Wednesday, November 2, 2011

Fed on hold, and that's good

The FOMC met for two days this week and decided that no changes in policy were necessary. That's a relief, because it's hard to see how being more accommodative than they already are could make any difference.

Today's problems (e.g., Greek intransigence, bloated governments, oppressive regulatory burdens, threats of higher tax burdens, threats of trade wars, oversize debt burdens, threats of Eurozone bank failures, slow growth, high unemployment) have nothing to do with a scarcity of dollars or interest rates that are too high. It's all about fiscal policies in the majority of developed economies that have relied for too long on the Keynesian notion that borrowing money from Peter and giving it to Paul can stimulate an economy, and its close corollary, that governments can direct the course of economic activity to everyone's benefit. The best thing that can be said about this brand of Keynesianism is that it is rapidly headed for the dustbin of history. Good riddance!

All the shouting these days is coming from the recipients of government largess fighting to resist the inevitable cutbacks in their handouts and subsidies. It's going to be a long, drawn-out process that could last for years, but the important thing is that it is underway, finally.

A review of the monetary evidence supports my claim that monetary policy is plenty accommodative already, and that therefore the economy is not being held back in the slightest by a scarcity of dollars or interest rates that are too high.

Relative to other currencies, the dollar is trading at very weak levels, both nominally (top chart) and in inflation-adjusted terms (bottom chart above). If dollars were scarce relative to other currencies, it would be much stronger. Given how weak it is, we can safely assume that dollars are in relatively abundant supply relative to the supply of other currencies.

In absolute terms, the M2 measure of money supply (my favorite) has grown significantly in recent years, and is well above its long-term trend (top chart). M2 has grown relatively rapidly despite the huge slowdown in real and nominal GDP growth. As the bottom chart shows, M2 has grown by leaps and bounds relative to the economy, reflecting a huge increase in the world's demand for dollar liquidity. The Fed's efforts to be accommodative have more than met the public's demand for money, and that can also be seen in the fact that Excess Reserves today are approximately $1.5 trillion.

The Fed funds rate has been essentially zero for almost three years now, and in real terms, using the PCE Core deflator (the Fed's preferred measure of inflation, and one that is almost certainly not overstating inflation, being up only 1.7% in the past year), the real funds rate is -1.4% (top chart). That is about as low as it has ever been (it was only briefly lower in 1974). In real terms, 10-yr Treasury yields are also very low, at -1.9% (bottom chart), although they were lower in the inflationary 1970s. Low real yields have almost always occurred at times when monetary policy was accommodative and inflation was relatively high.

Gold and commodity prices have soared since 2002, which was the year that the Fed began lowering the funds rate from 6.5% to eventually zero. High real and nominal rates make it difficult to own commodities (because of the opportunity cost of tying up money in inventory, and because taking speculative positions in futures incur a high cost), but cheap money makes it much easier and more attractive. The tremendous rise in gold and commodity prices in the past 10 years is strong prima facie evidence that monetary policy has been very accommodative and continues to be.

Measured by the difference between 30-yr and 2-yr Treasury yields, the yield curve is still unusually steep. This is typical of the early years of a business cycle expansion, when the Fed reverses course from the tight money policies which contributed to the previous recession. Flat curves are a classic sign of tight money, but that is manifestly not the case today. Today's steep curve reflect's the market's strong belief that interest rates cannot stay at zero forever, and will have to rise in the future.

Comparing the nominal yield on Treasuries with the real yield on their TIPS counterpart is a reliable way of measuring the market's implicit inflation expectations. As the top chart shows, the market's 5-yr, 5-yr forward inflation expectations are about 2.25% today. The second chart shows that the market expects the CPI to average 2.1% over the next 10 years. Neither measure of expected inflation is particularly high, considering that CPI inflation has averaged 2.3% over the past 5 years, and 2.5% over the past 10 years. But they are both an order of magnitude higher than they were at the end of 2008, and that's key. With the benefit of hindsight, we now know that even though the Fed had launched its first quantitative easing program in late Sept. '08, there was still a severe shortage of dollar liquidity at the end of the year when everyone wanted safe-haven dollar cash. Late 2008 will go down in history as a classic example of a liquidity shortage that was so severe that even the Fed's extraordinary and unprecedented efforts to expand bank reserves were insufficient. Fortunately the shortage was resolved shortly after, and a recovery followed by mid-2009.

All of the charts above are based on sensitive, real-time market prices. No seasonal adjustments, no lags, no room for bias. The message of every one is the same: there is no sign of any shortage of dollar liquidity, nor any sign that interest rates are so high that they are depressing economic activity. Instead, there are abundant signs that monetary policy is very accommodative. Therefore there is no reason for the Fed to do more than it already has. If anything needs fixing, it's fiscal policy, and Greece is the poster boy for that claim.


McKibbinUSA said...

Once again, the Fed is taking its "...growth is down, employment is down, but inflation is in near zero single-digit levels..." approach to monetary policy -- once again, I am arguing that those who are waiting for the Fed to fix the US economy are delusional -- however, the Fed will not be able to stop the defaults unfolding before our eyes along the southern flank of Europe followed by California -- the question we should all be analyzing is how to exploit a global default scenario...

Benjamin Cole said...

Strong wrap-up by Scott Grannis.

Still, Milton Friedman would say that Grannis is making a cardinal error: conflating low interest rates with "easy" money.

Interest rates have been at zero in Japan for 20 years. Yet the yen has soared against other currencies. Obviously, money is very, very tight in Japan---enough to suffocate their economy, and kill investors: Stocks and real estate down 80 percent since 1990.

Money is not easy today in the USA. We hit zero bound, or close enough. To be easy today, we need to go to negative 2 percent or so, according to some.

Since we cannot go to negative 2 percent, we should apply alternatives, such as sustained QE and lower IOR for banks.

I concur that federal deficit spending is a bad idea, and that defense, rural subsidies, and entitlements need to be cut back.

Anonymous said...

Hi Scott,

I have read your blog for a while and I have found it very useful and enjoyable. I have traded equities and fixed income for a while and have an Economics degree from a Tier 1 school.

I am very curious what you think about Modern Monetary Theory/Chartalism.

Specifically that "sovereign currency issuers" with floating exchange rates can never run out of money, and do not have to borrow money before they can spend it.

Their only currency creation constraint is inflation.

And that Greece in the position it is in becuase it is a "currency user" and must borrow money before it can spend.

And that the U.S. has not had to actually borrow money since we went off the Gold Standard.

Very interested in your thoughts.

And BTW I agree with many of your viewpoints.

Thank you for the blog and keep up the great work.