The Fed is too easy, but profits are spectacular

Despite numerous signs that inflation is running well above the Fed's target, the FOMC today showed no signs of panic. Instead, they hinted that the current tapering of Treasury purchases is now likely to be accelerated modestly, and that might bring forward by a few months the first hike in rates (late summer '22?). In my view, a true tightening of monetary policy (i.e., a draining of reserves, a hike in real short-term interest rates, and an inversion of the yield curve) is still far in the future. Meanwhile, corporate profits have set new all-time highs, both nominally and relative to GDP (third quarter profits were released today in the first revision to third quarter GDP numbers). With a profits boom and a gentle Fed as a backdrop, the downside risk to equities of a Fed tightening is minimal and far enough in the future to ignore for now.

Chart #1

Chart #1 tells us that the bond market is not unaware of the fact that inflation is rising. 5-yr inflation expectations (green line) have jumped from 0.2% in March of last year (when deflation and depression fears were rampant) to now 3.07%. The Fed has been telling us they want to see the CPI over 2% for at least a few years, and now the bond market sees the CPI averaging over 3% for the next 5 years. The Fed's inflation-boosting efforts have thus been more than accomplished. If I were running the Fed I'd be pushing for—at the very least—an immediate end to bond purchases. I think they are way too easy at this point.

Chart #2

Chart #2 is a reminder of what true Fed tightening looks like. Every recession in the past 50+ years (with the exception of last year's recession) has been preceded by a sustained tightening of monetary policy which takes the form of high real interest rates (blue line) and a flat or inverted yield curve (red line). Today we have just the opposite. Furthermore, to judge by the level of real short-term interest rates, monetary policy has never been so easy.

Chart #3

Chart #3 shows how Treasury yields tend to track inflation fundamentals. But today, yields are far below the current level of inflation. Yes, yields have jumped from the lows of last year, but they are still far below where they should be given the current level of inflation. I predict the red line will be rising for at least the next few years.

Chart #4

Chart #4 is one of the MOST IMPORTANT charts that the world is apparently still blissfully unaware of today. This is the elephant in the living room; the 800-lb gorilla that nobody sees. Inflation is up beyond all prior expectations because the money supply has exploded in the wake of the Covid lockdowns. By my estimates, there is an extra $4 trillion sitting in bank accounts held by the public, relative to what we would have expected to see in a normal environment. Moreover, M2 has been growing at about a 12% annual rate so far this year, and that is about twice what its growth rate has been over the past several decades.  

Don't just take my word for it: check out John Cochrane's discussion of this issue here. Briefly, he says that the Fed has done a massive "helicopter drop" of money, and that is the source of the inflation that is staring us in the face. It's not transitory, it's going to be with us for awhile, and it is going to be significant. (John Cochrane is one of my favorite economists.) You can read more about this in many of my prior posts.

At some point the Fed is going to have to take major steps to bring money growth back to some semblance of normality, but it's not going to happen soon. Meanwhile, the market seems willing to give the Fed the benefit of the doubt.

Chart #5

Chart #6

Fortunately, there is plenty of good news these days to offset the bad. Chart #5 shows corporate profits compared to nominal GDP. (This measure of profits is the best measure of true economic profits that exists, and it has been consistently calculated in the GDP accounts since the late 1940s.) Both are at all time highs. Chart #6 shows that profits relative to GDP are also at an all-time high.

The economy is growing and corporate profits are on the moon. What's not to like?

Chart #7 

Chart #7 compares corporate profits as calculated in the GDP accounts (red line) and trailing 12-month earnings per share (profits from continuing operations) as calculated by Bloomberg (blue line). Not surprisingly, both tend to track each other over time. But since the red line is a quarterly number, it tends to lead the blue line. This suggests that reported corporate profits are going to be very impressive for the foreseeable future.

Chart #8

Chart #8 is my calculation of a PE ratio for the S&P 500 that uses NIPA profits (the red line in Chart #7) as the E in a standard PE calculation. I've normalized the result so that the long term average of PE ratios for both series are the same. Yes, PE ratios are elevated today, but they are much lower than they were in the "bubble" that formed in the late 1990s. They are also elevated because the market is expecting trailing 12-month earnings to rise over the next year. Relative to forward expectations, today's S&P 500 PE ratio is a relatively modest 21.

That's all for now. My attention now turns to making some of the ingredients for our family Thanksgiving gathering tomorrow; my sister is hosting 36 of us!