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Fama on the Fed and Inflation
I don’t agree with Eugene Fama on everything, but I’d be a fool if I didn’t agree with him on quite a bit. Fama wrote the paper which, back in the early 1980s, pointed out that if you modeled inflation as a result of monetary factors and Keynesian factors (unemployment, e.g.), the Keynesian factors didn’t add anything. Since then, economists have pretty much forgotten that lesson, so that we have to continually battle the Keynesian “let’s just expand government spending” crowd.
Many of his views about efficient markets are pretty extreme, and that’s where I can’t agree wholeheartedly. However, I read with interest the discussion between Fama and Bob Litterman in this month’s issue of the Financial Analysts Journal. The full interview, called “An Experienced View on Markets and Investing,” is located here, and since the FAJ has made the entire interview available for free I am going to quote liberally from the last page. Indeed, I am going to print three of the last four questions, because they correlate exactly to things I have written in this space, and echo almost exactly the views I have expressed. Considering Fama is one of the godfathers of modern finance, I take this as indication I am on the right track, at least sometimes.
In the passages below, I have added all the emphasis marks.
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Litterman: What impact will the big expansion in the Federal Reserve’s balance sheet have on the markets?
Fama: It has basically rendered the Fed powerless to control inflation. In 2008, when Lehman Brothers collapsed, the Fed wanted to get the markets moving and made massive purchases of securities. The corollary to that activity, however, is that reserves issued by the Fed and held by banks exploded. An explosion in reserves causes an explosion in the price level unless interest is paid on the reserves. So, the Fed started to pay interest on its reserves, which means that the central bank issued bonds to buy bonds. I think it’s a largely neutral activity.
Before 2008, controlling inflation was a matter of controlling the monetary base (currency plus reserves). But when the central bank pays interest on its reserves, it is the currency supply that determines inflation. But banks can exchange currency for reserves on demand, which means the Fed cannot control the currency supply and inflation, or the price level, is out of its control. The Fed had the power to control inflation, but I don’t think it does under the current scenario.
[Ashton’s note: Fama identifies why the monetary base is no longer tied to inflation – the link to transactional money has been severed thanks to IOER. See some of my remarks on this here.]
Litterman: But isn’t one way out of our debt problem to inflate it away?
Fama: Yes, that’s one way to handle it, but it’s far from a great solution. If the Fed were to stop paying interest on its reserves, we’d probably have a big inflation problem. The monetary base was about $150 billion before the Fed stepped in in 2008. Currency plus required reserves are still in that neighborhood, but the Fed is holding $2.5 trillion—trillion!—worth of debt financed almost entirely by excess reserves. The price level could expand by the ratio of those two numbers, and that translates into hyperinflation. Economies typically do not function well in hyperinflation. The real value of the government debt might disappear, but the economy is likely to disappear with it.
Litterman: What would your suggestion be for monetary or fiscal policy at this point?
Fama: Simple. Balance the budget. I heard a very prominent person say in private that we could balance the budget by going back to the level of government expenditures in 2007. The economy is currently about the size it was then. If you just rolled expenditures back to that point, I think it would come close to balancing the budget.
[Ashton’s note – just this month, I commented that all you have to do to get the budget back into a semblance of balance was to reverse most of the things that were done over the last decade.]
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The whole FAJ article is pretty good, but I wanted to make sure that everyone caught this part of it!
The End-of-Year Downshift Is Beginning
With the last major central bank meeting of the year (the Federal Reserve’s) due on Wednesday, and few important pieces of data ahead aside from Friday’s CPI, markets seem to be starting the inevitable downshift into the end-of-year holidays. Admittedly, it is somewhat hard to tell. It looks like aggregate equity volume in 2012 will be down a stunning 28% or so from 2011 (see chart below, source Bloomberg). This continues a recent trend, but accelerates it as well.
I’ve discussed in these articles in the past the possible causes of this seemingly-secular decline. I believe that there are at least two causes. One is not particularly worrisome; there was probably already a trend in place for volume to move off of organized exchanges to “dark pools” and the like. But the recent drop in volumes seems more likely to be caused by recent events, and judging from anecdotal evidence I’ve seen – namely, that market-makers are reducing the scale of their operations across almost all products because of the regulatory difficulties of maintaining those operations – a big part of the recent decline is likely to be attributable to the gradual implementation of Dodd-Frank and the Volcker Rule. This is something less than shocking. What hasn’t yet happened, but I suspect may, is that asset prices themselves decline if liquidity is meaningfully impacted by declining volumes. For any given asset, the fair price is a direct function of liquidity (as well as many other things, of course), which is why there is such a thing as a ‘liquidity discount’ enshrined even in tax law. The decline in liquidity itself is probably non-linear (since market-makers will be less aggressive as they perceive other market-makers being less aggressive), and therefore the decline in asset values is likely non-linear as well.
Not to mention being totally unpredictable as to timing, I might add. But there is something to the old rule of technical analysis rule that markets can go down on big volume, but they can’t typically go up for an extended period on low volume.
Global political events haven’t yet left town for the holidays. Italian Prime Minister Mario Monti announced on Saturday that he plans to resign after former Prime Minister Berlusconi withdrew his support. 10-year Italian yields jumped 30bps to 4.81%, but remain considerably below the levels associated with any serious concern about Italy (see chart, source Bloomberg).
Across the Ionian Sea, Greece extended the original deadline for its debt buyback by two days, signaling that it hasn’t reached its target. According to reports, the government has received tenders for €26bln (in face amount) versus its target of €30bln. However, the important number is the difference between the face amount of the debt offered compared to the price paid by the government. That number needs to get to €20bln, and there is no way to know if the government is close. If they have overpaid relative to the 33 cents on the dollar they were expecting to pay, and have spent, say, €10bln to get those €26bln in tenders, then they’re not really all that close. If they have spent €7bln, then they’re very close and I would guess close enough. I’m not sure we know.
In the U.S., no apparent progress has been made on the fiscal cliff.
But here’s a little story that caught my eye. “NYC Base Subway Fare May Rise to $2.50, Board Members Say.” I only point it out because the 11% hike in base fares seems out-of-place with a weak economy…if, that is, you think that economic growth causes inflation. Personally, I don’t believe in that old, discredited notion, but some people do.
Looking forward over the balance of the month, I don’t expect that we will see a Santa Claus rally in equities. Although we got such a rally in 2010 (+6.5% in the S&P 500), and smaller ones in 2009 (+2.8%) and 2011 (+0.9%), there seems to me to be too much uncertainty for investors to make significant bets into the end of the year. The outcome in December is likely to be decided by a coin flip – if the fiscal cliff is resolved, then equity markets will rally (and that rally probably should be sold, since the underlying fundamentals are still very poor); if the fiscal cliff is not resolved, stocks will slide into the end of the year (and that selloff is probably worth buying, if it’s deep enough, since there’s a reasonable chance that the issues are resolved after both sides realize the other side isn’t going to blink). I’m not sure that’s a market I want to have a strong commitment to right now, in either direction.
