Why Fed policy is hurting the economy

John Taylor wrote a very interesting article in the WSJ last week, "Fed Policy Is a Drag on the Economy," in which he argues that the Fed has been hurting the economy by keeping short-term interest rates extremely low, and promising to keep them extremely low for a long time. This of course runs directly counter to what we have been led to believe.

He describes a variety of problems created by super-easy monetary policy (e.g., encouraging people to take on too much risk, creating great uncertainty about the Fed's ability to reverse its QE efforts, making it easy for the federal government to fund its massive spending plans, and forcing other central banks to follow suite.) More importantly, perhaps, he argues that very low interest rates create disincentives to save, and this limits the economy's ability to grow. "While borrowers might like a near-zero rate, there is little incentive for lenders to extend credit at that rate. ... lenders supply less credit at the lower rate. The decline in credit availability reduces aggregate demand, which tends to increase unemployment, a classic unintended consequence of the policy."

In other words, while everyone, including the Fed, thinks that ultra low interest rates provide an important source of stimulus to the economy, it's quite likely that they do just the opposite. The Law of Unintended Consequences strikes yet again!

Taylor had a somewhat-related blog post the other day in which he discusses the "strong inverse relationship between fixed investment and the unemployment rate." He accompanied the post with a chart that got my attention, because I saw a way to improve it.

 

The above chart uses the same data as Taylor's original chart, but includes data going back to 1960 (his only went back to 1990). The interpretation of the chart remains the same. There is a strong inverse relationship between fixed investment as a share of GDP (fixed investment includes private residential and nonresidential construction, and private investment in equipment and software) and the unemployment rate, which is a good proxy for the health of the economy. He is careful to note that while the correlation is strong, we cannot infer the direction of causality. But this does illustrate how a lack of investment could go a long way to explaining why the recovery has been so weak. 

It then occurred to me to put his two ideas together, to see if the Fed's monetary policy was correlated with the amount of fixed investment. Where Taylor's WSJ article focuses on how artificially low interest rates limit lending and therefore aggregate demand, and his chart compares fixed investment to the unemployment rate, I wanted to see if there was a link between Fed policy and fixed investment.

As the chart above shows, Fed policy is indeed highly correlated to fixed investment (even more so than the unemployment rate is). This fits hand and glove with the first chart, which links fixed investment to the unemployment rate. The red line in the above chart is the real Federal funds rate (using the Core PCE deflator), since that is a good proxy for the degree to which monetary policy is "tight" or "easy."

This puts some meat on the bones of Taylor's WSJ article. The Fed's unusually accommodative monetary policy stance, which promises extremely low interest rates (negative in real terms) for a long time to come, does appear to be a factor in limiting the amount of funds available for investment, and in reducing aggregate demand, and that in turn helps to explain why the recovery has been so weak.

How else to explain the fact that fixed investment is almost always very strong when monetary policy is very tight, and weak when monetary policy is easy? How else to explain how a decade of extremely low interest rates have failed to stimulate Japan's economy?

Food for thought and controversy...

Housing price update

The housing market is really heating up, with many areas of the country reporting rising prices and even bidding wars. Mark Perry has lots of details here and here. I offer some charts to complement his:

Based on the chart above, it looks like the best that can be said for housing prices is that they have been relatively flat over the past four years.

But as this chart shows, housing prices as measured by the Radar Logic folks (quite similar to the CoreLogic data Mark uses) are up over 10% in the past year. We haven't seen anything like this for a very over six years.

To better appreciate what is going on, I offer the above chart, which compares the Radar Logic price index in 2011 (orange) to the index in 2012 (white). Instead of following their normal seasonal pattern (in which prices tend to fall from summer through winter), prices last year didn't fall at all. On a seasonally adjusted basis, therefore, prices are up significantly. This is a very important change on the margin.

One of the key characteristics of today's housing market is a shortage of homes for sale. As this chart shows, the inventory of homes for sale is about as low as it's ever been. Presumably, the recent strong price action will convince banks and homeowners who were reluctant to sell at depressed prices to put their properties on the market in the coming months, which are traditionally the strongest for housing sales. If they don't, prices could rise even more.

The message of TIPS: slower growth, more inflation

Opinion polls and gauges of investor sentiment have their limitations, because they can only sample a fraction of the people making real decisions. Market prices, on the other hand, reflect the best judgment of everyone who cares. In the case of TIPS and Treasuries, there are many millions of individuals and investors around the world who care very deeply about their prices. Indeed, it could be argued that the owners of many tens of trillions of dollars of securities around the world care deeply about the prices of TIPS and Treasuries, because the vast majority of the world's bonds are priced off of the Treasury curve. Since growth and inflation are the two most important drivers of TIPS and Treasury yields, it's reasonable to think that their pricing can accurately reveal the market's assumptions about the future of economic growth and inflation.

The charts that follow illustrate a few ways to interpret the message of TIPS and Treasuries.

Comparing the real yield on TIPS to the nominal yield on Treasuries of comparable maturity reveals the market's inflation expectations. The above chart shows the nominal yield on 5-yr Treasuries (red), the real yield on 5-yr TIPS (blue), and the difference between them (green), which is the market's implied or expected annual inflation rate over the next 5 years. Note that over the past several months, nominal yields have turned up a bit, and real yields have continued to decline. Thus, the expected inflation rate has increased of late. Why? Demand for TIPS has increased (thus pushing their real yield lower), at the expense of Treasuries, because investors increasingly fear higher inflation. TIPS benefit from higher inflation because their nominal yield rises as inflation rises, but Treasuries, of course, suffer from higher inflation because their inflation-adjusted yield declines.

If we look at the long-term picture, nominal and real yields have tended to move together, and expected inflation hasn't changed much on average over the past 15 years. Currently, though, it is near the high end of its range. In other words, while inflation expectations have increased on the margin in recent months, they are not excessively high. But consider this: since inflation currently is running in the range of 1.5-2%, and it is expected to average 2.5% over the next five years, that implies that the market believes that inflation will accelerate meaningfully in the next several years, possibly reaching 3 or 4% at some point.

The level of real yields on TIPS reveals a lot about the market's expectations for real economic growth. The chart above compares the real yield on 5-yr TIPS with the 2-yr annualized real growth of GDP. Although the correlation between these two is not very tight, we do see that real TIPS yields have declined as the pace of economic growth has slowed. The chart suggests that the current level of TIPS yields is consistent with expectations for real growth of 0-1% over the next few years. In other words, the very low level of real yields on TIPS is telling us that the market is very pessimistic about the prospects for economic growth in coming years.

It also makes sense that real yields on TIPS should be in the same neighborhood as real economic growth, because there is a fundamental arbitrage between the two. Strong real growth should feed through to strong returns on equities, and weak economic growth should feed through to weak returns on equities. I note that both Treasuries and equities are priced to relatively weak growth expectations: the PE ratio on the S&P 500 is currently about 15, which is below average, despite the fact that corporate earnings are at record highs. The bond and equity markets are in synch on the question of expected growth. I've written more on this subject here.

But aren't Treasury yields being manipulated by the Fed, and doesn't this distort the message of TIPS?

I don't believe so. The Fed currently owns about $1.7 trillion of Treasuries, and that is only 15% of the Treasuries held by the public. Furthermore, only $76 billion of that amount (4.5%) are TIPS. TIPS and Treasuries owned by the Fed represent a very small fraction of total TIPS and total Treasuries, not nearly enough to allow Fed purchases to distort their prices.

The chart above compares the nominal yield on 5-yr Treasuries (red) with the year over year increase in the Core CPI. The correlation between the two was fairly tight during most of the period shown in the chart, and that correlation tends to hold over longer periods as well.

Beginning in early 2011, however, the two began an important divergence: Treasury yields fell but inflation rose. This divergence had very little to do with the Fed's Quantitative Easing program, despite what many may say to the contrary. The Fed started buying Treasuries in the third quarter of 2010 and stopped at the end of June 2011, and Treasury yields barely budged on net for the period. From mid-2011 until just a few months ago, the Fed was not buying any Treasuries on net, and yields were roughly unchanged.

5-yr Treasury yields are essentially the market's estimate of what the average return on overnight interest rates (e.g., the Fed funds rate) will be over the next five years. If the market believes that the economy will be very weak for at least the next several years, then the market also believes that the Fed will, as promised, keep short-term interest rates very low for a long time. The Fed can't manipulate 5- or even 10-yr Treasury yields, but it can influence the market's expectations, provided the market believes that the Fed's announced intentions are reasonable given the outlook for growth. In short, both Treasury and TIPS yields are very low today—despite being unusually low relative to inflation—because the market is convinced that the prospects for U.S. economic growth are dismal, and the market is willing to pay a very high price (in the form of very low yields) for the safety of Treasuries.

To sum up, the message of TIPS and Treasuries is that the market expects very weak growth in the next few years, along with rising inflation. This is significant, because it runs directly counter to the traditional Keynesian/Phillips Curve way of thinking, which holds that very weak growth—especially when growth is substantially below potential growth as it is today—should produce a decline in inflation. The bond market has cast aside its Keynesian predilections. And everyone by now should have lost faith in the Keynesian theory that holds that big increases in government spending, financed with deficit spending, are stimulative, and in the Keynesian theory that holds that the Fed has the ability to stimulate growth by keeping real interest rates low. The past four years have been a valuable lesson in why this is all nonsense. Government bureaucrats who think they can pull levers and micro-manage growth and inflation are fooling themselves and doing us all a disservice.

This is good news. Ultimately, markets figure things out. Now we just have to get the message to the politicians.

Note to readers: this analysis is meant to reveal what the market's expectations are for growth and inflation. This is not my view of what is going to happen. I continue to believe that the economy will manage to do better than expectations, even if it only results in disappointingly slow growth of 2-3%. And even though inflation has not picked up as I thought it would, I continue to worry that it will pick up, and significantly so. That doesn't translate into a recommendation to buy TIPS or gold, however, since they are very expensive inflation hedges at this point. I think equities and real estate are the better choice, since they are still attractively priced and ought to benefit from stronger-than-expected growth and higher-than-expected inflation.