock market is not artificially inflated. Prices are up because the economy has consistently exceeded expectations, and because corporate profits are at near-record levels, both nominally and relative to GDP. The current level of PE ratios is only modestly higher than their long-term average. The earnings yield on stocks compares very favorably to the yield on corporate bonds, which is again symptomatic of a market that is risk averse.

Gold: Gold prices are still quite elevated relative to their long-term inflation-adjusted average, which I calculate to be roughly $600/oz. Gold rose because investors feared a host of potential calamities: a global financial collapse, a Middle East meltdown, and a QE-fueled explosion of inflation. Gold has fallen in recent years because those fears have been largely unrealized. Gold is still very expensive, however, because investors are still very risk averse, only somewhat less so than a few years ago. Commodity prices have tended to follow gold prices, but they are not as overextended as gold prices today.

The future: There are abundant signs that the U.S. economy continues to grow, albeit relatively slowly. This is likely to continue, and it is possible that growth could improve somewhat in the foreseeable future because: 1) government spending as a % of GDP has shrunk dramatically, thus reducing the drag of spending on growth, and 2) the policy outlook should improve in the wake of next week's elections, as policy is likely to become more business- and growth-friendly.

The Fed: Members of the FOMC are overly-impressed with their ability to "guide" the U.S. economy, and overly-concerned with the relatively low level of current inflation. Monetary policy was never meant to be an instrument for fine-tuning growth, much less creating or promoting growth. Monetary policy that is good and proper can facilitate growth, but it cannot create growth. Growth comes only from working harder, investing, and taking risk, and low interest rates do nothing in that regard. Massive changes in the way monetary policy is conducted only create uncertainty which depresses investment and growth. One key source of risk going forward is that, because of the Fed's hubris, FOMC members may fail to react in a timely fashion to signs of improving confidence and declining money demand: a failure to reverse QE in response to a decline in the demand for safe assets could result in an unwelcome abundance of money and higher inflation. At today's levels, Treasury yields offer hardly any cushion at all for this risk and are thus very unattractive. Deflation, contrary to widespread claims in the punditocracy, is not a threat to growth, and is not a black hole that captures and annihilates slow-growing economies.

All of these themes have appeared in my posts over the past 5-6 years. If anything has changed of late, it is that risk aversion appears to be on a slow decline, and the outlook for fiscal policy is improving, if only because the misguided policies of the past 5-6 years have failed so miserably. One long-enduring theme has been that the equities were likely to do well because the economy was likely to exceed expectations, which were dismal because of all the risk aversion, fears, and uncertainties that have existed.

The world doesn't change on a dime, and so many of these same themes are likely to survive for another few years at least.


Hans said...

" the Fed has not been printing money, as I've long argued. Quantitative Easing has been all about swapping bank reserves (T-bill substitutes) for notes and bonds."

Mr Grannis, please explain to me why a bank would give up higher yielding bonds and notes for 25 base points?

Scott Grannis said...

I can't pretend to know exactly why, but the fact that they have done this, and to a significant degree, suggests that they have been trying to deleverage/bolster their balance sheets. It's another symptom of the risk aversion that has characterized the current business cycle expansion. Bank reserves pay only 0.25%, but they are risk free, and the rate will likely float up over time.

NormanB said...

Great piece. THX.

Lawyer in NJ said...

Although I enjoy (and learn from) your perspective and analysis, you make it sound as if public policy was fine before Obama took office, and that is demonstrably false given the situation he inherited.

Scott Grannis said...

It was not my intention to imply that policy was fine before Obama. Bush et. al. made a number of mistakes, as did the Dems in Congress. The Great Recession was most likely the by-product of Freddie and Fannie and their congressional allies, on top of government-sponsored distortions in the mortgage market that began decades ago. Tax policy has been sub-optimal for decades as well. Transfer payments, particularly social security and medicare, have long been on an unsustainable path.

Thanks to his ignorance of how an economy and free markets work, Obama made a bad situation worse.

Lawyer in NJ said...

In trying to weigh alternative perspectives, with regard to the role of Fannie and Freddie, I would be curious about your response to this claim:

•Nonbank mortgage underwriting exploded from 2001 to 2007, along with the private label securitization market, which eclipsed Fannie and Freddie during the boom.

Check the mortgage origination data: The vast majority of subprime mortgages — the loans at the heart of the global crisis — were underwritten by unregulated private firms. These were lenders who sold the bulk of their mortgages to Wall Street, not to Fannie or Freddie. Indeed, these firms had no deposits, so they were not under the jurisdiction of the Federal Deposit Insurance Corp or the Office of Thrift Supervision. The relative market share of Fannie Mae and Freddie Mac dropped from a high of 57 percent of all new mortgage originations in 2003, down to 37 percent as the bubble was developing in 2005-06.

The Big Picture

steve said...

Lawyer in NJ

If you're trying to castigate Bush for blame re '08, castigate away! Bush was a pathetic LIBERAL republican way over his head. most certainly NOT conservative. 2nd worst president (besides O of course) since Carter. If Hillary were anything like her husband WAS (he seems to have gone off reservation) I'd go for her but her recent comments re business are enlightening. Would not trust her as far as I could throw her (not far).

steve said...

"Members of the FOMC are overly-impressed with their ability to "guide" the U.S. economy, and overly-concerned with the relatively low level of current inflation."

Dead on correct. More perspicacious words have never been written by scott. Moreover, policy leaders (pols and fed) failed to allow capitalism to work in '08 and the result is a languid economy.

Scott Grannis said...

Re Freddie and Fannie: if those two government-sponsored giants had not been willing to buy virtually all of the AAA-rated tranches of MBS securities that banks and Wall Street firms could generate, regardless of underwriting standards, the housing bubble would never have inflated to the extent it did. Freddie and Fannie were the only two elephants in the living room.

Scott Grannis said...

Re the mortgage/housing crisis: Strongly suggest you read John Allison's account of the crisis. "The Financial Crisis and the Free Market Cure." It's the best one that I have read.

Benjamin Cole said...

Scott Grannis: You have to make up your mind. First you say the Fed is not printing money through QE, then you say the dollar is sinking due to QE.

I think the Fed is in fact "printing money" through QE, but you are correct in that much of the money has been deposited in banks and remains inert. still a portion of the QE funds could have been invested in other assets or simply spent both having good results for the economy. Probably, QE should just be a larger and more sustained program.

Hans said...

Excellent posts! Thank you all.