Tuesday, December 14, 2010

What the FOMC statement didn't say

Today's FOMC statement was unsurprising, and the decision to leave policy unchanged was as expected. The statement reiterated the view that the economy was growing at a disappointing rate, and that "measures of underlying inflation have continued to trend downward."

But the most important part of the statement was what wasn't said. Nowhere was there any mention of the fact that 10-yr Treasury yields have jumped over 100 bps in the past two months (see above chart), while 80% of that rise is due to an increase in the real yield on 10-yr TIPS—a sign that the rise in yields is mostly due to an increase in real growth expectations. Plus, there was not a single reference to the stock market, which is now up almost 12% year to date, and up almost 20% since the Fed first floated the idea of QE2 (see chart below of the S&P 500). The rise in bond yields and the rise in equity prices are classic indicators of a big increase in the market's expectation for future growth. Why couldn't the Fed at least acknowledge this?

Another glaring omission was the failure to mention the fact that the dollar is very weak from an historical and inflation-adjusted perspective (see chart below). The dollar's historical weakness is reflected, not surprisingly, in gold prices which are now at historical highs. A very weak dollar is almost proof-positive that there is an over-supply of dollars in the world. And we still need more quantitative easing?

If the Fed persists in ignoring the market's signals, they will end up making another mistake. It's very unfortunate, since past mistakes (e.g., tightening too much in the late 1990s, then easing too much in the early 2000s) have given us a roller-coaster stock market, huge gyrations in interest rates, and a massive housing boom and bust. Monetary mistakes coupled with fiscal policy mistakes (e.g., last year's $1 trillion of "stimulus" that turned out not to be stimulative at all) have been the bane of the U.S. economy for over a decade now, and it's high time our policymakers learned how to pay attention to the market and how to understand what makes the economy tick.

I'm amazed that the FOMC has managed to ignore the market-based indicators for so long. But I find it hard to believe that this state of affairs can continue for much longer. The bond market vigilantes have only just begun to raise the alarm, and sooner or later the Fed will be forced to take note. The Tea Partiers have already beat our politicians over the head, and that's begun to bring positive change to Washington. Despite the miserable state of affairs, there is still room for optimism.


brodero said...

Ron Paul's desire to abolish the Fed
would guarantee an depression for this country...

Benjamin Cole said...

Jeez, Ron Paul, a crank-kook when it comes to the Fed, will be heading House oversight of the Fed. Paul believes the Fed is behind secret plots far and wide, such as funding Saddam Hussien.

Paul could be very unsettling for markets, should the R-Party capture the Senate or White House. It may lead to politicization of the Fed.

The abolition of the Fed, a Paul goal, seems contrary to what every other advanced nation has done, which has been to establish central banks.

I keep thinking there has to be another party in the United States I can vote for.

We seem to be going from bad to worse to outright cranks and frauds.

As to QE2--well, everytime the economy or Dow or bond market sneezes or rallies, some say, "QE2 did it."

I don't know. But if QE2 caused a 20 percent gain in the Dow, I say pour it on, baby, pour it on, tip the whole barrel over, and bring up the heavy stuff from the basement.

Public Library said...

I am 100% for the abolition of the Fed. If we have a metal standard, what use is a Federal Reserve for printing certificates?

We could redeploy their efforts into private sector good. You can't print your way to prosperity and there is ZERO proof the money supply needs to grow with economic activity.

And there is zero proof an economy cannot grow with decreasing prices. The US economy succeeded mightily in the 1800's while prices were declining.

The Federal Reserve stands for the centralization of power to the benefit of banks/governments and at the expense of the people.

Sooner we wake the more quickly we can retool ourselves to succeed.

Benjamin Cole said...

Public Library:

I will say it again: The Nipponistas represent the worst threat to America today, next to which the Taliban becomes microscopic.

Go to Japan and reflect upon the merits of deflation. Some say an entire generation of young people is growing without hopes of raising families, so cruddy is the outlook.

Asset values just keep going down. The population is shrinking, while property and equity values are down 75 percent in 20 years.

They are being eclipsed by South Korea, China, even Thailand in some regards.

That's the future for America is the Nipponistas or Ron Paul ever get in control.

Jamie BuchersGhost said...

Fairly new reader to your blog, although i've visted in the past. I'm wondering if you could speak a bit about the "while 80% of that rise is due to an increase in the real yield on 10-yr TIPS".
I'm asking from an perspective of trying to educate myself, not challenge you to defend. Was hoping you could elaborate on this comment a bit.
Is this a historical correlation, that your referencing?

Much thanks in advance, you do great work.

Scott Grannis said...

Re the increase in yields: What I am trying to say is that while 10-yr Treasury yields have risen by 100 bps (one percentage point), 10-yr TIPS real yields have risen by 80 bps (0.8 percentage points). So 80% of the increase in nominal yields was due to an increase in real yields, and only 20% was due to an increase in inflation expectations (which in turn are defined as the difference between nominal and real yields).

Scott Grannis said...

Further to my previous: the increase in real yields is generally interpreted to represent an increase in the market's expectations for real economic growth.

brodero said...

Pub Library...you abolish the FED
you return to the 1880's or 1890"s
read about the Panic of 1893 and that is the world you will have. Ron Paul doesn't care... he is an OB/GYN...he can still deliver babies in a depression....

Frozen in the North said...

Public Library:

Using the 19th century as proof that the American economy can operate with the gold standard is ridiculous. Secondly, see how the Japanese are enjoying continued falling prices.

Odds are that if its not working for them, its not going to be great for us.

Frozen in the North said...
This comment has been removed by the author.
Frozen in the North said...

Your argument on the rise in yield is persuasive, it suggest that bond holders perceived additional strength to the global economy. The rise may have little or nothing to do with the U.S. situation (beyond selling the news of QE2). If contraction is averted in America, it can only be good for those who "feed the beast", therefore its a reflection of greater risk appetite, moving away from T-Bills, and as the FT pointed out this morning:

"Now this fall seems sure to reverse, as emerging countries build up their economies. Moreover, global desired savings are also likely to fall, as ageing bites and consumption soars in big emerging countries. The effect will be to drive up demand for savings relative to supply and so raise the real rate of interest."

Public Library said...

Since when in the history of mankind did the efficient market need a cartel to monopolize paper printing and abolish the free market for making coins?

I didn't realize what sheep we have here.

David Cook said...


Thank you for the informative blog! I'd like to point out that I feel the FOMC actually wants some inflation here. This is not something they can readily admit from a political standpoint -- however, there are a number of benefits to large banks:

a period of inflation would reduce, in real dollars, the value of underperforming loans.

it would also raise property values, eventually, helping to reduce the quantity of real estate they would have to take on

and of course the Federal Govt would like to to pay back some of the current debt with inflated dollars.

I 100% agree with your analysis that the market is signaling the potential for inflation and growth. However, just like the housing bubble situation, I also feel the FOMC is fully aware of this and wants it to happen.

Benjamin Cole said...

Milton Friedman contended that increases in the money supply would not lead to inflation if there is slack in the economy. Friedman said first you get boosts in output, then you get inflation after you max out.

We have slack.

Ergo, boosting money supply now will not lead to inflation, but we can hope will lead to growth.

Unknown said...


What other prerequisites do you see for a stock market rally, any indicators, thoughts?
I could mention a potential flow shift from bond mkt to equities, take a look on last first time in this cycle redemptions in muni bonds in US (ca 3 bn USD). Last month bonds funds return was negative, so after a quarter or two people will start to rethink their investments.

Next negative issue on gov bonds is that in Europe due to a new rules of lending to weak countries by ECB, only bonds bought by ECB are senior ones, the rest of bondholders is at risk.

Scott Grannis said...

David: It's certainly true that the Fed wants more inflation than we currently have--they have made that clear. I suppose the issue you raise depends on what your definition of "more" is. If it is substantially more, as you seem to think, then that does solve a lot of problems, as you suggest, but that in turn has a long-term cost in the form of lower real output and the recession that is sure to follow a period of "too much" inflation. I would like to think the Fed doesn't want as much inflation as you suggest, but I worry that they are likely to get it because they are going to be slow to react.