E-piphany

For the second day in a row, stocks “advanced on the outlook for global recovery.” Considering that we have been told for at least six months that we are already in a global recovery, this seems like an odd reason to rally today, and I suspect this really means that people don’t have any idea why the market went up, other than that it stopped going down.

Such a feeble reason, however, was insufficient to keep prices elevated and to pierce convincingly the recent price range in stocks. Volume was again slack, barely crossing the billion-share mark, and stocks fell back to end the day -0.2%. I am sure that all of those people who rushed to buy the morning gap, expecting apparently that they would never see lower prices again, are delighted that they got in to early.

As mysterious as the rally was, there were no specific causes for the reversal either. Moody’s cut Greece’s debt to junk, but this certainly wasn’t a surprise to anyone. Bonds rallied as stocks fell, but prices had been down so far they just couldn’t recover the close. September 10y Note futures fell 14/32nds on the day with cash 10y yields at 3.26%.

In other news, the latest price tag for the cost of saving Fannie Mae and Freddie Mac is $160bln, with a worst case (probably) of $1 trillion. So, the next time you hear about how the government’s bailouts are actually making money, you might bring this up…

The Barclays inflation conference kicked off today; this tends to produce rather lethargic trading in inflation land but breakevens rose 2-3bps with the general rise in yields.

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Speaking of inflation, or rather deflation, a friend pointed me today to an article posted on the website of the Philly Fed entitled “Monetary Policy In A Liquidity Trap.” It is interesting reading. It explains the classic problem of a liquidity trap: if inflation expectations are negative, then since nominal rates cannot go negative (n.b., in fact they not only can, they have over the last couple of years, but they cannot go deeply negative) it means the Fed is restricted in such a case to a low but positive real interest rate when a negative real interest rate may be called for. In theory, this means the central bank is hamstrung, because “with no opportunity cost for holding money, the public is willing to hold just about any amount of money the central bank supplies” (because if interest rates are zero, you earn the same amount holding cash or a fixed-income instrument).

Therefore, according to the author, there are limits to “quantitative easing.” There are conditions, in theory, under which Helicopter Ben cannot get airborne or, even airborne, dropping money does no good. Therefore, says the author, the Fed needs to credibly raise expectations of what future inflation will be, once the liquidity trap ends.

Like I said, this is an interesting piece, for several reasons. For one thing, it implies that the Fed should actually be telling everyone that they’re going to let inflation get rolling once the current period of disinflationary tendency is done, when in practice they’re doing precisely the opposite and doing everything they can to convince us that they are not going to countenance higher inflation. I believe that they will; that they won’t be able to bear the political heat from hiking rates to restrain inflation when unemployment is at 7%, 8%, or 9%.

However, I think the author is likely wrong on a key point that lies behind the Fed’s (supposed) continued focus on fighting future inflation. The FOMC believes that they can always produce inflation through the printing press, and I agree. The author of the Philadelphia Fed piece implies that the velocity of money in a liquidity trap converges on zero (because if there is any floor to the decline in velocity, then some amount of quantitative easing must increase prices or output or both).  Pointing to Japan and the supposed failure of QE is a bad example, because they didn’t pursue QE for very long or very aggressively. I guarantee that if you increase the money supply tenfold, prices will rise. It is of course less clear that if you increase the money supply a scant 20% it will have any important effect in a liquidity trap situation. The author just has the scale wrong, while the FOMC firmly believes that protracted deflation can only happen if there is a failure of political will that prevents such aggressive action.

This debate probably matters, because we are caught between some disinflationary forces and some strong inflationary ones. In my opinion, the former are ebbing relative to the latter, and inflation is likely to turn higher in late Q3 or early Q4 (although there are a significant amount of moving parts right now, to be sure!). But whether the Fed decides (oddly) to be hawkish in the depths of a huge recession or decides to be dovish and try to protect against a second leg of the crisis is very much a question mark. The variance of potential outcomes favors a conservative investment position.

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On Tuesday, the only economic data due is the Empire Manufacturing index (Consensus: 20.00 from 19.11). I have no opinion on this indicator and doubt it provokes a market response unless it is quite weak.