Tuesday, April 17, 2012

Understanding the risks of Fed policy

Here's an updated version of a chart that I've followed for decades. What it tells me is that the Fed is in the process of repeating past errors, since they almost always react to developments in the economy rather than being proactive. In short, the Fed is way too easy today, and this portends higher inflation in the future.

Capacity utilization (blue line) is arguably a good proxy for the strength of the economy. The stronger the economy, the higher the utilization rate of factor capacity. (It's a flawed measure, I'll be quick to admit, since there is no way the Fed can actually measure the factory utilization rate—they have to make all sorts of assumptions and estimates to arrive at this number. But nevertheless it does seem to track the business cycle reasonably well.) Whatever the Fed might say about what guides monetary policy, the evidence suggests that the strength of the economy is an extremely important input.

The real Federal funds rate (red line) is arguably the best measure of how "easy" or "tight" monetary policy is. High real rates tend to increase the demand for money and slow the growth of the money supply, and if the Fed tightens enough, a relative scarcity of money develops which usually precipitates a recession. At the same time, the scarcity of money tends to pull down inflation. That's why inflation usually falls during and after recessions. As the business cycle matures, inflation tends to pick up because the Fed is slow to react to changes in the economy (note how the red line almost always lags the blue line).

What the chart is telling us now is that there has been a significant improvement in the health of the economy (the rebound in capacity utilization in recent years is unprecedented) but the Fed's monetary policy stance continues to be about as "easy" as it has ever been. Rarely has the Fed failed to respond for so long to a significant improvement in the economy. This suggests that the Fed is "falling behind the curve." We saw a similar situation in the late 1970s, when capacity utilization surged but it took the Fed several years before it got the nerve to push the real Fed funds rate above zero. One result of this delayed reaction, we now know, was that inflation accelerated significantly, rising from 5% in 1976 to a high of almost 15% in 1980. There are other troubling similarities between then and now: the dollar was very weak in the mid-1970s, commodity and gold prices were soaring, and Treasury yields were generally lower than the rate of inflation (i.e., real yields were negative across the yield curve).

I would also note that there were a few times in the past several decades when monetary policy became exceptionally "tight:" in the early 1980s, the Fed pushed the funds rate well above the rate of inflation, and they did the same in the late 1990s. Both periods were characterized by a subsequent and substantial decline in inflation.

To summarize: Monetary policy is very powerful, but it works with a lag that can amount to several years or more. (I should know, since I have been making this same forecast for the past three years. In my defense, I note that inflation today is much higher than it was expected to be three years ago.) The Fed is fallible, and usually reacts to events rather than being proactive. The Fed once again appears to be making a mistake by keeping interest rates very low for too long, even though the economy is improving noticeably, the dollar is very weak, and commodity prices are generally quite strong. As a consequence, inflation in the years to come is likely to be higher than the market expects (current inflation expectations embedded in TIPS and Treasury prices are 2-2.5%), than to be lower.

I've argued for a long time that it is too late for investors to seek inflation protection in gold. I think gold at current prices has already anticipated the likely consequences of the Fed's overly-easy monetary policy stance, and I think gold also reflects a substantial premium that investors seem willing to pay for protection against geo-political risk (e.g., the Eurozone sovereign debt crisis, which might destroy the euro, and the ongoing turmoil in the Middle East). Moreover, I think gold would react very negatively to even a hint that the Fed is going to accelerate its plans to raise interest rates.

I think it makes more sense to seek inflation protection in real assets that are still relatively depressed, and real estate jumps out as arguably the ideal candidate. I also believe that equities represent decent inflation hedges, since PE ratios are generally low and corporate profits over time inevitably benefit from increases in nominal GDP. (If inflation picks up, this is good for everyone's cash flows.)

Cash is hardly a safe haven these days, since it currently offers no yield, whereas the earnings yield on equities and the yields on corporate bonds provide substantial cushions against downside risk. And of course, if inflation proves to be higher than expected, then the purchasing power of cash will deteriorate significantly. Cash could prove to be the world's worst investment in the years to come.


Bill said...

Don't you need to see evidence of wage inflation to be really worried about inflation overall? It seems to me that there is little evidence that wages are going to rise quickly given the slack in labor demand.

Scott Grannis said...

Inflation is driven by monetary policy, not by wages. Moreover, wages usually lag inflation. I discovered this first-hand while living in Argentina in the late 1970s.

Benjamin Cole said...

Terrific wrap-up and blogging. Just because I often disagree with Scott Grannis, does not mean I don't appreciate the insights and work that goes into his blog.

Unit labor costs are flat to down--it is true, there will not be a cost-push inflation, despite weak demand, also called stagflation.

The TIPS market says inflation under 2 percent for as far as the eye can see.

One odd thing about the charts shown--capacity utilization seems to be topping out at lower and lower levels throughout the chart, after each recession.

A measurement bias worsening in time? Truly, we are using so much less of our capacity?

I sense we are into a new era, in which the adversary is deflation, not inflation.

Some are speculating whether the low interest rates of today, and the huge amount of debt being issued, will create a huge bond-owning class that prefers zero growth and zero inflation to robust growth and moderate inflation.

I agree with Grannis is one sense---the Fed must anticipate and never let inflation get too low, and must always avoid deflation. If you get deflation, you get the rentier class hooked on bond appreciation and then saddled with low yields. They are powerful and averse to growth and inflation.

See Japan.

Public Library said...

Agree with Scott and inflation is money printing. Print enough of it and it will surely find its way to your doorstep. The Feds history is littered with mistakes and commentary suggesting their job is reactionary by design.

Ben someday you will figure out deflation is the opposite of inflation. Inflation is money printing. Therefore, deflation is simply the result of the printing presses prior excesses.

There is nothing to fear about deflation. It’s called economic progress and lettign the market allocate resources most efficiently.

hoover said...

Scott, what are your thoughts on shorting Treasuries

seekingtraceevidence said...

Your comment about the Fed not being proactive has a strong history. A plot of weekly T-Bill Rate vs. Fed Funds Rate shows that the Fed lags on the upside till the economy is well on its way and then under Bernanke it moved FF rate 20-40bps higher. It simply lags as the economy slows and is always behind T-Bill rates on the downside.

Scott Grannis said...

Re: shorting Treasuries. It sure looks like an obvious trade to me, but the enemy is time. A steep yield curve means there is a cost to shorting Treasuries. The "long and variable lags" between monetary policy and its impact on the economy and inflation mean that the trade could take a long time to work, and it could be very expensive. However, I will note that I see what could be the beginnings of an uptrend in T-bond yields, especially at the long end.

Rob said...

Just buy TBT.

marcusbalbus said...

excellent post

McKibbinUSA said...

Scott, what should be done in either monetary or fiscal policy to address the issues of: a) the long-term downward trend in the employment to population ratio; b) the long-term declines in real worker wages; and c) the long-term declines in home values. I am interested in your views on these Main Street indicators. Is it your view that these indicators are irrelevant to monetary and/or fiscal policy? Thank you for the opportunity to comment on your excellent blog space.

Benjamin Cole said...

We could see years of near-zero inflation and deflation. Treasuries may only offer refuge, not returns.

The bad news out of Japan is that stocks and property have sunk for 20 years into a deflationary era, and property is still sinking.

Ergo, forget those categories, if the Fed remains fixated on nominal rates of inflation.

Okay, that leaves bonds--and interest rates may set some more, but there is not much room. We are hitting zero bound. Just as Japan did in 1992.

Anyone who wishes for a deflationary environment is not considering the Japan story. Even very low rates of inflation seems to mean the Fed can only spin its wheels, while fiscal policy is ineffective.

Ergo, the best place to be is in the moderate inflation rage, perhaps 3 percent to four percent. This allows the Fed to tighten when necessary and loosen when necessary with conventional tools.

When you get down to zero bound, and deflationary recessions, the only tool left is QE. That's why Milton Friedman told Japan to print lost of money. They did not listen, and have been easily eclipsed by China.

BTW, you hear a lot of braying about he ned for US leadership in the world, and prestige etc. I can assure you, if China keeps growing, and we do a Japan, this century will belong to China.

And we are on the Japan path.

Ed R said...

The economy is still at least 7 percent below 'normal' capacity utilization levels. And this after about 4 years of little new investment to expand that capacity. There are no signs of excess demand in any major sector except (arguably) oil; and other energy components (natural gas & coal) probably offset oil.

And as already pointed out unit labor costs continue to decline. (Scott probably likes this).

Summary: no significant inflation in the foreseeable future. Just check out the TIPs markets.

Rob said...

Scott, would love to hear your thoughts on this pro-Argentine piece in today's Guardian !


Donny Baseball said...

Ask yourself, "If the cost of everything I buy has gone up significantly, but wages in the aggregate have not gone up, am I experiencing inflation?"

I have three kids, I buy alot of milk and alot of cereal. Both items have gone up in price about 15% in just the last few months, and are up over 25% in 2 years. Should I give one second's thought to whether diary workers and cereal makers are earning more or less?

Squire said...

To me, inflation of ‘3 to four percent’ (Benjamin) is extremely high. In six years a savings account without considering the yield on the account will be reduced to a compounded 80% of what it was. Risk will be forced on all that don’t have cost of living increases build into their income. Speculation will become rampant and it will end in another bust. And that is with just 3.5% inflation. That is why the FED won’t raise their inflation target.

Scott Grannis said...

Rob: reading that piece on Argentina was like entering a true reality distortion field. The author must be one of those who still believe that socialism works and Cuba is doing great.

We are headed off to Argentina in a few hours so I will have more to say on this later.

Benjamin Cole said...


Yes, six straight years of 3.5 percent inflation will reduce an uninvested paper dollar to 80 cents or real value.

If you keep cash around, you will be sorry. If you are a drug lord, or living on exclusively US bond income, you want zero inflation or even deflation.

However, cash is intended as a medium of exchange, not a store of value.

If cash becomes a store of value, then it makes sense to bury cash (or gold) in your backyard. Read David Hume.

The result of many people burying cash or gold is a shrinking economy, and chronic deflationary recessions. It makes sense to keep the gold doubloon buried. Hide the cash in the safety deposit box and spent it later. Why hurry to invest? See also Japan.

From 1982 through 2007 the USA had moderate and varying inflation, usually between 2 percent and 6 percent. The stock market boomed. Property markets did very well. Industrial production soared. Per capita incomes rose.

I will take that 25 years again, happily.

In the same time, Japan nominal GDP shrank, wages fell by 15 percent, industrial production shrank, property values fell by 80 percent and are still falling, and the stock market fell 75 percent. They had 15 percent deflation--only a minor deflation of less than one percent a year, yet it was deeply corrosive to real output. That is how insidious deflation is.

There are many reasons that moderate inflation works to promote real economic growth. The economy is not a Swiss clock. It is not so perfectly crafted---the gears need a lot of lubricant. That lubricant is inflation.

By fixating on one aspect of monetary policy---inflation---you are losing sight of the larger and long-run picture.

I do not see how the USA can recover form a deep recession and real estate bust, while holding inflation at 1.5 percent (where it is now). Banks will take a long time to work through bad loans, consumers will own underwater houses, and small business guys, owners of warehouses, stores etc will not be able to borrow for expansion (small business guys usually borrow against their real estate).

Maybe in a perfect world, we can have zero inflation, But nirvana is for the f=afterlife. here on earth, we need a robust and growing GDP.

BTW, China prints a lot of money, and they are beating our ass all over Asia. They have become the largest trading partner of Thailand and most other Asian nations. Leadership is shifting to Peking.

We are asphyxiating ourselves with tight money and sailing aircraft carriers around.

Not hard to predict whose century this will be.

John said...

I'm no economist, but I think these technical issues surrounding the Fed are overblown. The U.S. economy, in my view, is hampered by two major cost items: oil and health care. The bloated costs of both of these are essentially no differet than skyrocketing taxes.