Wednesday, June 23, 2010

Fed remains in reactive mode, which is not helpful

Today's FOMC statement made no contribution to the market's understanding of the economy or the future course of Fed policy. The Fed knows just about as much as the market about what's going on—the U.S. economy is probably still growing, but there is the risk that the Euro debt crisis could be contagious. From a longer term perspective, the Fed is managing policy by looking in the rearview mirror, trying to nurse a sick economy (sick because it is almost 10% below trend growth) back to health with cheap money. Fed policy remains about as easy as it has ever been, as this chart suggests.

Fed governors, with the exception of Kansas Fed President Hoenig, have no interest in the message being sent by strong commodity prices, soaring gold prices, and the generally weak level of the dollar—namely, that money is in abundant supply and there is almost no chance that Fed policy is posing any problems for the economy. If anything, ongoing monetary accommodation may be fueling unrest among investors who worry about how the Fed's addition of $1 trillion to bank reserves will be unwound and what problems that may create in the interim (e.g., rising inflation, asset price bubbles).

Investors also worry about fiscal policy, which has been incredibly "stimulative" according to the Keynesian framework. Very easy money plus very stimulative fiscal policy for the past 18 months and we only have a modest recovery that is at risk of a Greek debt default? Yikes, maybe the economy is hanging by a thread...

A better way to understand things is from a supply-side/monetarist/classical economic perspective. Easy money can't create growth, it can only create inflation. Deficit-fueled spending also can't create growth, especially when, as now, it consists mostly of transfer payments that simply redistribute wealth in a way that weakens incentives to work and invest. Huge deficits and huge new government spending programs (e.g., Obamacare) further weaken investor confidence since they hold the threat of a major increase in future tax burdens. A lack of investor confidence in the future stability and strength of the dollar and the future level of tax rates and tax burdens equates to uncertainty, and uncertainty is bad for investment. If investment is weak, then economic growth is hard to come by. It takes hard work and risk-taking to create new companies and new jobs.

So the more the Fed tries to pump up growth with low interest rates, and the more Congress tries to pump up growth with new spending schemes, the worse it is for the economy. There is a dreadful lack of understanding of the basic principles of economics in Washington, especially among the Obama administration and members of the Democratic Party.

I believe that the market has been worried for a long time about the course of fiscal and monetary policy. Investors and risk-takers understand how things work much better than most politicians do. There are abundant signs of just how concerned the market is, from zero interest rates on cash to 3% interest rates on 10-yr Treasury bonds, and from above-average credit spreads to historically high implied volatility and $1200 gold prices. Morever, equity valuations have severely lagged the growth in corporate profits.

In this view of the world, the market advance to date has largely occurred despite the bad news from Washington, the Fed, and the Greeks, and the economy is recovering despite all the headwinds, thanks to the inherent dynamism of the U.S. economy and a free people's innate desire to improve their lot in life by working harder and finding ways to do things more efficiently. It's not a huge recovery or even a typical recovery, given the depth of the recent recession, but it is a recovery and it is likely to continue.

The one bright spot on the horizon, and something that could make a huge difference to the economy and the markets, is the upcoming November elections. It is the hope—and the increasing likelihood—that these elections could yield a significant rightward shift in fiscal policy that is sustaining what little optimism can be found. I think it's hard to underestimate the importance of this, because all the signs on the margin point to a sea-change in the public's attitude toward fiscal and monetary policy. When and if this change translates into an improved policy outlook, we could see an explosion of optimism, and that would be a very good thing indeed.


septizoniom said...

excellent post.

Benjamin Cole said...

Jeez, MZM is down from a year ago, and unit labor costs are sinking not rising, and property in all sectors--retail, industrial, office, industrial--is under water. The Dow is below the Clinton days.

And the Fed is too loose? Shouldn't the nominal values of assets rise if there is too much money being loosed on the nation? Should wages go up?

Money is not loose. The newly prosperous Indians and Chinese are buying gold. The Greece default has shaken confidence in even sovereign debt--buying gold has become a fever.

Low interest rates reflect the outlook for very low inflation, and a glut of capital, and we will have low interest rates from here to eternity (well for five to 10 years).

Just today, the WSJ (C18) has a story on private-equity buyout fund managers who cannot find a home for $280 billion, so they may just have to return it to the investors. Investors have to put the money somewhere...meaning low, low interest rates.

Everywhere they are stories of real estate funds, hedge funds, banks in Thailand etc sitting on money they cannot deploy. Gluts of capital.

If the globe has high savings rates, that will mean lower interest rates, regardless of what the Fed does. If China buys US debt, then there is plenty of capital left over. No crowding out. Lower interest rates.

The Fed is being too tight, if anything. We need a round of inflation, especially in property, to help repay loans and inspire property development.

In Transition said...

Mr. Grannis,
I appreciate your posts. I am not well versed in economoics but I appreciate your explanations. Also, it is helpful that you give thoughtful and researched information which counteracts some of the reactionary info found in the general news. Keep up the good work - I am sure there are many you appreciate your posts but do not respond.

Jeff said...

I know you have said that the Bond market has missed recoveries/inflation in the past, but the level of the 10 year has only been hit once since 1963 (other than the crisis time of last year)...the bond market is clearly pointing to bad times ahead...tough to keep ignoring it.

Benjamin Cole said...

Look at your previous post. Is that graph consistent with tight money?

Scott Grannis said...

Benjamin: when did I ever say money was tight?

Scott Grannis said...

Jeff: the bond market is not all-seeing or prescient. Yields were very low in the early 1960s because 1) we were on a gold standard and inflation was 0-1% for many years, 2) the dollar was stable, and 3) economic growth was fairly steady. Confidence was high, inflation was low, the dollar was strong. Those conditions absolutely warrant very low interest rates. Today's rates, however, can only be justified if one is very concerned about growth, the dollar and the possibility of deflation. The bond market has been worrying terribly about the economy ever since late 2008, yet the economy has performed way better than expectations at the time. The bond market continues to worry, and will likely continue to worry, until the Fed gives the all-clear and raises rates.

Scott Grannis said...

In Tran: thank you!

Benjamin Cole said...

Sorry, I had it backwards, a senior moment. Does the Great Depression-like graph on new home sales suggest loose money?

Scott Grannis said...

The collapse of the housing market over the past several years has had the effect of greatly increasing the public's demand for money. (That is equivalent to the observation that deleveraging is a widespread phenomenon: reduced demand for debt and paying down existing debt means more demand for money.) This increased demand has undoubtedly absorbed a good deal of the Fed's increased supply of money. Thus, the housing market collapse has had the effect of sharply mitigating the degree to which Fed policy has been easy; i.e., they haven't been as easy as you would think, given the massive expansion of bank reserves.

The collapse wasn't directly caused by easy money, but easy money helped fuel the upsurge in housing prices which eventually ran out of gas. The decline of prices prodded the Fed to ease even more.

Charles said...

The real question about Fed policy is why people are content to hold cash at .25% rather than invest. The answer is that people who invest and create jobs are spooked by the Obama administration. They are willing to hold dollars rather than euros because they have even less confidence in Europe. The alternative to dollars at .25% is pricey equity, commodities, emerging markets and gold. There really isn't much to run to out of cash. When this changes, the fed will have to accommodate higher interest rates very quickly or we face stagflation.

Scott Grannis said...

Charles: Thanks for bringing that up. The persistence of extremely low yields on cash is another sign that demand for money is very high, and the public's willingness to venture into riskier activities is very low. This is a big problem that needs to be overcome somehow. One good way to do that would be to cut taxes on labor and capital, thus increasing the after tax return to engaging in risky or productive activity. Another way would be to change the course of public policy: reverse direction and reduce rather than increase regulatory burdens that make starting and running businesses very difficult and expensive.

John said...


I try hard to stay out of politics as I have family members who hold opinions that are different from mine. I also believe arguing politics rarely changes anyone's mind.

I think your answer to Charles above is spot on. Unfortunately I also do not believe there is a single member of the current administration that holds that view. The same applies to the current congressional majority.

I am further dismayed at the shutdown of drilling by this administration in the GOM. I do not know, but I have read there was not a single petroleum engineer on his advisory board.

Perhaps it is an indication of something big building when one as adverse to political discussion as I am to be ranting on an economics blog about my dissatisfaction with the current government. I distinctly remember the Jimmy Carter Presidency and even John F. Kennedy but I have never experienced a more anti growth, anti business government than the current one. I can't wait to go vote.

Scott Grannis said...

John: I agree, Obama is really exceptionally bad, and in a way that's good, because he has ruined the reputation of liberals (progressives) for at least a generation or two to come. The voting is already showing that the public realizes this. This is very big stuff.

Benjamin Cole said...

Fellas, I hope your dreams come true.

But consider--let's look at Rand Paul, Tea Party candidate for Senate in Kentucky. Kentucky is a state, a red state, that gets back $1.51 for every dollar they send to DC (latest figs from Tax Foundation, right-wingers). That amounts to more than $4,000 per capita in net--net---federal spending (spending in excess of receipts) for every resident in Kentucky.

And given the size of federal spending in last couple years, probably close to $5k net--net--for every resident of Kentucky today.

Kentucky floats on top of a pool of federal lard. Sheesh, a Kentucky family of four is subsidized to the tune of $20k. That how enfeebled our rural states and residents have become. They would simply blow away without constant infusions of federal lard.

Okay, so our hero (I am a free-marketeer) Rand Paul wins and gets to DC. He says he wants to balance the federal budget, and he starts to look for places to cut--problem is, cutting anything would strike a sword into his constituents, who have been subsidized by urban residents for generations.

A balanced budget would wipe out $5k in income for every Kentucky resident, more or less. Or, you could balance the budget by raising taxes even more on urban residents such as Scott Grannis, who lives in California, a state that subsidizes the nation.

The real ersult? Paul increases his rhetoric a notch or two, bashes a particularly wasteful federal program or two (never in our defense sector though), and wraps himelf in the flag.

He may even get re-elected, always battling against federal waste, Don Quixote-like. Some Senators have been "fighting federal waste" for decades.

No R-Party president has even proposed a balanced federal budget since Eisenhower (my fave president, BTW).

Some Presidents, such as Reagan and the Bushes, even floated out ideas such as "deficits don't matter." The Reagan hagiographers usually leave out David Stockman--a guy who really wanted to balance the budget.

Good luck with the R-Party balanced the federal budget. I predict it will not happen in my life--and it hasn't even been proposed in more than 50 years by the R-Party.

Why do you vote for a party that always runs red ink?

John said...


Either one stays home or holds his/her nose and votes for somebody. My frustration with this government has me wanting them out more so than anyone in particular being in. We will see who the Repubs nominate to oppose President Obama. They can still blow it.