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They Came to Play
I am generally reluctant to call anything a “game changer,” because in a complex global economy with intricately interdependent markets it takes something truly special to change everything. However, I am tempted to attach that appellation to the ECB’s historic action this morning. It probably does not “change the game” per se, but it is very significant.
Feeble money growth in the Eurozone has been a big concern of mine for a while (and I mentioned it as recently as Monday). In our Quarterly Inflation Outlook back in February, we wrote:
“The new best candidate for having a lost decade, now, becomes Europe, as it sports the lowest M2 growth among major economic blocs… It frankly is shocking to us that money supply growth has been so weak and the central bank so lethargic towards this fact even with Draghi at the controls. It was generally thought that Draghi’s election posed a great risk to price stability in Europe… but in the other direction from what the Eurozone is now confronting. There have been murmurings about the possibility of the ECB instituting negative deposit rates and other aggressive stimulations of the money supply, but in the meantime money growth is slipping to well below where it needs to be to stabilize prices. Europe, in our view, is the biggest counterweight to global inflationary dynamics, which is good for the world but bad for Europe.”
All of that changed, in one fell swoop, today. The ECB’s actions were unprecedented, and largely unexpected. First, and somewhat expected, was the body’s decision to implement a negative deposit rate for bank reserves held at the ECB. This is akin to the Fed incorporating a negative rate for Interest on Excess Reserves (IOER). What it does is to actually penalize banks for holding excess reserves.
There are two ways for a bank to shed excess reserves. The first way is to sell the reserves to another bank in the interbank market. This doesn’t change anything about the aggregate amount of excess reserves; it just moves those reserves around. In the process, it will push market interest rates negative (since a bank should be willing to take any interest rate that is less negative than what the ECB is charging) and probably increase retail banking fees at the margin (since there is otherwise no way to charge depositors a negative rate). This will weaken banks, but doesn’t increase money growth. The second way a bank can shed excess reserves is to lend money, which increases the reserves it is required to hold and therefore changes the reserves from excess to required. A bank is incentivized to make marginally riskier loans (which lowers its margins due to increased credit losses) because there is a small advantage to using up “expensive” reserves. This also will weaken banks. But, more importantly, it will stimulate money growth and that is what the ECB is aiming for.
If that was all the ECB had done, though, it would not be terribly significant. The utilization of the ECB’s deposit facility is only about €29bln at this writing, which is already near the lowest level since the crisis began (see chart, source Bloomberg).
But the ECB did not stop there. At the press conference after the formal announcement, Draghi unveiled a package of €400bln in “targeted” LTRO, which means that if banks lend the money they acquire through the LTRO then the term of the loan is four years; otherwise it must be paid back in two years.[1] Even more important, the central bank suspended the sterilization of LTRO. “Sterilization” is when the bank soaks up the reserves created by the LTRO. As long as the ECB was sterilizing its quantitative easing, it could not have any impact. It is similar, but more extreme, to what the Fed did in instituting IOER to restrain banks from actually using the reserves created by QE. It never made much sense, but in the ECB’s case there was evidently some concern that doing QE without sterilization was not permitted under the institution’s charter.
Apparently, those concerns have been resolved. But QE without sterilization is meaningful. The ECB is thus not only doing quantitative easing, but is actively taking steps to make sure that the liquidity being added to the system is flushed, rather than leaked, into the transactional money supply.
If the ECB actually follows through on these pledges, then we can expect a rapid turn-around in the region’s money growth, and before long a turn higher in the region’s inflation readings. And, perhaps, not merely for the region: the chart below (source: Bloomberg, Enduring Investments) shows the correlation between core CPI in the US and the average increase in US and Eurozone M2. Currently US M2 is growing at better than 7% over the last year, while Eurozone M2 is 1.9%. Increasing the pace of M2 growth in Europe might well help push US inflation higher – not that it needed any help, as it is already swinging higher.
The renewed determination of the ECB to push prices higher should as a result be good not only for European inflation swaps (10-year inflation swaps were up 2-3bps today, but have a long way to go before they are back to normal levels – see chart, source Bloomberg), but also for US inflation swaps (which were up 1-2bps today).
Finally, if it is true that central bank generosity is what has been underpinning global asset markets, an aggressive ECB might give a bit more life to global equities. Perhaps one more leg. But then again, perhaps not – and when the piper’s tune is over, it could be brutal. It is currently quite dangerous to be dancing to that piper. For my money, I’d rather be long breakevens.
[1] This is interesting for lots of reasons, but one of them is that the ECB will measure (if I understand correctly) the net lending of the institution, so if that contracts then the loan will be called. But there are lots of reasons for an institution to decrease lending. Some of them, such as a generally weak economic environment or a weak balance sheet of the bank, would be exacerbated by an unwelcome “call” of the loan by the ECB. In the former case it would exacerbate a weak economic situation; in the latter it could accelerate a bank collapse. I may not understand the conditions for the call, but if my understanding is correct then this is a curious wrinkle.
Worried About Not Being Worried
I am beginning to worry about my own complacency. As a person who has been a participant in the fixed-income markets for a long time, I have become quite naturally a very cautious investor. Such caution is a quintessentially fixed-income mindset (although you might not guess that from the way bond people behaved in the run-up to the global financial crisis) – as a bond investor, you are essentially in the position of someone who is short options: taking in small amounts on a regular basis, with an occasional large loss when the credit defaults. A bond investor can greatly improve his performance in the long run relative to an index by merely avoiding the blow-ups. Miss the Enron moment, and you pick up a lot of relative performance. (The same is true of equities, but there is much more upside to being an optimist. The stock market selects for optimists, the bond market for pessimists.)
This is a lesson that many high-yield investors today, chasing near-term carry, seem to have forgotten. But my purpose here isn’t to bash those involved in the global reach for yield. I am merely pointing out that this is how I tend to think. I am always looking for the next disaster that hangs a portfolio with a big negative number. As Prince Humperdinck said in The Princess Bride, “I always think everything could be a trap – which is why I’m still alive.”
And I am starting to worry about my own complacency. I don’t get the feeling that we’re gearing up for Round 2 of the global financial crisis. Something bad, perhaps, but not catastrophic.
To be sure, there are a large number of potential pitfalls facing investors today, and I think market volatilities underestimate their probabilities substantially. We are facing an inflection in policy from the ECB this week, with analysts expecting a substantial additional easing action (and it is overdue, with money growth in Europe down to a feeble 1.9% y/y, near the worst levels of the post-crisis period – see chart, source Bloomberg). Absent a major change in policy, liquidity on the continent is going to become increasingly dear with possible ramifications for the real economy as well as the asset economy.
The Federal Reserve is facing a more-serious policy inflection point, with no agreement amongst FOMC members (as far as I can tell) about how to transition from the end of QE to the eventual tightening. I’ve pointed out before – while many Fed officials were whistling Dixie about how easy it would be to reverse policy – that there is no proven method for raising interest rates with the vast quantity of excess reserves sitting inert on bank balance sheets. Moreover, raising interest rates isn’t the key…restraining money growth is. The key point for markets is simply that there is no plan in place that removes these reserves, which means that interest rates are not likely to respond to Fed desires to see them rise. And, if the Fed uses a brute-force method of raising the interest paid on excess reserves, then rates may rise but we don’t know what will happen to the relative quantities of required and excess reserves (and it is the level of required reserves that actually matter for inflation). It is a thorny problem, and one which the markets aren’t giving enough credit regarding the difficulty thereof.
Valuation levels are high across the board (with the exception of commodity indices). They’re doubly high in stocks, with high multiples on earnings that are themselves high with respect to revenues. And yes, this concerns me. I expect more volatility ahead, and perhaps serious volatility. But the fact that I am just saying “perhaps,” when all of my experience and models say “there is no escape without some bad stuff happening,” means that I am being infected – relative to my usual caution – by the general complacency.
In other words, I am worried that I am not worried enough.
The interesting thing is that equity bulls said during the entire march higher that “it doesn’t matter what the fundamentals are, the Fed is pushing the market higher and spreads tighter.” I still don’t believe that was an inevitable outcome to the Fed’s QE, but the fact is that people believed it and they were correct: that was enough to keep the market going higher. I can’t be comfortable going along with the crowd in that circumstance, but in retrospect it would have been better to abandon the models, throw caution to the wind, and ride along with the fun. And perhaps this regret is one reason for my developing complacency.
But that way lies madness, since the problem is not the ride but the getting out when the ride is over. The Fed is no longer providing QE (or, in any event, QE will shortly end altogether). So what’s the excuse now? It seems to me that everyone is still riding on the fun train, and just watching carefully to see if anyone jumps off. I think the market rally is on very tenuous footing, because if faith in the market’s liquidity goes away, the value anchor is very far from these levels. Yet, part of me is skeptical that a market which hasn’t corrected in more than two years can actually return to those value anchors. I should know better, because the bond-market mindset reminds me that market gains are generally linear while market losses are discontinuous, sloppy, and non-linear. Especially, I ought to be thinking, when market liquidity is so poor thanks to the government’s assault on market makers over the last few years.
I keep wondering if there is one more pulse higher in stocks coming, one more decline in commodities before they begin to catch up with money growth and inflation, one more rally in bonds before they begin to discount a higher inflation path. And this is very possible, because while I worry about my own developing complacency most investors are not concerned about their own.
Complacency or no, insurance is cheap. The low current level of implied volatilities in almost every asset class makes portfolio protection worthwhile, even if it costs a bit of performance to acquire that protection.
As They Do, Not As They Say
Over the past week or two we have seen and heard from the Fed (in the minutes released on Wednesday), the ECB (after their April 3rd meeting), the BOJ (after their April 7th meeting), and the Bank of England (today). Having heard from the “big four,” I think it’s very interesting to compare what they seem to be indicating they will do to what they probably ought to do. (I am actually going to neglect the BOE, since their situation is quite complex at the moment and probably too much for a reasonable-length article).
In the US, the latest surprise – for some people – was the dovish tenor of the FOMC minutes when they were released yesterday. I shake my head in wonder at anyone who has managed to convince themselves that Chairman Yellen is a closet hawk even after years of evidence to the contrary (not least being the fact that she was nominated at all – not since Volcker has any Fed chief with remotely hawkish credentials been nominated to the Chairman’s position). After the FOMC meeting itself, a few weeks ago, TIPS had been clobbered and some (although not me) attributed that to the hawkish tone of the statement and the fact that Yellen had mentioned offhand that a lengthy period of low rates after QE has ended might be something like six months. The Fed is not hawkish at this point in its history; this is not to say that it does not have hawkish members but on the whole it is a dovish institution and I maintain that the Fed will likely tighten too late, and too little. For now, the Fed seems to be trying to make clear that they are concerned about low inflation and not likely to step on the brakes any more than they have.
What ought the Fed to be doing right now? The Fed ought to be tightening. Though growth is not robust, “robust” growth cannot be the standard demanded before starting a tightening of monetary policy, especially when there are tremendous excess reserves. The monetary policy car has no traction with such huge reserves, and the Fed needs to start trying to get control so that when it is time to steer, it can do so. Moreover, with disinflation fears waxing – incredibly – at the FOMC, inflation is in fact heading higher. Median inflation should approach or exceed 3% this year, despite the Fed’s belief that it will be well below 2% for a very long time. In a few months, the fear of disinflation and deflation will seem quaint.
No increase in policy rates is going to be coming any time soon. The Fed will continue to tighten very slowly, by winding down QE and then possibly starting to mop up some of the trillions in extra liquidity. That’s a sine qua non to rates going up, unless the Fed decides to establish a floor with the interest rate on excess reserves and to ship big boxes of money to Wall Street. But the interesting part will be when the Fed starts to mop up that liquidity either by outright bond sales (unlikely) or by some sort of massive reverse repo operation. It will get interesting because this classic tightening maneuver won’t be met with rising short rates – making it clear even to non-Fed-watchers that the Fed has no control over short rates at the moment. Again, I seriously doubt that the Fed will move with alacrity towards a tighter policy, and as it is they are at least a couple of years behind. But even if they do continue to tighten it will take years, not months, for the system to approach a normal state of liquidity.
The ECB talks like it is ready to ease further. ECB President Draghi was perceived as extremely bullish at his post-meeting presser last week, and recently there has been more chatter about negative deposit rates or other ways to increase the money supply.
And they need to do it. Disinflation, and possibly even deflation, actually probably is the threat in Europe, because the ECB has allowed money growth to slow back to the too-slow range that characterized the post-credit-crisis period (see chart, source ECB).
This obvious failure to keep money growth up is one reason for the strength of the Euro since 2012 – while the Fed talks about tightening, but does so in a way that only a dove could love, the ECB talks about easing, but does so in a way that can only appeal to hawks. Currency traders can smell it – European monetary policy may be as poorly managed as US monetary policy is, but holders of a currency prefer when the central bank is printing 2% more every year, rather than 6-8% as in the US. (Which would you prefer, a 2% dilution of your equity ownership, or an 8% dilution?)
The problem for the ECB is that their legal structures have been set up so that, at least officially, they don’t have the same tools for QE that other central banks have. Theoretically, they are prohibited from purchasing government bonds without sterilizing the intervention since that would mean effectively financing member governments. What ought the ECB to do? Well, I suppose it ought to follow its charter, but in a perfect world it is the ECB, and not the BOE or Fed, which would be doing QE. I suppose it will not surprise any reader to discover that I am a cynic, and I suspect that the ECB will at some point conclude that ceasing to sterilize the OMT bond portfolio is somehow allowed, even though practically speaking that would be the same as buying new government bonds without sterilization. We have already found out that in a pinch, the Federal Reserve is willing to be moderately “flexible” when it comes to its legal mandates. It would not surprise me a bit to see the ECB take a similar step. I suspect this will not happen in the next few months, since core European inflation for the year ended February has risen to 1.0% after being as low at 0.7% at year-end, but if that figure doesn’t continue to rise – and there’s no reason I can see that it should – then the ECB may test its flexibility later this year.
In Japan, the Bank of Japan has lifted core inflation to 0.8%, and it will continue to rise. Money supply growth is over 4% y/y, but only just barely. I believe that in Japan, what they profess to want and what they actually will act to secure are one and the same: increased QE, in increasing amounts, until everyone realizes that they are serious, the Yen declines markedly, and deflation is finally banished from the nation.
So in the race for weaker currencies, I suspect Japan will eventually win, with the US placing second and Europe having – annoyingly for its central bank, who would like a weaker currency to spur growth – the strongest unit.
Moving Goalposts
The equity melt-up continues, with the S&P 500 now up more than 25% year-to-date in a period of stagnant growth and an environment of declining market liquidity. The catalysts for the latest leg up were the comments and testimony by Fed Chairman-nominee Janet Yellen, whose confirmation hearings began today.
Her comments should alleviate any fear that Yellen will be anything other than the most dovish Fed Chairman in decades. Ordinarily, potential central bankers take advantage of confirmation hearings to burnish their monetarist and hawkish credentials, in much the same way that Presidential candidates always seem to try and campaign as moderates. It makes sense to do so, since the credibility of a central bank has long been considered to be related to its dedication to the philosophy that low and stable prices promote the best long-term growth/inflation tradeoff. Sadly, that no longer appears to be the case, and Janet Yellen should easily be confirmed despite some very scary remarks in both the scripted and the unscripted part of her hearing.
In her prepared remarks, Yellen commented that “A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases.” Given half a chance to repeat the tried-and-true mantra (which Greenspan used repeatedly) about the Fed balancing its growth and inflation responsibilities by focusing on inflation since growth in the long run is maximized then inflation is low and stable…Yellen focused on growth as not only the primary but virtually the only objective of the FOMC. As with Bernanke, the standard which has been set will be maintained: we now use extraordinary monetary tools until we not only get a recovery, but a strong recovery. My, have the goalposts moved quite a lot since Volcker!
That means that QE may indeed last forever, since QE may be one of the reasons that the recovery is not strong (notice that no country which has employed QE so far…or ever, as far as I know…has enjoyed a strong recovery). In a very direct sense, then, Yellen has declared that the beatings will continue until morale improves. And I always thought that was just a saying!
I would call that borderline insanity, but I am no longer sure it is borderline.
Among other points, Yellen noted that the Fed is intent on avoiding deflation. In this, they are likely to be successful just as I am likely to be successful in keeping alligators from roosting on my rooftop. So far, there is no sign of it happening, hooray! I must be doing something right!
Yellen also remarked that the Fed might still consider cutting the interest it pays on banks’ excess reserves, or IOER. The effect of this would be to release, all at once, some large but unknown quantity of sterile reserves into the transactional money supply. If there was any question that she is more dovish than Bernanke, there it is. It was never clear why the Fed was pursuing such a policy – flood the market with liquidity, and then pay the banks to not lend the money – unless the point was merely to reliquify the banks. It is as if the Fed shipped sealed crates of money to banks and then paid them rent for keeping the boxes in their safes, closed. If you’re going to do QE, this is at least a less-damaging way to do it although it raises the question of what you do when you need the boxes back. Yellen, on the other hand, is open to the idea of telling the banks that the Fed won’t pay them any longer to keep those boxes unopened, and instead will ship them crowbars. This only makes sense if you really do believe that money causes growth, but has nothing to do with inflation.
The future Fed Chairman also declared that the Fed has tools to avert emergence of asset bubble. Of course, no one really doubts that they have the tools; the question is whether they know how and when to use the tools. And, to bring this to current events, the question is no longer whether they can avert the emergence of an asset bubble, but whether they can deflate the one they have already re-inflated in stocks, and an emerging one in property! Oh, wait, she’s at the Federal Reserve…which means she won’t realize these are bubbles until after the bubble pops, and then will say that no one could have known.
Now, it may be that the U.S. is merely nominating Dr. Yellen in self-defense, to keep the dollar from becoming too strong or something. Last week’s surprise rate cut from the ECB, and the interesting interview by Peter Praet of the ECB in which he opens the door for asset purchases (which interview is ably summarized and dissected by Ambrose Evans-Pritchard here), keeps the heat on the Fed to remain the most accommodative of the major central banks.
At least the ECB had a reasonable argument that there was room for them to paint the least attractive house on the block. Europe is the only one of the four major economies (I exclude China since quality data is “iffy” at best) where central-tendency measures of inflation are declining (see chart, source Enduring Investments).
And that is, of course, not unrelated to the fact that the ECB is the only one of the four major central banks to be presiding over low and declining money supply gowth (see chart, source Enduring Investments).
Still, the Bundesbank holdovers must be apoplectic at these developments. I wonder if it’s too late to nominate one of them to be our next Fed Chairman?
There is of course little desire in the establishment to do so. The equity market continues to spiral higher, making the parties louder and longer. It is fun while it lasts, and changing to a bartender with a more-generous pour might extend the good times slightly longer.
It is no fun being the designated driver, but the good news is that I will be the one without the pounding headache tomorrow.
[Hmmm…erratum and thanks to JC for catching it. The S&P is “only” up 25.6% YTD (my Bloomberg terminal decided that it wants to default to the return in Canadian dollars). So originally the first paragraph had “32%” rather than 25%. Corrected!]
The Disturbing Evolution of Central Banking
One of the more disturbing meta-trends in markets these days is the direction the evolution of central banking seems to be taking.
I have written before (and pointed to others, including within the Fed, who have written before[1] ) about the disturbing lack of attention being paid in the discussion and execution of monetary policy to anything that remotely resembles money. Whether we have to be concerned about money growth in the short- and medium-terms, ultimately, will depend on what happens to the velocity of money, and on how rapidly the central bank responds to any increase in money velocity. But there are trends that could be much more deleterious in the long run as the fundamental nature of central banking seems to be changing.
Today the Bank of England released its Quarterly Inflation Report, in which it introduced an “Evans Rule” construction to guide its monetary policy looking forward. Specifically, the BoE pledged not to reduce asset purchases until unemployment dropped below 7% (although Mark Carney in the news conference verbally confused reducing asset purchases with raising interest rates), unless:
“in the MPC’s view, CPI inflation 18 to 24 months ahead is more likely than not to be below 2.5 percent; secondly, if medium-term inflation expectations remain sufficiently well anchored; and, thirdly, the Financial Policy Committee has not judged the stance of monetary policy — has not judged — pardon me — the Financial Policy Committee has not judged that the stance of monetary policy poses a significant threat to financial stability, a threat that cannot otherwise be contained through the considerable supervisory and regulatory policy tools of various authorities.”
This is quite considerably parallel to the FOMC’s own rule, and seems to be the “current thinking” among central bankers. But in this particular case, the emperor’s nakedness is revealed: not only is inflation in the UK already above the 2.5% target, at 2.9% and rising from the lows around 2.2% last year, but the inflation swaps market doesn’t contemplate any decline in that inflation rate for the full length of the curve. Not that the swaps market is necessarily correct…but I’ll take a market-based forecast over an economist consensus, any day of the week.
So, for all intents and purposes, while the BOE is saying that inflation remains their primary target, Carney is saying (as my friend Andy the fxpoet put it today) “…the BOE’s inflation mandate was really quite flexible. In other words, he doesn’t really care about it at all.”
Along with this, consider that the candidates which have so far been mooted as possible replacements for Bernanke at the US Fed are all various shades of dovish.
Here, then, we see the possible long-term repercussions of the 2008 crisis and the weak recovery on the whole landscape of monetary policy going forward for many years. In some sense, perhaps it is a natural response to the failure or monetary policy to “get growth going,” although as I never tire of pointing out monetary policy isn’t supposed to have a big impact on growth. So, the institutions are evolving to be even more dovish.
At one time, I thought it would happen the other way. I figured that, since the ultimate outcome of this monetary policy experiment is clearly going to be higher inflation, the reaction would be to put hawkish central bankers in charge for many years. But as it turns out, the economic cycle actually exceeded the institutional cycle in duration. In other words, institutions usually evolve so slowly that they tend not to evolve in ways that truly hurt them, since the implications of their evolution become apparent more quickly than further evolution can kick in and compound the problem. In this case, the monetary response to the crisis, and the aftermath, has taken so long – it’s only half over, since rates have gone down but not returned to normal – that the institutions in question are evolving with only half of the episode complete. That’s pretty unusual!
And it is pretty bad. Not only are central banks evolving to become ever-more-dovish right exactly at the time when they need to be guarding ever-more-diligently against rising inflation as rates and hence money velocity turn higher, but they are also becoming less independent at the same time. A reader sent me a link to an article by Philadelphia Fed President Plosser, who points out that the boundaries between fiscal and monetary policy are becoming dangerously blurred. It is somewhat comforting that some policymakers perceive this and are on guard against it, but so far they seem ineffectual in preventing the disturbing evolution of central banking.
[1] Consider reading almost anything by Daniel L. Thornton at the St. Louis Fed; his perspective is summed up in the opening sentence of his 2012 paper entitled “Why Money Matters, and Interest Rates Don’t,” which reads “Today ‘monetary policy’ should be more aptly named ‘interest rate policy’ because policymakers pay virtually no attention to money.”
Chutzpah
It has been a busy couple of weeks on the business side, which is why I haven’t been writing many articles. However, I wanted to be sure and pen a quick one today.
The main economic data is due out later this week: Existing Home Sales on Wednesday, New Home Sales on Thursday (both of these more interesting for the home price indications than for the volume figures), and Durable Goods on Friday. (Some of us also get excited about the 10-year TIPS re-opening on Thursday, with real yields at a 1-year high after a 35bp selloff over the last three weeks). But Monday and Tuesday have been relatively bereft of news, except for the occasional Fed speaker.
It is that “occasional Fed speaker” that I want to mention today.
St. Louis Fed President James Bullard today gave a speech in Europe, about the need for the ECB to pursue “aggressive” QE in order to prevent a long period of low inflation and deflation such as that experienced by Japan over the last few decades.
What word am I searching for here…would it be “chutzpah?”
I realize that Chairman Bernanke has already been featured on a magazine cover as a Hero. It bears remembering that Greenspan was also called the Maestro at one point, although we are now all aware that his management of the Fed helped to precipitate a massive crisis. History isn’t written in real time by bloggers. It’s written by historians, years later.
But hasn’t the Fed, after all, been really successful? Isn’t a victory lap deserved? Haven’t they earned the right to lecture to other central banks about the proper execution of monetary policy? After all, the Fed brought down the unemployment rate while inflation remains tame. Case closed.
Perhaps that would be a good argument if Earth was hit by a comet tomorrow and all life ceased. But in the event life continues, we will need to wait until the cycle is complete. Celebrating now is like pumping one’s fist in celebration in the middle of a motorcycle jump over 25 buses. Nice trick, but we’ll hold our applause until you stick the landing if you don’t mind.
There seems to be great faith in the Federal Reserve that the tough part is over. All that they need to do now, it seems they believe, is to just start tightening before inflation gets going; they can do it very gradually, supposedly, because of the great credibility the Fed has and because they understand how inflation responds to rates.
But in fact, inflation doesn’t respond to rates but to money. And not to reserves, but to transactional money. Transactional money responds not to total reserves, but to banking activity and the resulting level of required reserves…which the Fed is unable to directly affect. When the Fed begins to taper, and then to somehow drain reserves, I predict it will have almost zero impact on the inflation process until the excess reserves have been drained.
Indeed, if interest rates rise when the Fed begins to do this, it will perversely tend to increase the velocity of money, which tends to vary inversely with the opportunity cost of holding cash balances (that is, velocity goes up when interest rates go up, all else equal). It’s not the only thing that matters, but it’s pretty important, as the chart below suggests (I think I have run something like this chart previously).
Now, ordinarily when the Fed is raising rates, they’re also draining reserves – so the increase in money velocity is balanced by the decline in money to some degree. That won’t happen this time. When rates go up, velocity will go up, but the quantity of (M2) money will not change because it is driven by a multiplier that acts on required reserves. That means inflation may well rise as interest rates increase, at least for a while.
I might be wrong, but I am willing to wait and see how it plays out. If I am wrong, then you don’t have to put me on the cover of a magazine.
To conclude that inflation is fully tamed at this point, anyway, is remarkably optimistic. Home prices are skyrocketing at rates only rarely seen, and it would be incredible if that did not lead to higher rents and higher core inflation…literally within a couple of months from now, judging from the historical lag patterns.
But, again, I should return to my main point: it isn’t that the Fed is wrong, it’s just that they are so completely certain that they are right even though the difficult part of the trick – unwinding the extraordinary policy without any adverse effects – lies ahead.
Sit down, James Bullard. Let the ECB manage its own affairs. I am sure they can mess it up on their own, without your help. And certainly, without your condescending advice!
Is European Money Growth Helping Stoke U.S. Inflation?
The monthly European M2 numbers are out (they are released with approximately a one-month lag), and so we can get a look at the monetary conditions through the end of October.
The chart above (source: FRB and ECB) shows that whatever the ECB is claiming about not conducting QE, money supply growth is most definitely accelerating.
The data also allows me to update one of my current-favorite charts, showing the connection between developed markets money growth (proxied here by US M2 plus Euro M2) and core U.S. inflation. The chart is below (source: BLS, FRB, ECB, Enduring Investments calculations).
What is most amazing to me about this pretty reasonable (correlation= 0.6) relationship is that it is contemporaneous. This is really important, because what it means is that we can argue that money velocity may not actually have fallen in the U.S. as much as it is commonly believed to have. If the proper measure, now that all of our economies are so interconnected, is global money rather than narrowly domestic money, then one answer to the question “why did the 10% growth in the U.S. money supply not lead to much higher inflation, much higher real growth, or both” (the correlation between U.S. M2 growth and U.S. core inflation is only 0.44) could be “because Europe’s tight money was counterbalancing our loose money.”
If this speculation is right, then it makes the ubiquity of QE much more worrisome, because it means that even if the Fed stops throwing wood on the fire, if everyone else is doing so we may still see domestic inflation (although, in that case the dollar would likely strengthen appreciably, blunting that effect).
Mounting Pressure
The most striking facet of today’s trading was that the stock market actually reacted to the Fed’s announcement, which was precisely as universally expected: no change in anything but the technical language about where the economy currently stands. It wasn’t a huge reaction, but the fact that the S&P actually dropped 5 points on the news is mind-boggling to me because it implies that some people were expecting big things out of the Fed today.
To be sure, the arrow of action on the Fed is clear and pointed to ever-increasing amounts of liquidity, but this wasn’t ever on the docket for today. However several Street economists have predicted, plausibly I think, that when Operation Twist expires in December (partly because the SOMA will run out of short-dated Treasuries to sell) the Fed might keep going with the buying leg of the Twist – effectively increasing the monthly outright purchases of paper to $85bln (including Treasuries) from $40bln (all mortgage paper) currently.
Operation Twist has been a useless operation from the standpoint of monetary policy – it has neither added nor subtracted liquidity from the system. It may have had some value from the standpoint of asset-market-maintenance policy, by removing duration from the market and forcing investors to accept more risk for the same amount of reward. So it may be the case that Twist had some effect, but mostly a bad effect since it certainly doesn’t seem from market pricing that investors have been timid about taking risk. And I suppose it ought also be observed that “asset-market-maintenance” isn’t part of the legislative mandate of the Federal Reserve. However, legislators can be generous when markets are being pumped up – it’s when the air goes out that they’re unhappy.
Weirdly, though, I would prefer Operation Twist, which has little impact, to what is likely to replace it (additional QE).
Policymakers globally are growing increasingly bold about quantitative easing. In Europe today, ECB President Draghi told German legislators that outright bond purchases by the ECB “will not lead to inflation. In our assessment, the greater risk to price stability is currently falling prices in some euro-area countries. In this sense, OMTs are not in contradiction to our mandate: in fact, they are essential for ensuring we can continue to achieve it.” (See also this story.)
Central bankers are getting bold, but I’m not sure I understand why. They clearly see the connection between QE and inflation – fending off deflation was the purpose of QE2 and Draghi is clearly indicating the same even though core inflation in the Eurozone has risen from 0.8% in 2010 to 1.5% now (see chart below, source Bloomberg). That’s not exactly flashing red signals on inflation, but it is utterly fantastic to suggest that it indicates deflation is a greater risk.
In the U.S., QE3 and the likely acceleration of QE3 later this year is happening in the context of year-on-year rises in median new home sales prices (released today) and existing home sales prices (released last week) of over 11%, as the chart below (Source: Bloomberg) shows. Note that the existing home sales data is much more dependable on a month-to-month basis, because the number of existing homes and existing home sales swamps the number of new homes sold, but both show the same, clear trend. Home prices are now rising nearly as fast, nationwide, as they did in the bubble years.
For the record, the all-time record one-year price rise in existing home sales was 17.4% in May, 1979. Of course, in May 1979 core inflation was rising at 9.4%. In fact, with the exception of the last phases of the bubble of the early ‘Aughts, existing home sales prices are rising at the fastest margin above core inflation ever, as the chart below shows (Source: Bloomberg; Enduring Investments calculations)
Policymakers, and investors, seem to be numb to the threat of additional QE for one of two reasons. Either it is because of the belief that prior QE did not cause inflation (incorrect, as illustrated above and by the statements of intentionality of the policymakers themselves) or because they’re buying the line that QE is only adding to “sterile” excess reserves.
I think that this is dangerously sanguine. In fact, although it is true that QE initially results in greater excess reserves only, and these have only slowly trickled into transactional money, I think there’s reason to believe that adding more QE may increase that pace of transmission. Picture a large cylindrical vat, open on top with a small valve at the bottom. The water in the vat represents excess reserves, and the water trickling out through the valve is transactional money.
Many things can affect the pace at which the vat water flows through the valve – lending opportunities tied to credit demand and credit quality, disincentives to lend such as Interest on Excess Reserves (IOER), and moral suasion in both directions. Crank IOER to 25%, and all of the water poured into the vat remain as sterile excess reserves and QE is just reliquifying the banking system. Put IOER at a 10% penalty rate, and all of the water going in the top will flow out of the bottom very quickly – and all of the other water that’s already in the vat, too.
But even if you don’t adjust the valve at all, the greater weight of water in the cylinder, as you keep adding more water, will increase the flow out of the valve. Adding more QE is akin, economically, to increasing the weight of water in the cylinder.
The parallel economic concept is that a greater of excess reserves increases the opportunity cost of reserves. The average return on assets for a bank gradually declines as more of these assets become excess reserves rather than required reserves against lent funds. Leverage also declines, with the result (as I have pointed out before) that return on equity suffers. The chart below (Source: Bloomberg) shows the return on equity for large banks (those with more than $10bln in assets). You can see that while bank earnings have recovered significantly from the nadir of the crisis, they also appear to have leveled off at around 8% compared to the 15% that was the consistent standard prior to 2007.
The lending officers in these banks, although they’re being told to increase the quality of their loans, are being told more and more to also increase the quantity of their loans. They cannot do both, but as the pressure of too many reserves on the balance sheet builds, the pressure to make more marginal loans increases as well. This is the part of the valve that the Fed cannot control, and where danger lies going forward. The multiplier may well respond, eventually, to the weight of the reserves themselves.
Not Good Enough To Warrant That Reaction
Stocks surged today, although still on fairly light volume, in a striking response to the ECB’s proposal of a plan we already knew most of the details of. The S&P rallied 2%, and Treasury yields rose 7bps at the 10-year point (1.67%), with 10y TIPS yields +5bps (-0.65%) and breakevens therefore 2bps wider. Commodities were relatively strong, outside of the livestock group.
The ECB’s plan is essentially as described in leaks previously, although apparently there are some minor asterisks that prevent the central bank from just going in to buy lots of bonds right away. The ECB didn’t cut rates, or make the deposit rate negative, as some 40% of economists expected according to Bloomberg. That cut wasn’t in the cards, for the nonce anyway. As I pointed out yesterday, if the ECB wants to sterilize bond purchases, they certainly can’t cut deposit rates and probably have to raise them (if they were serious about sterilizing). In theory, they could cut deposit rates and then offer short-term bank bills as a way to absorb the extra money in circulation, but that’s the same thing in the end: we hold your money and pay you interest. The fact that it isn’t reserves, but bills, is not relevant to the sterilization discussion, and that approach is actually somewhat more flexible since the ECB can more easily raise the rate it pays on bills to be sure of soaking up enough money than it can adjust the deposit rate to accomplish the same thing. The problem, though, is that bill sales occur in the open, and it will be really obvious if they aren’t able to sterilize the purchases.
It continues to be striking how resistant central bankers are to the notion that markets, and not central bankers, ought to set market rates. Bloomberg and other media sources wrote of the ECB’s “fight to wrest back control of rates…after nearly three years of turmoil.” When, exactly, were rates in control of central bankers to begin with? Other than the trivial case of the overnight rate, that is. That’s just crazy talk.
There is, however, still the issue that sovereign governments need to formally request aid, and agree to conditions, before the unlimited buying can begin. It occurs to me that the unlimited buying might be tied to the conditions, and so not be unlimited after all. But the bigger problem is that governments (especially now that their rates have rallied a bit and the wolf has temporarily retreated from the door) insist on having the temerity to negotiate conditions, rather than to simply accept the gruel the EU says they’re entitled to. For example, according to the Spanish news outlet El Pais, Spain’s opening bid is for a full bailout without any extra conditions (hat tip to Andy F). At least that gives them plenty of room for concessions.
Now, perhaps the rally in equities wasn’t due to the ECB’s offer to buy bonds after all. Maybe it was because the economic data was slightly stronger than expected, although I’m skeptical of that. ADP showed a gain of 201,000 jobs, the highest gain since March, plus an upward revision to 173,000 last month. Initial Claims were a bit lower than expected, at 365,000. These are both on the better side of expectations, but negligibly so given the size of the error bars involved. The ADP report may have encouraged some shorts to cover in front of the Employment Report tomorrow, but the short-term correlation between changes in ADP and changes in the Employment Report is quite poor, as the chart below shows. The R-squared of the relationship is 0.165. That is, if you know that ADP accelerated 28k this month compared with last month, it tells you almost nothing about whether Non-Farm Payrolls will accelerate or decelerate from last month’s figure.
The correlation of the levels of the changes themselves is of course much better, with an R-squared of 0.857 over the same period, but the standard error is 93k. So, today’s 201k from ADP would produce a point estimate, based on the regression (not shown here), of 210k for Payrolls. But the error bar would make the expected range 117k on the low side to 303k on the high side. Ergo, it’s still a bit early to get over-excited about the Payrolls report tomorrow.
There’s a secondary concern here that is silly, but needs to be considered. If the number is strong tomorrow, there will be some investors (and perhaps quite many) who will be skeptical that the numbers just happened to improve right in the middle of the Democratic National Convention, hours after President Obama accepts the nomination. I am not one of those who will be skeptical, not because I think any particular Administration is above the idea of manipulating the data, but because I think it would be almost impossible to do so without the conspiracy coming to light. There are simply too many people involved in the generating of this government statistic (and, of course, the ADP figure is not remotely influenced by the government). But the same people who believe the government manipulates CPI will believe they manipulate the jobs report, and this has market implications: if the figure is weak, investors will have a higher level of confidence in the data (since it goes without saying that no one would manipulate the number to be worse) than if it is strong, which further implies – especially after today’s rally – that the price response in the equity market is likely to be skewed negatively. I don’t like taking positions ahead of major numbers, but in this case I’d be inclined to shade a bit short. But just a bit.
ADP was a bit stronger-than-expected, and Payrolls may be higher or lower. But either way, these figures do have the usual error bars, and it seems unlikely that this augurs an unexpected and durable improvement in the employment situation when the man on the street is still reporting that jobs are harder to get. Nevertheless, the economy seems not to be getting worse at the moment, either, and with traditional monetary policy there would be no cause whatsoever to ease. I suppose it goes without saying that those traditions are no longer being observed, however, and I continue to think we’ll see the Fed ease next week – almost regardless of what the data does.
Deserving It
Does Chad “Ochocinco” Johnson deserve another chance?
That’s a question I saw several times bandied about today on the NFL Network. (It is, after all, kickoff night of the NFL and so you will perhaps forgive the digression.) But no one seemed to ask the question that I find much more interesting, and more relevant in other familiar contexts as well:
Does any other team deserve to be saddled with Ochocinco for another season?
Because really, it isn’t just a question of whether he deserves another chance. That would imply there is some objective standard by which his ‘deservedness’ should be measured. It seems to me that this begs the question. Shouldn’t the arbiters of whether he deserves another chance be the people who actually have to be saddled with the consequences of giving him another chance?
I’m just saying…
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There is a very interesting development in inflation land: Deutsche Bank, which along with Credit Suisse distanced themselves from less-innovative firms earlier this year when they issued ETN/ETF structures that allow an investor to invest in a long-breakeven position, has created a tradeable index that proxies core inflation.
Now, it isn’t any mystery that you can create core inflation by taking headline inflation and stripping out energy (and, if you feel like torturing yourself with tiny futures positions, food) – for example, I presented a chart of ‘implied core inflation’ in the article linked here – so the DB product doesn’t break any new theoretical ground. But it is a huge leap forward in that it allows more market participants to trade in a direct way something that acts like core inflation.
Why would an investor care about core inflation? Is it because he “doesn’t care about buying gasoline and food”? No, an investor may wish to buy a core-inflation-linked bond for the same reason that a Fed governor wants to focus on core even though all prices matter: core inflation moves around less in the short run, but in the long run core and headline inflation move together. The chart below (Source: Bloomberg) shows the core CPI price index, and the headline CPI price index, normalized so that they were both 100 on December 31, 1979. Since then, prices have tripled, whether you are looking at headline or core. The difference in the compounded inflation rate? Core inflation has risen at a 3.471% inflation rate, while headline inflation has grown at 3.415%.
This is why central bankers want to focus on core – headline provides lots of noise but almost no signal. And it’s the same reason that investors should prefer bonds linked to core inflation: you get virtually all of the long-term protection against inflation that you do with headline-inflation-linked bonds (like TIPS), but with much lower short-term volatility.
Now, Deutsche’s index isn’t truly core inflation, but a proxy thereof. It appears to be a decent proxy, but it is still a proxy (and we have some more theoretical/quantitative critiques that are beyond the scope of this column). And their product is a swap, not a bond (although it would not surprise me to see bonds linked to this index in the very near future). So it isn’t perfect – but it is a huge step forward, and Deutsche Bank (and Allan Levin, the guy there who has the vision) deserves praise for actually innovating. Innovation tends to happen on the buy side, and with smaller firms, not with big sell-side institutions, and we should cheer it when we see it.
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Now, back to actual markets: tomorrow, the ECB is expected to announce a new program of buying periphery bonds when necessary. Actually, it is a bit more than expectation, since the plan was leaked today. Supposedly, the ECB will announce that they are going to do “unlimited, sterilized bond buying” of securities three years and less in maturity.
The Euro was somewhat buoyed by this news. The idea is that big bond purchases will bring down sovereign yields, but sterilization of the purchases will mean that it isn’t truly monetization and therefore not inflationary.
This seems ridiculous to me. I am not surprised at the idea that the ECB would conduct large purchases of bonds that no one else seems to want; they did quite a bit of that with Greece, after all. But I’ve lost track – are they still sterilizing the billions in bonds that they’ve already bought, as well as the two LTRO operations which they claimed to sterilize, but never explicitly did except through the expedient of paying interest on reserves to sop up the liquidity?
How are they going to sterilize more purchases? There are basically three straightforward ways for a central bank to remove liquidity from the market. We used to think that there were only two, because the only ways the central bank ever did it was to (a) conduct large reverse-repurchase operations in which the central bank lent bonds and borrowed cash, taking the cash temporarily out of the economy and (b) to sell bonds outright, to make a permanent reduction in reserves. Now we recognize a third option, although we’re not sure how efficacious it is: (c) raising the interest rate on deposits of excess reserves at the central bank, so as to discourage the multiplication of those reserves.
But for the ECB’s purchases to be effective in terms of their size, they will be far too large to use reverse-repos as a sterilization method; and it doesn’t seem to make much sense to be selling bonds when they’re buying other bonds, unless they want to try and push up the yields of countries like the Netherlands and Germany (which might not be politically too astute) at the same time that they’re lowering the yields of Spain and Portugal. And they just cut the deposit rate to zero in July…are they going to raise it again?
I can understand the political cleverness of such an announcement, if the ECB makes it: make the bond buys “unlimited” to suggest that they can’t be outmuscled, but also sterilized so it’s not printing. But these can’t both be true – because there is not unlimited capacity for sterilization.
That plan can only work if, in fact, the ECB doesn’t actually buy many bonds. In the past, they’ve tried to trick the market into rallying with “bazooka-like” comments so that they didn’t actually have to do anything. To date, it has never worked. I doubt this will, either.
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Back in the U.S., the wave of Employment data is about to hit. Tomorrow morning, Initial Claims (Consensus: 370k) will be released; about Claims the only thing I want to note is that while it is down considerably from the peak of the most-recent recession, it is only slightly below where it was at the peak of the last recession. Over the last 52 weeks, Claims have averaged 381k; in May of 2002 that average reached 419k. Also due out tomorrow is the ADP report (Consensus: 140k), which is expected to weaken slightly from last month’s figure. On Friday, of course, the Payrolls report is expected to show a rise of 127k new jobs with the Unemployment Rate steady at 8.3%.
Some observers have made a lot of the fact that the Citigroup Economic Surprise index has risen from -65 or so in July to nearly flat now. But this is not a sign of improving economic conditions; it is a sign of improving economic forecasts. Remember that this index doesn’t capture absolute levels, but the degree to which economists are missing. The current level is near flat because economists adapted their forecasts to the weak data, not because the data improved to catch up with the over-optimistic forecasts. I wouldn’t draw much relief from that indicator.
Now, with the ECB and the Fed on the calendar over the next week, markets may well get some relief. But the economy, not so much, even if we do deserve it.
