Wednesday, November 24, 2021

The Fed is too easy, but profits are spectacular

Despite numerous signs that inflation is running well above the Fed's target, the FOMC today showed no signs of panic. Instead, they hinted that the current tapering of Treasury purchases is now likely to be accelerated modestly, and that might bring forward by a few months the first hike in rates (late summer '22?). In my view, a true tightening of monetary policy (i.e., a draining of reserves, a hike in real short-term interest rates, and an inversion of the yield curve) is still far in the future. Meanwhile, corporate profits have set new all-time highs, both nominally and relative to GDP (third quarter profits were released today in the first revision to third quarter GDP numbers). With a profits boom and a gentle Fed as a backdrop, the downside risk to equities of a Fed tightening is minimal and far enough in the future to ignore for now.

Chart #1

Chart #1 tells us that the bond market is not unaware of the fact that inflation is rising. 5-yr inflation expectations (green line) have jumped from 0.2% in March of last year (when deflation and depression fears were rampant) to now 3.07%. The Fed has been telling us they want to see the CPI over 2% for at least a few years, and now the bond market sees the CPI averaging over 3% for the next 5 years. The Fed's inflation-boosting efforts have thus been more than accomplished. If I were running the Fed I'd be pushing for—at the very least—an immediate end to bond purchases. I think they are way too easy at this point.

Chart #2

Chart #2 is a reminder of what true Fed tightening looks like. Every recession in the past 50+ years (with the exception of last year's recession) has been preceded by a sustained tightening of monetary policy which takes the form of high real interest rates (blue line) and a flat or inverted yield curve (red line). Today we have just the opposite. Furthermore, to judge by the level of real short-term interest rates, monetary policy has never been so easy.

Chart #3

Chart #3 shows how Treasury yields tend to track inflation fundamentals. But today, yields are far below the current level of inflation. Yes, yields have jumped from the lows of last year, but they are still far below where they should be given the current level of inflation. I predict the red line will be rising for at least the next few years.

Chart #4

Chart #4 is one of the MOST IMPORTANT charts that the world is apparently still blissfully unaware of today. This is the elephant in the living room; the 800-lb gorilla that nobody sees. Inflation is up beyond all prior expectations because the money supply has exploded in the wake of the Covid lockdowns. By my estimates, there is an extra $4 trillion sitting in bank accounts held by the public, relative to what we would have expected to see in a normal environment. Moreover, M2 has been growing at about a 12% annual rate so far this year, and that is about twice what its growth rate has been over the past several decades.  

Don't just take my word for it: check out John Cochrane's discussion of this issue here. Briefly, he says that the Fed has done a massive "helicopter drop" of money, and that is the source of the inflation that is staring us in the face. It's not transitory, it's going to be with us for awhile, and it is going to be significant. (John Cochrane is one of my favorite economists.) You can read more about this in many of my prior posts.

At some point the Fed is going to have to take major steps to bring money growth back to some semblance of normality, but it's not going to happen soon. Meanwhile, the market seems willing to give the Fed the benefit of the doubt.

Chart #5

Chart #6

Fortunately, there is plenty of good news these days to offset the bad. Chart #5 shows corporate profits compared to nominal GDP. (This measure of profits is the best measure of true economic profits that exists, and it has been consistently calculated in the GDP accounts since the late 1940s.) Both are at all time highs. Chart #6 shows that profits relative to GDP are also at an all-time high.

The economy is growing and corporate profits are on the moon. What's not to like?

Chart #7 

Chart #7 compares corporate profits as calculated in the GDP accounts (red line) and trailing 12-month earnings per share (profits from continuing operations) as calculated by Bloomberg (blue line). Not surprisingly, both tend to track each other over time. But since the red line is a quarterly number, it tends to lead the blue line. This suggests that reported corporate profits are going to be very impressive for the foreseeable future.

Chart #8

Chart #8 is my calculation of a PE ratio for the S&P 500 that uses NIPA profits (the red line in Chart #7) as the E in a standard PE calculation. I've normalized the result so that the long term average of PE ratios for both series are the same. Yes, PE ratios are elevated today, but they are much lower than they were in the "bubble" that formed in the late 1990s. They are also elevated because the market is expecting trailing 12-month earnings to rise over the next year. Relative to forward expectations, today's S&P 500 PE ratio is a relatively modest 21.

That's all for now. My attention now turns to making some of the ingredients for our family Thanksgiving gathering tomorrow; my sister is hosting 36 of us! 


ebg investor said...

Thank you Scott for the optimistic update! Happy Thanksgiving to all friends from Canada.

Benjamin Cole said...

Another excellent Scott Grannis review of the US economy.

And yes, note those present-day corporate profits, best ever---the Reagan days look positively wan compared to now.

My take: the US government needs a huge overhaul (including the military), but America's corporate sector is very well run. That is what competition does for you.

Well, we will see if the 40-year global disinflationary trend is over.

John Cochrane is a great economist and thinker, IMHO.

However, everything Cochrane says about the US is true in spades about Japan, and they have no inflation.

Wishing prosperity to all!

Scott Grannis said...

Benjamin, re Japan: Japan does not have explosive money supply growth and never has had. Check your facts.

Benjamin Cole said...,Billion%20in%20February%20of%201960.

True, Japan's big bulge was in M1 in the last two years was in M1. Eyeballing it, M1 is up nearly 25% since 2020 start of year. M2 not so much. But M1 should be even "hotter" than M2, more spendable.

But my understanding is that John Cochrane is more concerned with fiscal deficits. He talks a lot about the "Fiscal theory of the price level."

Japan is the king of fiscal deficits.

BTW, I am inclined to think the Fed has overdone it also, and I am a fan of a much, much smaller federal government. Much smaller than even the most rock-ribbed Republican would tolerate.

But I like to look around...see what people say.

Scott Grannis said...

Re Japan's M2 money supply. Here are some facts to add to the discussion. Over the past 18 years, Japan's M2 money supply has increased at an annualized rate of about 3%, while US M2 has increased at an annualized rate of a little over 7%. Japan did see a Covid-related acceleration in M2 during the year 2020, but their M2 increased by 9% that year, whereas US M2 increased by 25%. Over the past 12 months, Japan's M2 has increased by about 4%, whereas US M2 has increased by 13%.

Scott Grannis said...

Inflation in Japan vs US: Since the end of 2019, Japan's CPI has registered a net decline of -0.6%, US CPI has registered a net increase of 7.2%. Over the past 18 years, Japan's CPI has registered a net increase of 4.4%, US CPI has registered a net increase of 50%.

In conclusion, I think it's fair to say that Japan's monetary policy has been far more conservative than US monetary policy, by at least an order of magnitude.

Cabodog said...

Another great analysis. Thank you Scott and happy holidays to you and your family.

Benjamin Cole said...


I wave the white flag on M2 and Japan.

But that is not what the every smart John Cochrane talks about.

He is a fan of the "fiscal theory of the price level."

"The fiscal theory of the price level is the idea that government fiscal policy, including debt and taxes present and future, is the primary determinant of the price level or inflation as opposed to monetary theory. FTPL requires confidence the government will not default on its debts, but rather 'inflate away' debts."


Japan has run up fiscal deficits, aka the national debt, to roughly 250% of GDP, while the US is up to 130% or so.

I have asked in the comments section of Cochrane's excellent blog if the Bank of Japan practice of buying back the national debt (about half so far) reduces the public's concern that Japan will default on the debt...but never really gotten a reply.

There is yet another take on monetary policy and supply at an outfit named Divisia.

In a nutshell, Divisia says the definitions of money supply are somewhat arbitrary, and needs refining, due to evolving financial markets.

"In recent decades transaction and liquidity services have been augmented dramatically by the growth of privately supplied unregulated monetary services from bank-supplied credit cards and from the services provided by unregulated shadow banking."


They have an interesting chart showing a big bump in money supply in 2020, but coming back down now.

I have been wondering about Bitcoin, and if it walks likes a duck and quacks like a duck, if it is not a duck. More money supply.

Anyway, happy holidays, and yes we will see some inflation for a couple of years. At least I think so.

Carl said...

^The shadow banking stuff is interesting but i think there is a problem with the interpretation of the bump in money supply.
Shadow banking has become quite large but its funding is in large part dependent on wholesale funding and regulated commercial banks (especially large ones).
In March 2020, the bump in money supply was mostly due to large corporations massively drawing credit lines (creating a loan in a fractional reserve environment). The following explains that well:
Small banks took over some of the money supply support with the PPP program (financed with US public debt...). At that time of stress, most shadow bank participants were under funding stress (limited financing, often facing short-term maturities) and were able to put capital to work (and to reach main street people) only when the Fed reestablished liquidity in wholesale financing (this was an issue also in 2007-8).
The credit card financing may be part of it because main street people may use credit cards as a loan instrument (revolving debt). When a credit card is used, there is a delay between when money is created (merchant) and when the consumer pays back (money retired) and this delay can be lengthened through an aggregate increase in revolving credit card debt. The problem with the credit card story is that, in March 2020, main street people started to delever their credit card revolving balance and evidence shows that they eventually used part of their "stimmies" to do so.
So, numbers show that the evolution of revolving credit card debt after March 2020 and for a few months contributed to a lower (not higher) amount of broad money supply.

i think you should not wave the white flag on M2 in Japan and you may be onto something...

Benjamin Cole said...

Carl--I think I am wrong on Japan, at least as measured by M2.

In any event, if you are married, then you know to wave the white flag is sometimes necessary to remain a member of your household with whom conversations take place.

There may be a case to be made that M2 is no longer the right metric to follow.

Obviously, central banks have become concerned in the last 10 years they no longer "control the money supply," due to non-bank banks, Bitcoin, and who knows what else. International capital flows are yet another question.

For that matter, in Japan there is paper cash in circulation, outside of banks, equal to $8,824 in resident.

"According to a survey done by the Bank of Japan, bank notes and coins circulating among homes and businesses had a value of about 123 trillion yen at the end of 2020--by simple arithmetic, a little less than a million yen per person."


Even in the US, there is $6,700 in paper cash in circulation for every resident.

No one really knows where is all this paper cash, and many say the US dollars are offshore, though without any real evidence, except some anecdotes.

Obviously, in Japan or the US, if people started to spend the huge piles of paper cash out there, there would be a huge surge in demand.

What does this mean?

I don't know. One take-away is that whether M2 is growing too fast or not depends on the propensity to spend, or velocity.

Which is perhaps to say when inflation gets above a target, then M2 is too high.