Giving the Kremlinologists Something to Do
As is well known by now, on Wednesday the US central monetary planning bureau finally went through with its threat to hike the target range for overnight bank lending rates from nothing to almost nothing.
Photo credit: Luca Brenta
The very next day, the effective federal funds rate had increased from 15 to 37 basis points – moreover, as illustrated by the trend in short term rates prior to the FOMC meeting, the markets had already fully anticipated the rate hike:
US 3-month t-bill discount rate and the one year t-note yield: between the October and December FOMC meetings, the markets fully discounted the impending rate hike. Once again we can see that there is actually a feedback loop between the Fed and the markets, and that it is not true that the Fed has absolutely no control over interest rates (even though the degree of its control is limited) – click to enlarge.
Of course, some markets still managed to act surprised (and/or confused), most prominently the US stock market, which is traditionally the very last market to get the memo, regardless of what is at issue. This is why asset bubbles so often end in crashes – market participants tend to very “suddenly” realize that something is amiss.
This time, the trusty WSJ FOMC statement tracker reveals that the planners have given us Kremlinologists something to do, by changing the statement’s content quite a bit. By contrast to the previous carbon copy approach, it tells a completely new story. Well, almost.
Between the October and the December meetings, the minds of the committee members have evidently experienced a great epiphany. Suddenly they have realized that the economy is indeed just awesome. This part of the statement can be safely ignored. As anyone who hasn’t spent the past century in a coma should know by now, the economic forecasts of housewives are a great deal more reliable than those of the Fed. Unfortunately the statement didn’t include the housewives’ forecast, but we can infer from Gallup’s US economic confidence index that they are probably on a slightly different page right now.
US economic confidence as expressed by people living outside of the ivory tower: in steady decline since late 2014 and firmly stuck in negative territory.
Data-dependent as they profess themselves to be, the planners appear to have neglected taking too close a look at most of the economic data that have actually been released recently – even those their own models are calculating. More on this further below.
What is most important is what they are actually up to. One decision that was easily foreseeable was this one:
“The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.”
This is no surprise because any attempt to actually shrink the Fed’s balance sheet permanently would crash the money supply. The deposit money created in the course of “QE” would disappear again whence it has come, namely into thin air.
Naturally, a lot of ink was spilled again on the planners’ absurd desire to debase the value of the currency by precisely two percent per year. This is so moronic in so many ways one is almost at a loss for words (David Stockman has just offered a trenchant evisceration of the Fed’s attempts to “steer” the economy, which is well worth the read). Here is a brief quote from his article:
In fact, Yellen’s tinker toy model [of the economy, ed.] is so deficient as to confirm that she and her posse are essentially flying blind. That alone should give investors pause – especially because Yellen confessed explicitly that “monetary policy is an exercise in forecasting”.
Accordingly, her answers were riddled with ritualistic reminders about all the dashboards, incoming data and economic system telemetry that the Fed is vigilantly monitoring. But all that minding of everybody else’s business is not a virtue—-its proof that Yellen is the ultimate Keynesian catechumen.”
What interests us here most is however the timing of this rate hike decision and its possible effects on the money supply – and with it, the economy. All in all, it may be not have much practical effect – as the economy has already decided to turn down on its own.
US Money Supply and the Economy
As we have previously pointed out, it is quite amazing that the credit cycle seems to have entered its initial collapse phase already before the Fed has hiked its administered rates even once. As a reminder, C&I charge-offs and delinquencies have begun to surge in what is usually a clear recession warning, while junk bonds and leveraged loans are similarly in great trouble.
Recently we could observe a noticeable decline in the annualized rate of US money supply growth as well, however, as the next chart shows, this decline was partially reversed in November. In order to ensure that its rate hike “sticks”, the Fed has raised interest it pays on bank reserves to 50 basis points (removing the incentive for banks to attempt to lend their excess reserves and flood the federal funds market with offers) and has begun to implement a fairly sizable amount of reverse repos to temporarily remove liquidity from the markets.
Per experience, these reverse repos won’t influence the monthly money supply data much, but we believe they do impinge on financial market liquidity to some extent. In other words, it will become even more difficult to keep all the asset bubble balls in the air.
In short, the stock market may become a little less fun – and currently it isn’t much fun to begin with, as only a small handful of stocks is holding up the whole shebang. With around 70% of listed stocks trading below their 200-day moving average, it actually requires quite a leap of the imagination by now to still call it a bull market. The average diversified portfolio is unlikely to inspire much bullish enthusiasm at this stage.
Let us take a closer look at the brief spike in money supply growth in November:
This spike has brought the annualized growth rate of TMS-2 back to 7.93% from 6.8% in October:
Looking at the components, we notice that currency and various forms of deposit money grew at their by now “normal” pace of between 7.3% to 8%, which incidentally represents the true pace of inflation. Rising consumer prices are just one of the many effects of inflation, and by no means the most pernicious one.
However, the main culprit of the surge was a sharp increase in the US Treasury’s general account at the Fed, which grew at an annualized pace of more than 210% to a total of more than $200 billion in the month:
This is indeed money – it is functionally no different from money the Treasury holds in deposits with commercial banks. There are three ways in which the domestic US money supply can increase: either new money is created ex nihilo by 1. the Fed or 2. commercial banks, or 3. dollars held in accounts abroad are deposited in the US. The source of additional money isn’t really relevant, as its economic effects are going to play out regardless of where it came from. However, depending on who gets his mitts on new money first, these effects will either mainly be reflected in asset prices, capital investment or consumption.
Since spikes and subsequent declines in the Treasury’s general account at the Fed have become a regular occurrences since the GFC, it seems unlikely that the overarching trend in money supply growth will actually change because of such a spike. We believe therefore that the recent trend toward a slowdown in money supply growth has merely been interrupted, and is likely to resume.
This brings us to the bubble economy. In the meantime gross output data have been updated until the end of Q2 – and as we suspected, the trends that were already clearly visible in Q1 have continued. If the economy is a dog, then this dog isn’t going to hunt:
The most recent updates on industrial production and the latest Fed district surveys confirm that the downtrends seen above are continuing apace. Here is an overview of recent data points by Mish: Industrial production craters by most in 3.5 years (down 8 months of the past 10), Philly Fed back in contraction, Kansas City manufaturing back in contraction (with a “severe contraction” in employment), massive collapse in truck shipments.
You get the drift: the part of the economy that is actually responsible for 40% of all economic output (not the 12% reported in the extremely flawed GDP measure) is in terrible shape and it still isn’t getting any better.
From the perspective of the planners themselves, the timing of the rate hike therefore strikes us as rather odd, even though the hike is of little practical significance. However, as David Stockman has pointed out, the merry pranksters at the Fed are essentially slaves of the Keynesian paradigm of the 1960s (this is especially true of Ms. Yellen herself).
Roger Garrison, ever the gentleman, refers to the Keynesian model as “labor-based macroeconomics” (see his book “Time and Money” – pdf for details). We are usually less gentlemanly and tend to refer to it as “utter bunkum”. However, Mr. Garrison is not wrong – Keynes and his disciples are uniquely focused on employment, and there is one major trick in their book: inflate and inflate and inflate, so as to lower the real wages of workers. It is held that this will create “full employment” and won’t be resisted as much by workers as the nominal wage adjustments one might expect a free market to deliver when a bust plays out.
This view should have been thoroughly discredited by the events of the 1970s, but as you can see, the planners haven’t really learned anything from that episode – except for coming to the (almost certainly wrong) conclusion that they will be capable to “stop inflation at any time”.
What they don’t mention: the reason why we have such huge boom-bust cycles is precisely that they are inflating all the time. Prior to the Fed implementing its “scientific” monetary policy (which is really “intervention based on the atrociously bad guesses of some of the worst forecasters on the planet”), economic busts were actually more frequent. Fractionally reserved banks tended to bring credit expansions to an end much sooner voluntarily without a “lender of last resort” backstopping them all the way.
The overall long term effect was one of remarkable economic stability. Although credit expansion by private banks still engendered boom-bust cycles, these were far milder and usually self-corrected quite quickly. It took the Federal Reserve to produce events like the Great Depression and the Great Financial Crisis. No dislocations of similar impact had ever been encountered before it was decided that we needed central economic planning and the “stabilizers” took over.
Here is a chart we have shown in a recent Bill Bonner missive that illustrates the above nicely – namely the Dow-gold ratio:
The rate hike was indeed mainly implemented due to the decline in the official U3 unemployment rate. The Fed’s mandate enjoins it to produce “maximum employment” and “price stability”. Never mind that unemployment really stands around 10% if one counts all the people that have simply fallen out of the statistics (they are represented in the U6 unemployment rate). They certainly have no work, but are nevertheless officially no longer regarded as “unemployed”.
With respect to price indexes, FOMC participants are likely correct in suspecting that they are going to show faster growth rates next year due to base effects. What they apparently don’t see – but will find out soon enough – is that once a major long term bubble bursts, the economy gets zombified if its attempt to correct is arrested by even more intervention.
This phenomenon could be observed in Japan over the past 26 years. Instead of taking the short term pain and allowing all malinvested capital to be liquidated, Japan’s policymakers decided to deficit spend and print out the wazoo – precisely what has been done in he US in the wake of the 2008 crisis. By trying to reverse corrective market processes, they have ultimately produced the so-called “lost decades”.
Since the playbook of monetary authorities has in essence been the same since Irving Fisher first came up with the disastrous “price stabilization” idea, we must expect that little will change. As soon as asset prices decline sufficiently and recent economic weakness intensifies further, it will be back to square one.
Lastly, we are not saying that things will play out exactly in the US as they have in Japan. There are many things that suggest that the situation will develop differently, at least to some extent. The common denominator is only this: central planning and unrestrained fiat money have created such a huge credit boom that the economy’s pool of real funding has come been severely undermined.
Once this happens, it is no longer even possible to create the faux prosperity of a boom to a similar extent as previously by simply printing money. As soon as monetary pumping slows down sufficiently, the bust will tend to return with a vengeance. We strongly suspect that Ms. Yellen and her colleagues will learn this part of the lesson next. Or let us rather say: they aren’t going to learn anything from it – but they will undoubtedly face another “no-one could have seen it coming” scenario. We can’t wait to see what their encore will be when that happens.
Charts by: StockCharts, St. Louis Federal Reserve Research, Sharelynx