Wednesday, January 13, 2010

Why zero rates are not driving the equity rally

I've been asserting for some time now that the equity market rally has nothing to do with the Fed's zero interest rate policy or with fiscal stimulus. Indeed, I think the rally continues despite the Fed's too-easy monetary policy and despite the terribly misguided fiscal stimulus policies coming out of Washington. Those are some mighty controversial assertions, given that there appears to be a multitude of observers who assert just the opposite—that the rally is a bubble, that the economy's strength is ephemeral, that the recovery is unsustainable, and that things are simply so bad that they can never get put right. For more than a year I've pointed out my rationale for, and the evidence of, a genuine recovery developing, but it can't hurt to put it all down in one place, and it might convince some of the skeptics.

But before I begin, let me say that the Fed's quantitative easing/zero interest rate policy was likely instrumental in averting a financial meltdown a year ago, and so the policy should get credit for setting the stage for recovery. Without a functioning banking system, a recovery probably would have been impossible. To be sure, the banking system is still not back to "normal" and many small businesses are having difficulty accessing credit. But that doesn't make a recovery impossible, nor does it ensure the demise of the current recovery; it only slows things down.

This recession turned into a profound recession right after the failure of Lehman Brothers in September '08. A worldwide panic ensued, in which the demand for money and risk-free assets rose astronomically and spending collapsed. If the Fed had not responded with an equally astronomical injection of bank reserves to the system, the financial panic would not only have led to a steep recession, but also to what would likely have been a painful deflation. The Fed did the right thing, but it took them awhile to figure it out. (The need for quantitative easing has long since passed, I think, but that is the subject of a separate debate.)

What follows is a recap of why I think the rally is genuine and not just the result of fiscal or monetary stimulus:

Printing money can never create growth. The only way an economy can grow at a rate faster than its population growth is if it can utilize existing resources in a more productive fashion; it it can produce more from a given amount of labor, capital, and resources. Gains in productivity, in turn, only result from great effort: from investment, from risk-taking, from saving, and from working harder and smarter. In an inflationary environment brought on by easy money, people tend to favor speculative activities (e.g. investments that pay off if prices rise, such as commodity speculation and real estate purchases) over productive activities (e.g., new plant and equipment, worker training, computers, infrastructure). In the extreme—something I learned from the years I lived and worked in Argentina in the late 1970s—an inflationary environment makes planning and productive investment virtually impossible. Everything becomes reduced to price speculation and survival. Look at the record of any country that has experienced high and rising inflation and you will find very little, if any, real growth. Alas, generations of Fed governors have failed to learn this lesson, and Mr. Bernanke in particular continues to believe that the Fed can fine-tune economic growth by raising and lowering the Federal funds rate.

Monetary policy that is too accommodative can actually be anti-growth. When monetary policy over-supplies money to an economy, the result is not growth but rising prices. Monetary policy that is too easy creates great uncertainty: how far will the currency fall? how much will prices rise? what is the end game? how high will interest rates have to go to stop the inflation? how bad will the next recession be? Already we see these questions being asked by fearful investors. Uncertainty is an investment killer, and if you shut down investment you all but guarantee that future growth will be disappointing.
Zero interest rates do not stimulate an economy, but they are symptomatic of great fears that the economy is in trouble. The main reason the Fed has kept short-term rates at zero for more than a year is that it is terribly afraid that the economy is weak and vulnerable. The Fed's insistence on this tenuous outlook has convinced the bond market to feel the same way, and that is evident in the fact that credit spreads are still historically wide, expectations of rate hikes over the next two years are still very modest, and the dollar is still very weak. Investors' demand for safe assets like T-bills and money market funds would not be as strong as it is today if zero rates had convinced everyone that a durable recovery was underway. Money velocity is still very low compared to where it was prior to the recession, which means that the demand for money is still very high—and again, that is symptomatic of great fears about the durability of the recovery.

Keynesian fiscal stimulus is almost always counterproductive. This is a corollary to some of the above points about monetary policy. If more government spending produced a stronger and more productive economy, then socialism and communism would be the dominant form of economic organization in the world. Instead we see that the most dynamic economies are those that have the most freedom and the smallest government presence. China might be a major exception, except for the fact that its double-digit growth is arguably the result of moving from a very socialist economy to a quasi-free market economy. From my supply-side perspective, fiscal stimulus of the spending variety (such as we have now) is an obvious anti-growth factor, since it creates immediate expectations of higher future tax burdens, and that in turn dampens the urge to invest and take risk. It's highly likely that the outlook for growth in the number of small businesses—the major source of new jobs in our economy—is dismal right now because people are fearful of how much their tax burdens are going to rise. Every day we hear about some new proposal to "tax the rich" to pay for all the new spending and healthcare initiatives.

There have been many signs of improvement in the economy for a long time. I've been highlighting a long and growing list of "green shoots" and "V-signs" since November 2008, well before the fiscal and monetary stimulus had a chance to work. The earliest signs of recovery were a significant narrowing of swap spreads in Nov. '08, followed by a narrowing of credit spreads in Dec. '08 and Mar. '09. In April '09 we saw a big jump in copper prices, and I reiterated my call for the recession to end by mid-year. In May '09 we saw rising commodity prices, rising emerging market equities, rising shipping rates, falling weekly unemployment claims, and higher Japanese industrial production. In June '09 we saw a big jump in the ISM manufacturing index. In July we saw the beginnings of declining spreads for ABS and CMBX securities, impressive gains in industrial metals prices, and a big decline in corporate layoff announcements. It was also clear by then that currency and M2 growth had slowed, signaling a rebound in money velocity that would propel spending. The list goes on, and you can find everything in my prior posts.

I think it is also extremely important to acknowledge the role of public policy in the equity market rally. In the first few months of last year, the market was struck dumb by the realization that Obama's agenda consisted of a rapid and massive expansion of government spending and control over the economy (e.g., fiscal "pump-priming", income redistribution, cap and trade, nationalization of healthcare, banks and auto companies, stronger and more pervasive unions). As soon as this agenda began meeting serious pushback in early March, the equity market began to recover. Since then, the prospects for a rollback of expansive government and a major shift in political power as a result of the Nov. '10 elections have combined to infuse the market with a measure of optimism, where before there was only doom and gloom.

In sum, although zero interest rates played an important role in ending the recession, they have not been the driving force of the recovery which started some six months ago. This recovery is being driven by the activities that drive all recoveries: people adjust to new circumstances, with an innate desire to avoid poverty and seek prosperity; prices adjust until markets clear; workers shift from declining to rising sectors of the economy; people work harder; companies tighten their belts and restructure; confidence recovers; risk-taking resumes. I think these changes are well underway, and the equity market is keenly aware of this. Thus the equity rally is based on solid fundamentals.

To think that politicians or Fed governors can wave a magic wand and turn a recession into a recovery is just silly. Recoveries are made the old-fashioned way: with lots of hard work. This hard work is already paying off, and the results are not going to vanish the day the Fed abandons its zero-interest rate policy. The sooner the Fed raises rates, the better in my book.


Unknown said...

clap, clap! couldn´t agree more! I wonder why those incredible thoughts, aren´t in any of my economics books. The same arguments could be used to show why a "W" is incredibly unlikely.

I keep asking myself why politicians and people in general don´t learn: they think that taxing banks, will not spillover to taxpayers? incredibly naive or simply populist...

Bret said...

"Monetary policy that is too easy creates great uncertainty..."

I completely agree with everything you wrote with the possible exception of the above statement.

I think that the easiness of the money policy is less the cause of great uncertainty than the uncertainty of the money policy coupled with being in uncharted territory.

For example, if monetary policy was set to have 10% inflation per year forever and we'd had 10% inflation for the last few decades, there would not be great uncertainty due to monetary policy.

Scott Grannis said...

Bret: that's a good point. But what you are saying effectively is that predictable monetary policy, whether it delivers 1% inflation or 10% inflation, is not as bad as not knowing at all how much inflation we are going to have. Today the forecasts of inflation range from deflation to hyperinflation. That's a big range of error, and a source of great uncertainty and risk for the markets.

Bret said...

I completely agree.

nodice said...

fantastic post! Your blog is so refreshing. The chronic skepticim out there is sickening. It's like people are actually cheering for the economy to tank. I suppose it's sour grapes for getting burned by the market both on the way down and up.

septizoniom said...

thank you for this elaboration. of course we will never know what would have happened with the counterfactual.

Public Library said...

The Fed and its policies are the source of our ills. Exactly as you suggest, their deep rooted belief in "fine-tuning" is what drives us from boom to bust.

The equity rally may not be driven by zero rates, but the longer the Fed keeps its pedal to the medal, the more likely we will see another problem crop up soon.

We are in a current state of transition. Future Fed policies will undoubtedly deliver us into another predicament.

If only because of the sheer scale of their new found operations.

Having said that, it has never been easier for a bank to make money off the short/long spread on rates.

This in turn drives bankers bottom-lines. Surely as the easy cash flows in, the equity prices will rise quite handsomely.

Whether its driving or not, its surely contributing and again as you suggest, will become a problem if not reigned in.

dave said...

Scott -- your blog is always excellent, but this post really goes above and beyond. This post should be required reading. We linked to it in our latest post on the Taylor Frigon Advisor []


ronrasch said...

Thank you for summing it up Scott and the recap of the work that makes this the best economic blog on the net.