E-piphany

What a great world we live in, where all assets rally but in sequence rather than in parallel! Yesterday, it was stocks soaring while bonds were quiet. Today, it was bonds soaring while stocks drifted. As before, the source of the rally is a bit of a head-scratcher; and, as before, it doesn’t matter much once Friday’s data (or tomorrow’s ADP preview of that data, if it is significantly different from expectations) prints. Bonds perhaps had the excuse (not available to equities) of being a trifle oversold. And bond traders were no doubt heartened by a Beckner piece citing various Fed officials musing about potentially continuing the MBS purchase program beyond its scheduled lapse in March. But it tends to be dangerous to play for big bull moves in fixed income in the early part of the year…so I am wary.

***

A brief opinion paper from the St. Louis Fed (in the “Economic Synopses” series, 2009, Number 47), entitled “The Case for ‘Inflation First’ Monetary Policy, was published in mid-December. It went largely unnoticed, as is appropriate in most cases since the author is not a policymaker per se but merely representing his opinion.

However, in the context of the current debate over monetary policy, it is always useful to get a glimpse of the arguments of one side or the other to try and evaluate how compelling they are. Although this paper (available here) is only a page and a half, and perhaps because it is only a page and a half, it is worth reading.

The author argues that there are several reasons that central banks might want to operate under a “hierarchical mandate,” in which price stability is to be achieved before economic stability is attempted.

The first of these is that (as asserted by the author on the basis of one paper and the ambiguity of theory on the subject) money supply changes do not affect the real growth rate of the economy in the long run. Let’s concede that we are not sure.

More importantly, he observes that often monetary policy that is intended to stabilize the economy can destabilize prices. It is of course well-known that, say, easing monetary policy might help growth while goosing inflation, since MV≡PQ. The lever that pushes up real output (Q) is an increase in the money supply, which also tends to increase P (the price level). That is, the division of the effect of an increase in the money supply on the price level and output level is indeterminate…they might even, in some circumstances, have opposite signs…but tend to be similar in practice. This is not a problem if there is a demand shock, in which both prices and output are pressured lower, but becomes a real dilemma when a supply shock pressures prices higher while output is pressured lower.

This is a well-known dilemma, of course, and this is an important reason that a “hierarchical mandate” might be useful: it states clearly which effect the Fed is supposed to combat. In the case of a supply shock, dampening the swings in prices will tend to enhance the swings in output. The author cites Bernanke saying there is a long-run tradeoff of volatility in prices for volatility in output based on this observation. Again, from the crude quantity theory it’s hard to argue otherwise, although this doesn’t argue for stabilizing one over the other.

But the final point the author makes is this: “…policymakers might prefer a hierarchical mandate because the more firmly anchored are inflation expectations, the more aggressively policymakers will be able to pursue economic stability.”

Why is it a matter of faith in policymaker circles that “well-anchored inflation expectations” will anchor inflation actually experienced? This would be true if inflation was mostly a behavioral phenomenon: shopkeepers raise prices because they think their customers are expecting it. But I am not aware of any evidence that that’s how it actually works. More likely is that retailers tend to employ some sort of “cost-plus” approach, where changes in the costs of their inputs are reflected to some degree (based on the elasticity of supply and demand, and other things) in the prices they charge their end customers. That’s exactly the opposite causality: price increases respond to previous price increases, and somewhere back there prices rose because auction goods were bid up because too much money chased too few goods. No expectations are required at all to get that inflation started.

This strikes me as a theory that seems to sound very plausible but is very difficult to support with actual data. So too, as a result, is the author’s conclusion: “…policymakers…should think of price stability and economic stability as complements – the best way to achieve the latter is to be firmly committed to the former.” That is exactly the opposite of his previous observation, that achieving price stability puts all the economic volatility into real growth, and that observation made some sense.

How about this: maybe policymakers should avoid doing much of anything in response to supply shocks, until they figure out how the heck this all works?

The old saw goes “buy at the sound of cannons; sell at the sound of trumpets.” But I don’t know how that adage applies in a situation such as this, when the sound of cannons is being provided by the market itself.

A spectacular start to the new year in the equity world was all the more remarkable because it did not coincide with a selloff in the bond market. March TNote futures were actually up a couple of ticks, which isn’t exactly a ringing endorsement of the sense of economic healing that (according to news outlets) was the underpinning for the New Decade Salvo.

I don’t think it was due to Bernanke’s mea-non-culpa this weekend. Speaking of which, I think there is reasonable cause to argue that low rates didn’t cause the housing bubble, but Bernanke didn’t get the cause right and, anyway, I don’t trust any economist who thinks that more regulation is the answer.

I am pretty sure it wasn’t the spectacular performance recently by the TSA in keeping our skies and airports safe (see the earlier story about Newark Liberty Airport, and of course the briefs bomber…hey, is that an explosive device in your pants or are you just glad to see me?).

Although, come to think of it, maybe the boom-boom boxers episode has something to do with this – there was a period, about six months after 9/11, and after the anthrax attacks, when every rumor of terrorism was met with a market rally because traders had become conditioned. You see, every time there was a rumor in the early days after 9/11, the market plunged, and then when said rumor turned out to be false the market rallied hard as the sellers had to buy their sales back. The ensuing rally usually more-than-erased the selloff. As time went on, the dips got shorter and the rallies harder, until finally – I remember writing about this at the time – the market would immediately spike when a rumor hit the tape. Pavlov strikes again!

So perhaps we’ve just taken this to the logical next step to where an actual security breach is met with a market rally?

Also on the list of things-that-probably-didn’t-cause-the-rally was the prediction by Shiller and Case that default rates on prime mortgages will accelerate this year. This isn’t a very hard call, because defaults have a lot of momentum and a significant lag to economic conditions, but it gets more attention when Case and Shiller talk about it. Not enough attention, perhaps.

Whatever the reason, I suppose the more important point is that one day does not a market year make; trading on Monday through Thursday may be rendered moot if Friday’s Employment data is weak.

Okay, maybe this isn’t the easiest job in the world, but it surely is in the top decile. You sit in a chair all day, and your task is to make sure that people only pass you in one direction. If someone passes you going the other direction, you ask them to stop and go back the other way. In the worst case, you call a bunch of your buddies to stop that person.

Here is the story of the security breach yesterday at Newark’s Liberty Airport. Seems like someone on the TSA was taking “Liberty Airport” as a descriptive term rather than as a business name.

I just want to point out that these are the folks we are asking to handle our health care.