Wednesday, May 19, 2021

The Fed and our politicians are playing with fire

Beware the monetary and fiscal misunderstandings that proliferate these days. 

There are two reasons to expect higher inflation now and in the future, and monetary "stimulus" is not one of them. There is no reason to expect that all the fiscal "stimulus" spending being contemplated in Washington will do anything good for the economy. The government cannot possibly spend money more efficiently and productively than the private sector. Raising taxes on the most productive members of society cannot possibly make the less productive members better off. 
Monetary policy can be "stimulative" only to the extent that it is neutral—i.e., neither too lose nor too tight. The Fed can't create growth and prosperity by printing more money, but it can hobble growth by being too tight or too lose; bad monetary policy introduces distortions to the economy that only work to slow growth. To the extent monetary policy is predictable and focused on preserving the value of the dollar it can be a factor which promotes growth by instilling confidence in the future and thus encouraging investment. But artificially low interest rates (which many claim we have today) do not necessarily make the economy stronger. On the contrary, keeping rates artificially low encourages borrowing and spending and discourages investment. Investment is the key to growth, not spending or demand—this is the central insight of supply-side economics.

Long-time readers will know that I have for years argued that Quantitative Easing was not stimulative. Instead, I saw it as a response by the Fed to the economy's demand for additional cash and cash equivalents. That demand, in turn, was created by the extraordinary bouts of uncertainty that have buffeted the economy since the Great Recession of 2008-09. By engaging in QE, the Fed was simply responding to an increase in money demand by transmogrifying notes and bonds into bank reserves (which pay a floating rate of interest and are default-free, just like T-bills). I have pointed out that the huge increases in the M2 supply that we saw in the late 2000s and early 2010s were not inflationary because the Fed was essentially converting notes and bonds into cash equivalents, which in turn was necessary to avoid a shortage of money. When the Fed adds money to match an increase in money demand, it is not inflationary; inflation only happens when the supply of money exceeds the demand for it.

I am now arguing that we are in the early stages of a monetary policy mistake that the Fed is committing. Last year the Fed boosted M2 by over $4 trillion in response to the unprecedented, catastrophic and extremely costly shutdown of the US economy. That was fine then, but it's not fine now. The economy is rebounding, confidence is returning, fears have eased, and the demand for money is consequently no longer increasing and in fact is decreasing. But the Fed is not reversing its QE in response, and so unwanted money  is accumulating. That shows up in dollar weakness, rising commodity prices, rising housing prices, and rising inflation expectations. Lots of unwanted money is likely helping stock prices to rise as well. 

If monetary policy is too easy or too tight, that affects the current and future value of the dollar, and the future thus becomes less certain. Uncertainty is the enemy of investment, and investment is the source of growth and prosperity. An uncertain future inhibits growth by encouraging investors to choose safety over risky ventures which promise to enhance productivity and living standards. As my mentor John Rutledge used to say, inflation is like a thick fog that settles on the highway, forcing everyone to slow down. Deflation is just as bad. A strong and stable dollar is nirvana. Huge increases in the money supply coupled with massive deficit-fueled government spending is most definitely not nirvana. It's time to get very worried that policymakers are going to be too slow to respond to the huge improvement in the economic outlook.

In the charts that follow I first cover the state of fiscal policy, which has deteriorated like never before. Spending is essentially out of control and off the charts. The Fed used the avalanche of new Treasury debt (about $4 trillion in just the past year) as an excuse to massively grow its balance sheet. Reckless spending and easy money are a very bad combination that will feed future inflation and slow the economy—unless they show clear signs of reversing soon.

At the onset of the Covid crisis, it all made sense. Fear skyrocketed and the demand for cash exploded. Everyone wanted to hold more cash (currency, checking accounts, demand and savings deposits) in order to protect against the unknown consequences of shutting down the global economy overnight. Those who didn't lose their jobs were unable—and likely unwilling—to spend all the money they were making. The Fed had no choice but to balloon its balance sheet in order to supply more cash and cash equivalents, and the federal government had no choice but to replace the incomes that were lost by an army of unemployed due to the arbitrary and sudden shutdown of the economy.

The Covid-19 pandemic is essentially over, at least in the US, since we have by now effectively achieved herd immunity via vaccines and antibodies. With the economy rapidly rebounding and confidence returning by leaps and bounds, the Fed is failing to reverse its money creation efforts, and unwanted money is thus flowing into other and better stores of value. Indeed, the Fed keeps insisting that it won't need to reverse course for a very long time! (Although the April FOMC minutes—released today—did acknowledge that eventually they will have to do so.)

Compounding these problems, politicians—looking to assuage their guilt over unnecessary shutdowns and quite possibly with an eye on future elections—voted for a significant boost in unemployment benefits. So much so that many millions of workers have realized they are better off staying at home rather than returning to work. But it's important to remember that supply bottlenecks and temporary labor shortages are not what create inflation: only Fed mistakes do. And it's also the case that this issue—excessive unemployment benefits—is already fading, since the extra benefits are set to expire by September and meanwhile, a growing number of states have decided to cancel those benefits.

What should be obvious to investors is that there is a significant cost to holding cash. Holding cash or most cash equivalents these days—and probably for the next two years—is almost certainly going to result in the loss of 3% or more in terms of purchasing power per year, because cash pays zero interest. And there is a lot of extra cash out there that is wasting away in bank savings and deposits—over $4 trillion, according to the M2 measure of the money supply.

So there is a compelling reason these days to avoid cash if at all possible. And, given the extremely low level of interest rates and spreads, investors should also avoid most fixed income instruments as well, because interest rates inevitably will rise and bond prices will decline significantly even if future inflation is only 2-3% per year.

For better or worse, and it's no surprise, the market has already begun to reprice along these lines. Inflation is fully expected to average almost 3% per year (2.7% is the market's current expectation) for the next 5 years, according to the TIPS market. Housing prices have risen dramatically all over the country. Used car prices have exploded. Commodity prices are soaring. The dollar is hovering around its weakest level in the past 5 years. All these indicators are consistent with there being a surplus of dollars in the world. Simply put, the value of the dollar is declining, and rising inflation is the natural counterpart to a weakening currency.

As for housing, affordability is the key factor driving housing prices, and this is unlikely to deteriorate any time soon. If mortgage interest rates remain low, prices will continue to climb until they become unbearable. But meanwhile, incomes will be growing as well, so current conditions could continue for a few more years. But at some point, higher rates could easily pop the inflating housing bubble.

What to do? No easy solutions present themselves. It’s not obvious how all this will play out; there are too many variables involved to make confident forecasts. Beyond, that is, predicting that lots of purchasing power and bond market valuations will be eroded with the passage of time. Big debtors, especially the US government, will benefit. Creditors in general will suffer, as will those in the private sector that have behaved responsibly by avoiding risky investments and holding onto “safe” cash. These processes are well underway. Very unfortunately, this all adds up to a significant headwind to future growth. Things may look fairly rosy right now, but over the long haul there could be significant problems. This realization may well explain why real interest rates on Treasuries are incredibly low.

Furthermore, it’s not unreasonable to think things could spin out of control. You can’t play fast and loose with the value of the world’s most popular currency without sowing negative seeds. The Fed may be forced to go back on its word and tighten well in advance of what they are promising today, and this could result in havoc for many markets. Meanwhile, the Fed is risking its credibility daily, and that is not good.

At the very least, a sooner-than-expected Fed tightening could lead to another round of panic such as we saw in late 2018. In retrospect, it is clear that the Fed back then had been tightening preemptively (unnecessarily worrying about higher inflation). That’s probably why they are so anxious to avoid tighening again—probably until it becomes painfully obvious that a tightening is necessary. And by that time, it’s likely they will have to tighten by more than they and the market would like. And that is exactly what has preceded and triggered nearly every recession in my lifetime. It's all so unfortunate.

The charts that follow give you a snapshot of the origins of the mess we find ourselves in today. Massive government spending and an overly-accommodative Fed have introduced profound risks to the economy and to financial markets.

Chart #1

Chart #1 shows the 12-month running total of federal government spending and revenues. Spending has literally exploded, while tax receipts have been growing quite slowly for the past 5-6 years. This is not a sustainable situation.
Chart #2

Chart #2 shows federal government spending and revenues as a percent of GDP. Spending stands out starkly as unprecedented, while revenues are only moderately below long-term averages.

Chart #3

Chart # 3 shows the 12-month rolling sum of monthly budget surpluses and deficits. The only other time deficits have been this large was during World War II. At least back then we had something to show for the spending: world peace and global growth. Today we have done little more than take trillions from the pockets of the more productive only to put it into the pockets of the less productive. Income redistribution on a massive scale cannot possibly lead to a growing and productive economy.

Chart #4

Chart #4 shows federal debt held by the public, which you can find here. Please note that the best measure of the debt outstanding is "Public Debt," i.e., debt held by the public. This does not include intragovernmental debt. If it did, that would be double-counting. 

Chart #5

Chart #5 shows total federal debt as a percent of GDP. It's huge in nominal terms, and almost as big relative to GDP as it was during WWII. In the aftermath of WWII debt shrunk rapidly relative to GDP, mainly because economic growth was spectacular. Although growth in recent quarters has been exceptionally strong, this is unlikely to be the case for the rest of this year and next. Why? Because last year's huge increase in debt was not put to productive use, as it was during WWII. 

Chart #6

Chart #6 shows the true burden of federal debt, which is defined as debt service costs relative to GDP. Although the debt is huge in nominal terms, interest rates are historically very low, with the result that servicing the debt only requires a modest 2.5% of GDP per year. This is very likely to increase in coming years as interest rates rise, even if annual budget deficits decline, but the increase is going to be slow (i.e., it doesn't present an imminent or dangerous risk for the next few years—we have time to get things fixed).
The following charts have important information about the money supply and inflation.

Chart #7

Chart #7 compares the nominal growth of GDP and M2 over the past 60 years. There is enough money in the wild today to support an enormous increase in nominal GDP. If people decide they are holding more money than they feel comfortable with, the current M2 money supply could quickly translate into a huge increase in nominal prices. In other words, the Fed has already supplied the fuel for a whole lot of inflation if the market's demand for money declines.

Chart #8

Chart #8 shows my preferred measure of money demand, which is M2 as a percent of GDP. This is akin to measuring how much of the average person's annual income he or she wants to hold in the form of cash and cash equivalents. As should be obvious, money demand has skyrocketed in recent years, and it's never ever been as high as it is today. The Fed last year purchased trillions of dollars' worth of newly-issued federal debt. The vast majority of the increase in M2 came in the form of bank savings deposits. Banks effectively invested strong savings inflows into bank reserves, which are functionally equivalent to T-bills. As a result, banks have a supply of bank reserves that is orders of magnitude more than would normally be required to collateralize their deposits. Should banks find more attractive lending opportunities in the private sector, the Fed's current provision of bank reserves would be sufficient to facilitate a further enormous increase in the M2 money supply ($1 of reserves is typically required for every $10 of deposits).

Chart #9

The Fed would like us to believe that the big (and surprisingly large) increase in consumer price inflation over the past year is just a temporary phenomenon. While it's true that the rise in prices in March and April of last year was depressed by the Covid shutdown, that's not necessarily the reason for the outsized jump in prices in the past two months. Chart #9 tries to illustrate this, by comparing the CPI index to its long-term 2% per annum trend, using a semi-log scale. If the jump in recent inflation were just payback for the slump a year ago, the current level of the CPI index would not be above it's long-term trend. But it is.  

Chart #10

I think it's fair to say the current rate of inflation is best measured using the seasonally adjusted trend of the past six months, which you can see in Chart #10. Overall inflation is up at a 5% annualized rate over  the past six months, while ex-energy inflation is up at a 3.1% annualized rate. A casual observer might say that we're already living in a 4% inflation world, which is double what we've seen in the past two decades.

Chart #11

National average home prices are up well over 10% in the past year, and rising. In inflation-adjusted terms, home prices today are as high as they were at the peak of the housing market bubble in 2005. But back then fixed rate mortgages were going for 5% or so, whereas today they are only 3% or so, as you can see in Chart #11.

Chart #12

Despite recent price increases, very low interest rates and abundant supplies of cash have conspired to make housing very affordable, as you can see in Chart #12. In fact, house prices today are much more affordable for the average family than they were in 2005.

Chart #13

Chart #13 shows why house prices are likely to continue to rise. The supply of unsold homes on the market today is just about as low as it has ever been. It's a huge seller's market, with lots more willing buyers than sellers. Prices could continue to rise even if mortgage rates increase by another percentage point or so.

Chart #14

Chart #14 compares the level of the dollar (inverted) to an index of the prices of industrial metals. The dollar is at its weakest level in the past 5 years, and a weak dollar can help explain why commodity prices are up (i.e., there is a fairly reliable correlation between dollar weakness and commodity price strength, and vice versa). But the recent gains in commodity prices look pretty impressive nonetheless. There must be a lot of demand for physical stuff, and that is likely fueled by the perception that with lots of money earning zero interest, it's better to be buying physical assets (which tend to rise with inflation) than it is to be buying financial assets such as bonds. Cash is trash.

Chart #15

Chart #15 shows there has been a rather impressive rise in consumer confidence since last summer. The US and Israel have basically won the fight against Covid, thanks to vaccines and acquired immunity. Other nations are working hard to catch up. The economy is throwing off its mask and people are getting back to work, anxious to live a normal life again. Who needs a huge stockpile of cash when the future looks so much brighter now than it did just six months ago?

Chart #16

Chart #16 shows the level of traffic passing through US airports since the Covid crisis began 14 months ago. The current level of traffic is still about 35% below the levels of two years ago (when it was about 2.5 million per day), but at this rate it won't take much longer to be completely normal. Things are improving rather rapidly these days. 

How long will it take the Fed to realize all this? How long will it take our politicians to realize that massive fiscal stimulus is not only no longer needed, but actually problematic and quite possibly dangerous?

Too much monetary and fiscal "stimulus" is quickly becoming a toxic brew and cause for great concern.