Tracking the decline in risk aversion

For most of the past five years I've argued that one of the dominant features of this recovery was risk aversion. The Great Recession so scared and shocked the world that risk aversion became exceptionally high. I've also argued that the main purpose of the Fed's QE program was to supply a very risk averse world with safe securities, by essentially converting ("transmogrifying") notes and bonds into T-bill equivalents (aka bank reserves). The point of QE was not to stimulate the economy, as many have argued, but to accommodate the world's intense demand for safe assets. We can be reasonably sure of this by observing that, despite a massive increase in bank reserves, there has been no excess supply of money, and we know that because inflation has been relatively low and stable and the dollar has also been stable (and is even increasing of late). In short, the Fed's injection of reserves was sufficient to satisfy the world's demand for reserves.

But since early last year things have been changing on the margin. Risk aversion is still to be found (e.g., huge increases in bank savings deposits, zero yields on 3-mo. T-bills), but it is declining. Confidence, the flip side of risk aversion, is slowly rebuilding, but it is still relatively low.

The graph above speaks directly to the existence of declining risk aversion. It shows the price of gold and the inverse of the real yield on 5-yr TIPS (a proxy for the price of TIPS). Both gold and TIPS are refuges for those who worry about inflation and end-of-the-world scenarios, so their prices reflect the intensity of the world's demand for safety. Gold prices maxed out at $1900/oz. a few years ago, which was roughly triple the average inflation-adjusted value of gold over the past century (now THAT's what I call paying a premium). TIPS prices maxed out at a negative real yield of almost 2% early last year, which meant that investors were willing to give up almost 2% of their annual purchasing power in order to capture the U.S. government-guaranteed, inflation-hedging properties of TIPS. In short, people were paying ridiculous prices to minimize risk. But that's changing.

Now it looks like TIPS real yields are on the verge of turning positive, and gold prices are on the verge of making multi-year lows. If gold breaks below $1200 and heads for $1000, and if real yields on 5-yr TIPS break above zero, those would both be signs of a significant decline in risk aversion. They would still be expensive, of course, but a lot less so.

As risk aversion recedes, then the need for QE also recedes. The Fed is on track to finish QE3 late next month, so as far as the market is concerned, QE3 is done. And the sky has not fallen, because the world no longer needs tons of new T-bill equivalents. That's good.

But declining risk aversion poses a risk to the Fed's promise that it will keep short-term interest rates exceptionally low until well into next year and even beyond. If the Fed is slow to react to a significant decline in risk aversion, the result will be higher-than-expected inflation. That's because declining risk aversion will be replaced by a rising appetite for risk. And that will mean a greater demand for loans, and it will mean that banks will be more willing to lend.

With banks today sitting on more than $2.6 trillion of excess reserves, there is effectively no limit to how much they can increase their lending. As the first of the graphs above shows, bank lending tends to track the growth of M2 over time, so a big increase in lending would likely translate into a big increase in the money supply. To date, the M2 money supply and total bank credit have been growing at just over 6% per year for the past 20 years, and that's coincided with moderate economic growth and relatively low inflation. A big increase in money lending from banks at a time when the world doesn't particularly want to hold extra money could give us a lot more inflation (and maybe a bit more growth). As the third graph shows, bank credit growth has already picked up this year after being very sluggish since 2008, so that's another sign of declining risk aversion and rising risk appetite.

Since it would take extraordinary measures to reverse its gigantic balance sheet in a relatively short time frame, the only practical way for the Fed to avoid a significant and unwanted increase in the money supply is to increase the interest it pays on reserves by enough to make banks content to continue to hold the already-massive amount of excess reserves. If risk aversion continues to decline, the Fed is going to have to accelerate its plan to raise short-term interest rates, or risk an unwanted—and potentially huge—increase in inflation.

This is not a call for hyperinflation. But I think we are getting closer to the day when the Fed starts falling behind the inflation curve, and that could prove to be very unsettling. This all bears watching very closely. Keep an eye on real yields, gold prices, and bank lending.

The August jobs report changes nothing

The month-to-month volatility of the jobs numbers, and the magnitude of their eventual revisions, make it nearly impossible to draw new conclusions from a one-month hit or miss relative to expectations. The fact that new private sector jobs increased 134K in August, well under expectations of 198K, is therefore not indicative of any sudden deterioration in the jobs market or the jobs outlook. As the following graphs show, all of the recent trends in the labor market remain unchanged.

The August drop in private sector job creation falls well within the normal range of this series on a month-to-month basis. Job growth by this measure is still averaging just under 200K per month, as it has for the past several years.

The six-month annualized growth rate of private sector jobs is still just a bit above 2%, the same rate we have seen since early 2011.

Total private sector jobs are making new highs, and have increased by over 8 million in the past five years. Public sector jobs are no longer declining, and are now growing very slowly.

The labor force is still growing at a miserably slow rate.

Part-time employment is still relatively flat, and is still declining slowly relative to total employment. This is the same pattern we have seen in nearly ever recovery in the past 50 years.

Conclusions: The economy is likely still growing at a 2-3% pace. It's still a very sub-par recovery. There is no sign of a recession or a boom. Things are not likely to change materially unless and until we get some improvement in fiscal policies (e.g., reduced regulatory burdens, lower and flatter marginal tax rates).

Now the service sector also looks strong

The U.S. economy is firing on all cylinders these days, to judge from the August ISM surveys. On Tuesday we learned of surprising strength in the manufacturing sector. Today came surprising strength in the service sector. As the graph above shows, the ISM survey uncovered the strongest level of business activity in the service sector in nine years.

The employment index, an indication of hiring plans and a good proxy for business' confidence in the future, reached an eight year high.

The overall service sector index reached a nine year high, and was by far the strongest recorded in the current expansion. Compared to the lackluster service in the Eurozone economy, the U.S. is practically booming.

Current and future indicators of the general health of the service and manufacturing sectors are all encouraging. But to date we haven't seen any meaningful pickup in hiring activity. Businesses may be feeling better about how things are going, but they haven't yet been willing to step up the pace of what has been to date rather lackluster investment. Today's ADP employment report (see graph above) suggests that tomorrow's payroll employment report is likely to show more of the same: growth in private sector jobs of slightly more than 200K per month, or thereabouts. Jobs growth of 300-400K a month is what we'd really like to see, but 200K is no reason to be pessimistic.

Meanwhile, big corporate layoffs have become almost a thing of the past, and weekly claims for unemployment are about as low as they have ever been. Businesses may not have stepped up their hiring activity, but it's been years since they resorted to any significant layoffs. I think this suggests that the economy is on pretty solid ground these days. Nobody is overextended, everyone has tightened their belts, and profits are rolling in by the bushel.

If there is a surprise around the corner, it's more likely to be on the upside than on the downside—more growth, rather than less.

Yet the myth of deflationary threats to growth persists. Just today the WSJ sent me the following alert: "The European Central Bank unexpectedly lowered all its interest rates to fresh record lows ...  in an effort to keep ultralow inflation rates from undermining the eurozone's fragile recovery."

Why should low inflation be a threat to growth? This is one of those myths that has been repeated so often that most people now assume it must be true. Sometimes prices need to fall in order for markets to clear; sometimes businesses need to fail in order for their assets to be redeployed by someone else.  Why should lower interest rates be a stimulus to growth? Just because central banks keep repeating that they do doesn't make it true.

Monetary policy is not holding back growth, and lower interest rates won't change that reality. Banks already have trillions of excess reserves: a few more or less is not going to change their willingness to lend, or business' willingness to borrow. It's time for better fiscal policies. Governments need to get out of the way by lowering regulatory burdens and marginal tax rates, and by eliminating subsidies.