Monday, October 18, 2010

Industrial production does not support the case for QE2

The September industrial production and capacity utilization releases came in a bit below expectations, but in the context of rising commodity prices and improving financial market health (e.g., very low swap spreads, generally declining credit spreads, declining implied volatility of equity and bond options) I consider this to be a blip and not the beginnings of a double-dip recession.

As the top chart shows, most major economies are experiencing a gradual recovery in industrial production, with a bit of weakness apparent in the summer months. Despite this weakness, U.S. industrial production over the past six months has risen at an annualized rate of 5%, and Eurozone industrial production is up at an impressive 9.6% pace over the same period. We've still got a ways to go before recovering to the peak levels of 2008, but we're making progress, and that's the most important thing.

I'm most interested in the second chart, since that gives some insight into the future course of monetary policy. As this chart suggests, monetary policy has a strong tendency to follow the health of the manufacturing sector, which in turn is a decent proxy for the health of the overall economy. When the economy weakens, the Fed almost always eases (by reducing the real Federal funds rate), and when the economy strengthens, the Fed tightens (by raising the real funds rate).

The 2008-2009 recession saw industrial production fall to extremely low levels, but that has been followed by a decent recovery. The Fed eased as much as it could in response, though they were limited by the so-called "zero bound." Regardless, the economy appears to have recovered enough, according to my reading of this chart, to obviate the need for further easing. If the Fed just kept policy on hold while the economy continued to gain ground, that would probably be sufficient stimulus.

One of the glaring flaws behind the supposed need for a second round of quantitative easing (QE2) is that there is no evidence at all that the economy is being held back by a lack of liquidity—the Fed can't fix something that's not broken. All measures of the money supply are growing at healthy rates and are at all-time high nominal levels; swap spreads are unusually low; credit spreads are in a declining trend; and equity prices are rising. Furthermore, there is little reason to think that a further (and likely quite modest) decline in Treasury yields or mortgage rates would provide significant stimulus to the economy. After all, mortgage rates are already at all-time lows, and housing affordability is better today than at almost any time in the past 30 years.

The great majority of the excess reserves that were added by QE1 are still sitting on deposit at the Fed. Increasing bank reserves by purchasing additional Treasury and/or MBS would likely only increase further the amount of idle reserves, while putting only modest downward pressure on interest rates. The more the Fed tries to stimulate via the purchases of bonds, the more the market will worry that monetary stimulus will lead to higher inflation, and that in turn will reduce the market's willingness to hold bonds. So the Fed can try to bring down interest rates further, but they are going to be fighting mounting headwinds that are working to drive interest rates higher.

If QE2 (or talk thereof) is good for anything, it is to throw lots of very cold water on deflation fears. With the dollar at extremely low levels, gold prices over $1300, and commodity prices setting new all-time highs, the likelihood of deflation is already de minimis in my view. But the market still worries (albeit less so every day) about deflation, and so does the Fed. Eliminating deflation fears would thus change the expected distribution of cash flow risk by effectively eliminating much of the downside risk, and that argues strongly for rising equity prices, since equity prices are the discounted present value of future cash flows. And by the same logic, eliminating deflation risk should lead to a gradual improvement in confidence and therefore a continued economic recovery.

In short, the Fed has probably done all it needs to do already.


Benjamin Cole said...


The core CPI is at 0.8 percent, and Boskin says that overstates the case.

Real estate is dead, depreciating. Investors do not expect inflation in real estate.

Stocks are where they were--in 1999. I know inflation can help and hurt stocks, but generally, equities are a hedge against inflation. We are into our 11th year of nowheresville on stocks.

Bonds yields are very low--bond investors do not thin inflation is a concern.

Unit labor costs are going down, not up.

Scott: J. Criickey Almighty, if you are worried about inflation now...what would have to happen for you not to be worried?

BTW, two economies have vigorous real growth, money growth and inflastion--China and India. That is where the demand for gold is coming from. It may make sense for a modest Indian to buy gold as an inflationary hedge--against the rupee. And for other traditional reasons.

Ergo, gold goes up, there are 2.5 billion Chinese and Indians, with expanding disposable incomes.

If bond investors, real estate buyers, and equities investors all think inflation is dead, then why is Scott Grannis worried about inflation?

John said...

"there is no evidence at all that the economy is being held back by a lack of liquidity—the Fed can't fix something that's not broken."

Now we're getting somwhere! The problem is lack of demand. Who wants to borrow to make something they can't sell?

Also, how come Europe with their long vacations and universl health care are kicking our butts in industrial growth?

GaRY said...

The Fed is trying to reflate the economy, but consumer spending isn't budging. Banks aren't lending partly because of the fear of serious inflation in the near future. Add on new banking regulations, high deficits, and the expectation of Republican gains in both houses.

The new money is flowing into stocks for now. A lower US dollar, but higher stock prices. This could go on through the winter and into April or May. If the new Congress can't fashion some compromises on regulation, spending, and taxes by then, stocks and the economy could tumble again.

Jeff said...

Scott, I was looking at a long-term chart of Dow/gold--specifically at the end of the 70's after Carter and inflation. The ration went to 1! But has been in low single digits several times.

Are we heading there again? Gold 11,000? Dow 1300? Both at 6,000?

Also, I'm still long Austrailian ST Bonds. Would love to buy more AUD is up 20% against USD since I bought last time. Can the dollar continue it's slide, or have we seen a bottoming...especially with the elections coming up?

My risk narrative is this: rates start to rise with economic activity. The fed/admin doesn't want that and takes continued action to keep low (QE, M supply, etc.). Inflation comes hurting stocks and dollar. Commodities continue to rise.

In other words, continuation of the same. But what is the next inflection point (if any) to make the currect trends change direction?

Your thoughts appreciated as always.

Jeff said...

Gold down $30 on China rate hike; dollar index up over a point. I have to this the inflection point??

Unknown said...

Don't you see prerequisite set up for the EM risk bubble.
FED is trying to force EM to absorb US production by reflating its economies. (last phase was US assets reflation)
Stronger EM crncy, reflating EM assets should boost demand for US goods.

Flow wise, bonds mkt is today biggger than equities were in TMT bubble, and there is, if I am right, 10 times more money parked in bonds than in equities.