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.


Andrew said...

Thank-you Scott;

Always appreciate your research and commentary.

My thoughts are that the wealth of society comes from the amount of efficient work that is accomplished over time. If little work is accomplished, or if it's not effective, then the standard of living will decline. We could hire people to watch TV all day, but what good would that do?

Our financial system is essentially just an accounting system. Money motivates people, but by itself it does not guarantee wealth or a higher standard of living. A good example would be to consider an island with only 1 person. It doesn't matter if that person has one dollar or a billion dollars. The standard of living on that island will be a function of how much work is completed and how efficiently it is completed.

Investments, if they are to ever make sense, must lead to a greater amount of work completed; either thru increased efficiency or more people working.

The beauty of private investments is that there is typically a cost-benefit that can be measured objectively. If it makes sense, then there will be more investment. If not, then end of that.

EHR said...

Thank you as always for your amazing posting and generosity sharing your expertise with us ordinary folk.

Aside from buying rental property or a bigger primary residence, what is a better alternative to cash today please? Commodities? Foreign currencies?

What range of Euro/Dollar is ideal please? Why is $1.22 too weak for the dollar?

John A said...

I would *highly* recommend everyone here read the following article. It appears the thinking at the Fed has changed substantially to allow (and maybe even encourage) higher inflation in order to create higher growth and (eventually) raise wages at the lower end of the wage scale.

Economic neoliberalism appears to be dead at the Fed, and the Biden administration too. In fact, it really started under Trump.

The Making of the Mother of All Economic Booms

K T Cat said...

John, I read the article, but it seemed like lot of theory and not much reality. As Scott suggests, I'm doing well in stocks and real estate, but my gardener and maid are stuck in a rent and cash world. Their wages aren't rising because there's massive competition coming over the border and with inflation returning, their bank accounts will be devalued.

I can't see the Fed raising rates too far because of the debt. A few points would blow the Federal budget to smithereens. Loose money and crazy spending don't look like winners for the working class.

Grechster said...

The article appropriate highlights this giant clash between the Old School thinking, which is always trying to head off '70's-style inflation, and the New School, led, apparently, by Lael Brainard, which buys into the Let-It-Run-Hot mantra.

Reality, as opposed to theory, would seem to be on the side of the New School, at least for now. Ten-year breakevens were 2.48% this morning, which is down from the very recent peak, and, more meaningfully, is lower than the five-year reading.

The hysteria of the prospect of significantly higher inflation just seems overwrought.

The real worry is that animal spirits, seemingly no matter what, just can't get off the mat. That being the case, it's hard to make the case for significantly higher inflation. The real worry, in my opinion, is that once we put the re-opening in the rear view, we'll be left with a GDP growing at a rate of 1.0-1.5%, weighed down by massive debt levels and a political regime that is hostile to investment and risk-taking.

Fred said...

Hi Scott- not sure I understand what you are recommending here. Stocks plus RE? If inflation does start to rise wouldn't it be prudent to hold cash in money market funds with interest rates rising? I'd rather have my principal preserved than have it go south with stocks and bonds as the FED raises rates even if buying power is diminished. Was cash trash in the '70s and early '80s when CDs paid high rates? I'm about 50% stock funds and 50% short term stable principal fund + cash in money market funds. If stocks take a sustained tumble I could see putting some of the cash to work in the stock market but right now it seems a bit frothy to me.

HDX said...
This comment has been removed by the author.
KB said...


The part of your post that jumped out at me was this line:

"...Furthermore, it’s not unreasonable to think things could spin out of control..."

The effects of inflation itself and the cost of holding cash are fairly understandable, particularly for those of us who lived through the late 1970s.

I'm more concerned about the 'spin out of control' scenario. Any chance you could write about that?

Best regards, Kurt

Kurt Brouwer

Tim H said...

I don't understand why the Treasury is not issuing very long-term fixed rate treasury bonds (think 50 years or more) to tamp down the frightening interest rate risk of our burgeoning debt. I believe the average maturity on that debt is a little more than 5 years, and If the Fed is forced to refinance at the historic 10-year rate, we could see interest expense crowding out the rest of the budget creating a debt spiral of doom. I haven't seen any mention of the Treasury even considering this option, one that seems completely and utterly obvious to me. What am I missing here?

Tim H said...

I don't understand why the Treasury is not issuing very long-term fixed rate treasury bonds (think 50 years or more) to tamp down the frightening interest rate risk of our burgeoning debt. I believe the average maturity on that debt is a little more than 5 years, and If the Fed is forced to refinance at the historic 10-year rate, we could see interest expense crowding out the rest of the budget creating a debt spiral of doom. I haven't seen any mention of the Treasury even considering this option, one that seems completely and utterly obvious to me. What am I missing here?

K T Cat said...

Tim, who would buy a 50-year Treasury? Would you? I wouldn't touch it because it's obvious the current system is unsustainable.

Benjamin Cole said...

Another superb piece of economic reasoning from Scott Grannis. I always feel re-grounded in my understanding of the US economy after reading a Grannis blog.

I do wonder about the conventional conception of US debt held by the public. In this day and age central banks are buying public debt, such as the Bank of Japan and the Federal Reserve.

It sure seems to me that central banks are part of the national government, regardless of any legal niceties.

Interest payments on bonds held by the Federal Reserve flow back into the national Treasury.

I share concerns that federal spending is wasteful on both social and military programs, and I would always prefer tax cuts over additional spending if fiscal stimulus is ever warranted.

Will we see inflation above 3% in the US on a sustained basis? Well, they are seeing sustained deflation in Japan despite large fiscal deficits and large amounts of monetary stimulus.

What is treated as axiomatic in conventional US macroeconomic circles does not seem to apply to every economy.

Add on: I see the chart on housing affordability, but in truth housing is unaffordable nearly anywhere on the West Coast and in other regions such as New York Boston and possibly Austin Texas. There needs to be a constitutional amendment to ban property zoning, which is the effective seizure of private land by government.

Adam said...

Thanks Scott for your update.
As US economy is an open one, doesn't it mean that at least part of the inflation will be exported.

Scott Grannis said...

Adam, re the US economy is an open one: Inflation is a monetary phenomenon. If the US is indeed being subject to inflationary monetary policy, this will only be “contagious” to the extent that other central banks commit the same error. There is some evidence for that, thought it’s still tenuous, in the fact that the dollar has not yet plumbed new lows compared to most other major currencies. That fact would suggest that other countries are following expansionary monetary policies as well.

Scott Grannis said...

Tim H, re why the Fed isn’t issuing more long bonds: If I were running the Fed, I would be pushing for more long-maturity bond issuance, given the extremely low level of long-term bond yields. Many smart companies are doing just that. Rising inflation makes issuing long-term debt an attractive proposition, just as it makes long-term bonds a very unattractive investment.

Scott Grannis said...

Re my previous comment. Meant to say that if I were Treasury Secretary, I would be pushing for longer maturity bonds. Seems like a no-brained from the government’s perspective, though very bad from the private sector’s perspective. Why? Because the government would be acting to take advantage of the private sector.

Benjamin Cole said...

There is a part of the above excellent post by Scott Grannis that has always puzzled me.

Let me explain.

It seems to me that financial markets are always in balance between supply and demand. The price of Apple is a balance between buyers and sellers, and the price of Treasury is in balance against all other financial assets, or cash.

So, before the Fed begins a quantitative easing program, the markets are already in balance. Investors and savers who want to be in cash already are. The price of Treasuries and all other investments already reflects the desires of investors.

At the risk of a tautology, markets are always balanced.

OK, so the Fed begins buying Treasuries. They print (digitize) and pay "cash" for Treasuries, through the 21 primary dealers, who then deposit the cash at commercial banks.

Now, after the Fed's QE program, commercial banks have swelling deposits, and perhaps interest rates are pushed lower a bit. I am not sure interest rates are pushed lower, as there is a global $500 trillion asset market (bonds, stocks, property). Perhaps interest rates are lower on the margin. But interest rates are set globally; we have globalized capital markets. Perhaps all the central banks buying government bonds in unison does push down rates marginally.

But for sure, commercial banks sit on a lot of cash.

The above scenario strikes me as a different scenario than "investors want to be in cash."

Also, I have never understood why an investor in a liquid and safe Treasury would prefer to be in liquid and safe cash. There is less interest-rate risk I suppose, but such risks should be reflected in the price of Treasuries.

This does not mean I favor huge federal spending. On the contrary I favor a much smaller federal government, reducing civilian, military and social welfare spending.
I prefer fiscal stimulus happen through tax cuts, such as holidays on Social Security taxes.

Anyway, that is my two cents. The nice thing about macroeconomic debates and observations is that no one is ever wrong.

Scott Grannis said...

Benjamin, re "I have never understood why an investor in a liquid and safe Treasury would prefer to be in liquid and safe cash." Treasury securities with a maturity greater than a few months may be "liquid and safe," but they are not r
risk-free because they are subject to price risk as the prevailing rate of interest changes. Cash that is completely safe and liquid has no interest rate risk, no default risk, and no liquidity risk. T-bills, bank reserves, and insured bank deposits fit that description.

Currency (e.g., dollar bills) also fits that description, but for practical purposes it is not possible to store a significant amount of money in the form of currency. Larger denomination bills would help in that regard, but the vast majority of "cash" must be held in something other than currency.

Benjamin Cole said...

Yes, I mentioned the term risk in my comment.

My point is that in free global financial markets, if some investors prefer to be in cash, then interest rate returns on Treasuries should rise to compensate for the perceived risk.

The free market is always in balance.

By unilaterally printing money and buying Treasuries, the Federal Reserve is artificially imbalancing the free market and also creating deposits (reserves) at commercial banks.

In my view the Federal Reserve is not accommodating an investor need. That need would be handled better by free markets, probably by Treasuries offering more interest to attract investors, and perhaps lower asset prices in equities and property.

That's my view, and perhaps in this case I am "going Austrian."

vito said...

Thanks for your thoughts

JC from MN said...

Thanks Scott, I always appreciate your commentary. Its the most lucid thing I read on the current state of macro economics.

Isn't the demand for M2 or excess bank reserves due in part (large part?), to low interest rates on bonds and similar debt instruments? If I remember (Econ 101) the liquidity trap (Keynes) resulted from very low bond rates and the belief among investors that if rates could only go up their bond principal could only go down.

Benjamin Cole said...

The view from Moody's Analytics 5/27/2021---

"The U.S. is not currently experiencing
stagflation, and it’s not going to over
the next couple of years. The debate
about stagflation is going to intensify
over the next few months as growth in
consumer prices continues to
accelerate. However, there are a ton of
temporary factors behind the
acceleration and recent gains in the CPI
are concentrated in the most volatile
components. This is likely not
sustainable; it is attributable to the
reopening of the economy."


Well, let's hope Moody's is right.

Rising national debt?

If the Fed buys back Treasuries (ala the Bank of Japan)...then who owns the debt?

Benjamin Cole said...

PCE core just posted at 3.1% April YOY.

That is higher than recently, but not much higher than Fed's 2% target, which the central bank undershot for years.

Keep watchin'.

Scott Grannis said...

My read of today's PCE inflation numbers reaffirms my belief that the Fed is making a significant monetary mistake. Inflation is moving broadly higher, and by a lot. I think we're now living in a 4% inflation world, and I see little reason it can't go higher. Beware the true cost of holding cash or cash equivalents.

Carl said...

"If the Fed buys back Treasuries (ala the Bank of Japan)...then who owns the debt?"
As a result of the temporary asset swap, it's then a liability of the future tax payer.

"Beware the true cost of holding cash or cash equivalents."
In American TV medical drama series (i'm watching New Amsterdam these days), when people are in shock with low blood pressure (fundamental economic stagnation), the typical response is to order a bolus of fluid (equivalent of cash into the system) and a "levophed" drip (equivalent of low interest rate to 'boost' the economy) and the typical outcome is a quasi-magical recovery, with the recovered patient then getting ready to run a marathon or whatever. In my humble experience, especially when a gradually diminishing dose-response relationship is seen, the typical response is deflationary heart failure.
In TV shoes and movies, people rarely discuss the fundamental reasons that led the person to the ER in the first place. But yes levophed tends to artificially elevate the blood pressure, temporarily.

Benjamin Cole said...


I am not sure what you mean by a "temporary asset swap." My guess is the Bank of Japan will hold onto its balance sheet in perpetuity.

Yes, Japanese taxpayers must pay the interest on JGBs, but then that interest flows back into the Japanese national Treasury.

Same-same in USA.

If large fiscal deficits and monetary easing must lead to inflation... Then Japan, by running large fiscal deficits and large quantitative-easing programs is in fact conducting a "tight" monetary policy...

I say that as there has been no inflation in Japan since 1997... they are presently in deflation...

One big difference between Japan and the United States that is rarely mentioned by macroeconomists, as it is a structural impediment and not a theoretical aspect of the economy, is that in Japan it is easier to build new housing...

Carl said...

Hi Benjamin,
Unknown Carl here.

Do you realize that we are going through one of the most interesting macro environments ever?
i am essentially a bottom-up investor but happen to think that this is one of the rare moments where one has to pay attention (FWIW).

There are huge deflationary forces that have been developing for a while and this has been more or less balanced by easy monetary and fiscal policy (growing and eventually reaching non-linear changes).

The word "temporary" is key. QE does NOT meet the pure definition of debt monetization because QEs are, by definition, temporary. The US (as well as the ECB and especially Japan) central bank authorities are adamant to deny the suggestion that these open market operations (and central balance sheet expansion) are permanent. Acknowledging the permanence of these programs would mean acknowledging that the emperor has no clothes. Think about it: debt on which you pay no interest and which is not expected to be paid back is not debt, it's the way to hyperinflation and to financial ruin. The reason this 'temporary' phenomenon has been allowed to continue is related to graphs that Mr. Grannis uses above: rising debt has been associated with lower interest rates and actually lower debt service burdens. The Fed's role is to lean against the wind and to remove the punchbowl before the party is gone too far and the present authorities in place seem determined to avoid being party poopers. Unfortunately, at this point of the game with such high debt levels, i think a deflationary bust will be part of an interim phase before sustained inflation becomes even possible. i also think Japan is leading the way.

randy said...

Modern Monetary Theory is just another manifestation of Post Modern philosophy. The "theory" relies on bewilderingly complex arguments, creative use of language that subtly changes long accepted meaning, and rejection of rationality and objective truths as constructs only serving those in power. Attempting to argue against post modern ideas like MMT faces the challenge of having to rebut the tortured language and "moral" claims that disagreement is actually rooted in some sort of heirarchical supremacy.

It's tedious. I'm so happy my kids are out of the education system. What a mess.

Ataraxia said...

Purposely blowing out spending so tax hikes on "rich" inevitable.

Benjamin Cole said...

Unknown Carl:

I enjoyed your comments.

I am totally ambivalent, undecided and fence-sitting on whether we will see sustained higher inflation going forward, and that is my position and I am not changing it.

Interesting note: The Reserve Bank of Australia has a 2% to 3% inflation band target, and no recession (until C19), in decades and decades. In Australia they got up to 4% inflation for a pass or two, but then inflation cooled back down to the target range, with no recession. Maybe 3% inflation (as measured) is a better target.

So maybe the US will get up to 4% inflation for a year or two, and then cool off. Housing is a killer but that has more to do with property zoning and regulations than monetary policy.

I surmise that many axioms of US-based macroeconomists do not apply elsewhere on the planet....which makes me wonder if they are true axioms. Bow to those totems you revere---but keep one eye open!

Carl said...

Part 1
Who knows then?

I would submit chart #7 is the most revealing.
You see a secular trend of lower economic growth, higher M2 stock growth, with a building disconnect. That was the reason for the medical metaphor. When somebody comes to the emergency room with heart failure, you need to get the liquidity going and even use unconventional remedies for life support but the key for the person to recover and lead a productive life is to go through an austerity regime (stop smoking, lose weight, improve nutrition and activity level). i'm afraid inflation targeting won't do the trick.

The US is pretty much the only place on the planet where inflation is showing signs of life and it's because of the massive levophed drip being applied (look at the trade balance).

Since the GFC, we live in an ample-monetary-reserves environment which is very unusual and, around September 2019, it became clear that the Fed’s involvement was no longer based on sound Bagehot’s rules and temporary in nature but supportive of a weakening underlying economic host, subject of becoming very sick, simply, for example, in relation to an exposure to a relatively benign virus.

Recently, side effects of this essential and omnipresent support (excess supply of government debt securities and excess supply of reserves) has become obvious in the reverse repo market, with a relative imbalance between Treasury securities and cash reserves as a result of the Treasury driving down its Treasury General Account at the Fed (therefore resulting in relative excess cash in the system). BTW it’s not true excess cash as the double-ledger associated government debt securities (bills and bonds) have already been issued into the system while the associated cash was temporarily parked at the Fed. It just shows how sick the monetary system has become. Too much cash has become toxic in the most liquid and deepest market in the world, at the heart of the global financial plumbing ?!

Overnight Reverse Repurchase Agreements: Treasury Securities Sold by the Federal Reserve in the Temporary Open Market Operations (RRPONTSYD) | FRED | St. Louis Fed (

Carl said...

Part 2
The Fed continues to buy 120B of fixed income securities per month (btw, they have continued to buy 40B of mortgage securities per month and help drive down mortgage rates and you wonder if limited supply is the only factor?) which generally corresponds to the rise in reported reserves held at the Fed by depository institutions. However, for the period between March 31st 2021 and May 26th 2021, the Treasury General Account of the Treasury at the Fed has been coming down by 343.1B which should correspond to a commensurate rise in deposited reserves. It has not. Why? Because this has been pretty much matched, for the same period, by an increase of 316.0B of the reverse repo balance.

Because of liquidity ratios such as the SLR, banks are full of reserves and excess cash reserves are driven into money market funds which, themselves, have tended (limited choices) to lend this cash against treasury collateral, typically at 0% interest and the pressure of the excess cash reserves is so high that the reverse repo rates have had a tendency to be negative. Because of this underlying monetary stress, the Fed has introduced some technical changes and has provided liquidity to this market by increasing the net balance of reverse repo operations. Note: this move removes reserves from the system while, simultaneously, the Fed continues to add reserves to the system through their open market operations (ie the opposite of a reverse repo operation). Those who follow this tend to focus on the technical aspects but forget the growing importance of fundamental issues related to solvency of the entire monetary system.

The excess money injected into the system results in excess savings only for a small minority of people. People in the low 80% percentile don’t typically truly save the ‘stimmies’ (typically shared between paying bills and paying down consumer loans and credit card balances). A lot of the excess savings of the top 20% percentile (the typical "investor") have been recycled into cash deposits at banks and money market funds (driving the reverse repo rates into negative territory) and a similar principle is happening in other sectors: government debt, corporate debt, junk bonds, equities, robinhood stocks etc etc, driving the yield on those securities to bubble levels never seen before. Please note the irony of the Treasury flushing the system with extra cash and engineering an increased demand for government debt securities, therefore driving its own yields down!

The Fed-Treasury complex is now involved in quasi-permanent first-resort support of the economy instead of a temporary last-resort liquidity provider, a purpose never intended to be and bound to result in delayed fundamental reforms and with obvious interim consequences. Timing is always difficult but IMO now is the time to be worried for once in a century breakdowns.

Carl said...

Part 3
Chart #7 is well complemented by trends in changes to M2 velocity that has occurred showing the gradually decreasing marginal utility of debt and Fed involvement in the economy.
Velocity of M2 Money Stock (M2V) | FRED | St. Louis Fed (

The government’s debt has been gradually displacing private loan growth (see evolution of loans to deposit ratio at US commercial banks etc) as a source M2 growth and this has given rise to declining productive growth. Fundamentals eventually play out and hopefully the Fed will run out of ammunitions before it’s too late. At least, that’s my bet. For now, I think deflationary forces will win over the temporary lift brought about by extraordinary fiscal and monetary measures. Given the wrong path taken, IMO, the sooner the better. Clearly, this is not a conventional or popular position. FYI, the forward curves for the Fed Fund rates (people don't typically look at those measures; instead they look at commodities and other similar aspects which often respond to short term speculative 'financial' pressures), which Mr. Grannis has used for his exposés of years past, have started to turn down.

But who really knows? On another Board where i've been trying to help with blind spots, i was recently called an irrelevant Cassandra. Oh well.

This feels like 2007 all over again, but on a much deeper level. Good luck to you (all).

Benjamin Cole said...

The GFC was triggered by a collapse in house prices. Not sure that happens again.

I do wish we would all agree on a super-rugged financial system. The real economy is farms, factories, trucks, construction, etc.

This pattern of "financial collapses" that harm the real economy is nutty.

Carl said...
This comment has been removed by the author.
Carl said...

"This pattern of "financial collapses" that harm the real economy is nutty."
Fair enough so i don't have much to add.

Just for fun, if you have a minute to spare, take a look at 49:53 to 51:05. It's about Mr. Paul Warburg (one of the driving force behind the 1913 Federal Reserve Act). So, if there's something to be learnt then, i will keep the mutterings private and be in a position to enjoy the future.

Recently, Mr. David Swensen died (of Yale endowment investment management fame, RIP) and i was reviewing some notes about his two major publications (about personal and institutional frameworks for investing). He makes the point that market timing is essentially a fool's errand. In one chapter however, he mentions that an exception could be made (in retrospect...) concerning the late1980s Japanese bubble which was pretty obvious (in hindsight...). LOL

In the meantime, get some popcorn and watch theatrics unfold with the Treasury General Account at the Fed (TGA) above 750B and needing to go down to 131B at the end of July (more than 600B in reserves 'creation)', assuming a debt ceiling accord does not occur until then.
i may comment here during the summer before the Fall. :)

Unknown said...

Hello from Spain.
Do you think that FED has begun to change direction with the recent massive REPOs (Inverse) policy.

Congrats again for your blog. Thx.

Scott Grannis said...

Re: does the recent surge in reverse repo activity indicate a change in the direction of Fed policy?

I doubt it, mainly because RRPs are very short-term in nature. But to be sure, we will have to wait a few months to see the money supply data. It's not a coincidence, unfortunately, that several months ago (just as money supply growth was beginning to increase yet again) the Fed began changing money supply definitions and ceased publishing weekly M2 data; they now publish official M2 data only about a month after the fact. As a result we have much less information and what we do have is seriously delayed.

HDX said...
This comment has been removed by the author.
Benjamin Cole said...


I too have noticed a gerontocracy or sorts emerge in the US---in both parties, too. And across organizational types.

Some of this may have to do with better health care, and the leading edge of the baby boom.

I do think this played a role in the COVID-19 lockdowns. It is true that people aged 65 years and older faced some risk from COVID-19. Kids, no, young adults, hardly any, miniscule. But who made policy?

Interestingly, many of the spectacular growth companies were started by younger sorts, such as Jobs at Apple, Musk at Tesla, Zuckerberg at Facebook, Google by some grad students, and so on.

Interesting topic.

On Chair Powell, he is actually a lawyer. He may have done a better job than the credentialed Bernanke did, back in 2008.

Anyone who contends we face higher rates of inflation can short bonds and, through certain ETFs, leverage up on that position. You can get rich, if the money-gods favor your convictions. Or, you can be prudent, and hedge a bit. (I never liked anyone who used the word "prudent". It is a word that Jimmy Carter would use.)

A word of warning: The late Martin Feldstein, and the late Paul Volcker, were titans in the field of macroeconomics. Certainly, both were very smart and experienced men. Since somewhere after 1980, both essentially advocated taking short positions on US Treasuries, and Feldstein explicitly so a few times. They were wrong for 40 years running.

Japan has been running larger fiscal deficits and a larger QE program than the US and for a long time, and Japan is in deflation as we speak.

In conclusion, I will quote my late Uncle Jerry, and say, "If you are not confused, then maybe you don't understand what is going on."

Uncle Jerry also said, and I think we can all sympathize with the sentiment in regards to certain aspects of modern macroeconomics, "Even if that is true, I still don't believe it."

Carl said...

The demographic question (and who the leaders are) is interesting but:
Is it significant?
Is it relevant as a cause or is it only a correlated variable?

In the last 20 years or so, average age in Congress has gone up by about 4 years (55 to 59) and average age on Boards has gone up by about 3 years (60 to 63). This specific aspect may represent simply a proportional increase to a gradually aging population.

What if it is simply a correlated variable that conflates in creating an environment for a secular decrease in dynamism that has been documented in the last 20 years in the following key areas: decreased social mobility (along the Great Gatsby curve with increasing inequality), decreasing residential mobility, decreased new business formation, decreasing productivity trends, decreased competition marked by increasing business sector concentration and elevated profit margins (vs GDP).

Yes this is confusing and we need to hope that animal spirits will win the day. But I really like the Prudent Man Rule (1830) and the concept of keeping your head if others lose theirs. It seems like leaders should try to do the same but age does not always equate to wisdom. Maturity has two meanings.

Benjamin Cole said...

ICE BofA US Corporate Index Option-Adjusted Spread

At a record low. I guess this means institutional investors are confident that US corporations can pay back their debts. I think this is a good sign----if there is an economic horror story in our future, institutional bond investors are not seeing it.

I have an edgy feeling that investors are over-valuing stocks and bonds, the same feeling I have had since about 1977.

Carl said...

If this meant to be funny, i appreciate the light tone.
If used to ridicule, it's still OK.

Now is a great time to be alive but i would argue that the mood around 1977 (death of equities etc) offered a better risk-reward profile for stocks (and for bonds also but less so). It turned out that, from 1977 to 1989, high-yield bonds offered better returns than investment grade bonds with lower volatility. I wonder if the institutional bond investor community saw this coming. As far as institutional insight, Mr. Buffett in 1979 put a piece in Forbes. It's about the risk of using a rear-view mirror approach and the potential value of contrarian thinking. See(pages 8-9):
Usually the markets and institutions 'get it' but you're not necessarily right because the market agrees with you. If you're happy with your long-term plan, you can stick with it and market timing (temporary deviation from asset allocation plan) is typically a costly endeavor but the title of this piece includes a theme of politicians and the Fed playing with fire.
Incomplete disclosure on an anonymous forum has low value, sometimes it's hard to differentiate luck from skill and past performance is a frail guide to the future but macro themes were important in the years leading to the GFC. In 2008, in my bond bucket, i switched the long-term US government bonds (yields down++) and invested some of the proceeds into investment grade bonds (Verizon, Kraft etc, with yields spiking to around 9 to 10%). I was also invested into Fairfax Financial, an insurer that sold their long-term US gov. bonds and bought munis (higher yield, not taxable) insured by Berkshire Hathaway.
Since 2011, i have 'traded' long-term US government bonds and, earlier this year, have built again a long position (slightly too early it seems). This is based on what is considered fundamental macro work but yes there is an "edgy feeling". The same edgy feeling i get when people play with fire or when the people in charge of putting out the fire are felt (in a contrarian way) to be arsonists.

Benjamin Cole said...


When it comes to macroeconomic soothsaying, I ridicule no one (well, except for blood relatives). Making predictions is hard, especially about the future.

When oil hit $130 back in 2007, I shorted it. It went to $145 and I got murdered.

By some miracle, some industrial land I was all but forced to buy in L.A.(to keep my business operating) was upzoned, and I got rich.

My first wife got most of that, but then I moved to low-cost country, and my new wife seems happy enough. Land values again rose sharply after we bought. I had to buy land to keep her family happy.

It is better to be lucky than smart.

randy said...

Benjamin.. definitely better karma to give luck it's due than to overplay smarts. I'm not much into superstition, but don't want to screw around with karma.

Carl said...

Yes humility required when discussing macro topics. i often say my life is a series of failures with some good spots in between. (more on humility later)

Back to the spirit of the data posted by Mr. Grannis, recently there was Mr. Druckenmiller (a macro guy obviously and a trader at heart so hard to replicate) showing how retail sales had been pushed back up (all of the Covid losses recouped and more ++ suggesting that some of the retail sales may have been pulled from the future (it's borrowed money after all). For now,(he may change his mind any time even radically) his present concern is the excessive amount of easy monetary and fiscal policy (numbers are mind boggling and unprecedented).
A few years ago, i visited Chicago around a conference. We went to the Chicago Federal Reserve and there was some kind of museum there with a retired Fed official conducting the tour. An 'attraction' there was a device (it felt like a flight simulator) and the person (my wife), by pushing some buttons (mainly around the management of interest rates), could 'control' the economy and prevent crashes (some participants did not succeed). The guide was overexuberant with confidence. i left the museum with an edgy feeling and i wonder if top Fed officials should not be more humble? Are they pushing their luck?

McKibbinUSA said...

Scott's posting paints a rather rosy picture of the US economy at this point. My concerns are that the US economy is already in a tailspin leaving the central bank sitting at the controls, albeit with dials and levers that are seized up. My guess is that the US defaulted some time ago on the national debt. Thus, what we are hearing from the Fed is akin to airline stewardesses reassuring we passengers that everything is fine and that we should stay in our seats until we land. Sadly, the staying in our seats may be our only choice at this point. Watch out for your family. I am long cryptocurrencies and precious metals.

Benjamin Cole said...

I often say my life is a series of failures with some good spots in between. (more on humility later)--Carl

Well, many financial bungles and blunders I have made.

But as I look back, my only real regrets are when I was not a nice guy. Probably the only metric that really counts.

randy said...

Uh-oh... the WSJ is stealing Scott Grannis trademarked content:

"The U.S. is barreling toward one of the greatest self-inflicted wounds in its history."

Scott Hammond said...

I am intrigued and confused by 'total federal revenues' in chart #7. Admittedly I don't know how this total is compiled. However, I don't see how it can be explained by 'capital gains tax given a strong market.' True the market has been strong since last years bottom, but presumably the bulk of 'traders' did NOT all buy at the bottom and sell prior to calendar end 2020; which would have needed to happen for such an uptick in revenue (yes- I am ignoring the fact some pay taxes quarterly).

Could a more plausible explanation be unemployment taxes? These flip side of these generous unemployment benefits seems to be appearing in the unemployment tax section business owners are being charged (i.e. tax/cost per employee is up materially). Any thoughts / insights would be welcome.