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Two Quick Items
Two relatively quick items that I want to address today; they have been in my ‘to do’ box for a while.
Negative Rates
One of the most interesting features of the fixed-income landscape today, and one that will likely serve in the future as an exam question on finance quizzes, is the increasingly widespread proliferation of negative nominal interest rates among government bond markets…and occasionally even for high-quality corporate paper.
In finance theory, this can’t happen. Because currency earns a 0% nominal interest rate, theory says that no rational person would ever accept a negative nominal interest rate. If I have $50 today, and put it in the bank, I will have $49 tomorrow. So why not just keep the $50 in my wallet? (Obviously this leads to high cash balances, which means low monetary velocity, by the way). And this is true in the absence of “other costs.”
So why are so many interest rates negative? Are individuals irrational? No: at least not so irrational that they prefer less money to more money. However, what is true at an individual level does not necessarily scale to the institutional level. An institution, such as a money fund or corporation, does not have the freedom to hold its assets in physical currency. Microsoft has $90 billion in cash and equivalents. If this were in $100 bills, it would weigh about one thousand tons. That’s a pretty big vault. And vaults cost money. Guards cost money. And, if Microsoft had this money in the vault, it would be harder to spend. It is much easier to wire $5 million than it is to send an armored car.
In the presence of those costs, Microsoft and other institutions will accept a negative interest rate. It will invest its money at a negative rate rather than build a vault.
Now, an important (if obvious) point is that cash balances are so high, and interest rates so low, because global central banks are making sure we have plenty of cash. Too much cash chasing too few investment opportunities causes rates to be low.
Walmart and Minimum Wage Increases
It has been a few weeks now, but when Walmart in February announced it was going to increase the minimum wages it plans to pay its employees (preceded by Starbucks, Aetna, and the Gap and followed by TJX and Target), I received a number of queries about what the hike was going to do to inflation. Is this the beginning of the much-feared “cost-push inflation”?
The answer is no. Wages, as I have said many times, follow inflation rather than lead it. Think about it: wouldn’t it be really weird for companies to raise wages and then raise prices, to the extent that they have control – at least with respect to timing – over both? No, whatever price increase is going to be caused by the increase in the wages Walmart expects to pay is already in the price. Walmart is not surprised by their own move to raise wages. Nor is anyone surprised by the general increase in the minimum wage, which happened in 2009.
So, while I continue to believe that inflation is rising, and will continue to rise…I don’t believe that the increase in prices is going to be any faster due to these wage increases. It does, however, increase my confidence that inflation is rising, since obviously these retailers are confident enough in the pricing environment to be able to increase wages (which are sticky – it is harder to lower them than to raise them).
Two Wrongs Don’t Make a Right
So, the Fed’s tightening is almost done.
Chairman Yellen informed Congress that a “high degree” of easing is needed given the slack in the labor market. This is in keeping with the Fed’s ongoing thematic presentation of “tapering is not tightening,” but of course tapering is indeed tightening. Call it “easing less” if you like, but going from “providing lots of liquidity” to “providing less liquidity” to “providing no added liquidity” is tightening.
I would argue that providing no added liquidity – which is where the Fed is headed, with the taper due to be completed in the autumn – is neutral policy, not an easy policy. But the Fed, like many observers, confuses the level of interest rates with the degree of accommodation. That is confusing a price (the interest rate) with a flow, but it seems not to bother them very much. (I explain the distinction, which is crucial to monetary policymaking, in this article.)
Now, whatever the Chairman thinks she’s saying, what she means is that the Fed isn’t going to be raising interest rates soon. This is partly because the main tool they had been planning to use, the reverse repo facility, isn’t as simple a solution as they believed at first. This isn’t terribly surprising; as I (and others) have been pointing out in presentations and articles for a while it isn’t trivially easy to drain $2 trillion in reverse repo transactions, even if you can do $2 billion with ease. The pattern is familiar, and should be mildly discomfiting:
- At first, the Fed thought to unwind the massive purchases of Treasuries by simply selling them. The original argument was that the Fed pushed rates lower by buying Treasuries, but selling them wouldn’t raise interest rates. This sort of perpetual motion machine never made much sense, and at some point it became clear that if the Treasury started to unwind the SOMA portfolio securities and rates rose, it would likely not be sufficient to drain all of the excess reserves, since the average selling price would most likely be lower than the average purchase price.
- The Fed then thought to just let the securities in the SOMA roll off. Then someone noticed that because of the TWIST program, the Fed doesn’t own many short-dated Treasuries, so that letting QE gradually drain itself would take more than a decade.
- No problem; we’ll just conduct massive reverse repo operations to drain a couple trillion dollars from the system. The link above shows that the Fed’s newly discovered skepticism on that matter; the website Sober Look recently had a good article on the topic as well.
None of this is surprising to people who actually have market experience; unfortunately, over the last decade or so the level of actual market expertise at the Federal Reserve has dropped significantly so they are re-discovering these things the hard way. Now, the focus is on interest on excess reserves (IOER) as the main tool for raising rates eventually.
All of this confusion is one reason that the Fed will move only slowly to ‘normalize’ interest rates. They’re simply not sure how they’ll do it. The problem with IOER is that we have no idea how sensitive the level of reserves it to the amount of interest paid on reserves…since we have never done this before. But to the Fed, that’s no problem because they don’t seem to care about reserves – they only care about the level of interest rates, which at the end of the day don’t matter nearly as much as the growth rate of the money supply.
And so US and UK money supply growth rates are both in the 6-7% range, and interestingly median inflation in the US recently accelerated to 2.3% while core inflation in the UK surprised everyone today by rising to 1.9% (as of April). Commercial bank credit growth in the US over the last 13 weeks has risen at a 10.4% pace, the highest rate since early 2008 (see chart, source Federal Reserve).
Slowing QE has not, evidently, slowed money supply growth, and this is one reason the Fed insists that tapering is not tightening. Unfortunately, this doesn’t mean that the Fed is right, but that they are wrong twice: first, tapering is tightening. Second, changing the pace of addition to reserves does not matter for growth in the money supply (and, hence, inflation) when there are enormous piles of inert reserves already. Picture a huge urn filled with coffee. The spigot at the bottom controls the pace at which coffee leaves the urn, and adding more coffee to the top of the urn has essentially no effect.
So money supply growth, and corporate loan growth, is currently not under control of the Fed in any way. Interest rates are under their control, but interest rates don’t cause changes in the money supply but rather the other way around. Here is another analogy: a robust harvest of corn pushes corn prices lower, but if the government officially sets the price of corn very low it does not cause a robust harvest of corn. This is exactly what the Fed is trying to do if they attempt to control the money supply by changing interest rates.
It actually is worse than this. Raising interest rates will tend to increase money velocity, a relationship which has held very well for the last two decades. I have written about this quite a bit in the past (see for one example this article from last September), but I – like many monetary economists – have often struggled with the fact that there was a regime shift in the early 1990s which messes up the beauty of this fit (see chart, source Enduring Investments).
We have recently resolved much of this problem in our own modeling. The following chart uses three (unstated here, but included in our quarterly inflation outlook to clients) inputs to model M2 velocity, and the regime shift is largely absent. Suffice to say that with a model that makes sense and fits a much wider range of history, we are even more confident now that any Fed move to hike interest rates, rather than to drain reserves, would be a mistake.
The bottom line is that it is good news that Yellen is not planning to hike interest rates soon. It is bad news that she is not planning to drain reserves any time soon. But the Fed is perilously close to making its big policy error of this cycle. Stay tuned.
Don’t Bank on it
Here is a post from Sober Look that has some really good charts on the changing asset mix at US banks. I was a little surprised that they didn’t point out the obvious connection in the charts, although they do make some key points in a previous post.
To summarize: the charts show that the loan-to-deposit ratio in the banking system recently hit a 35-year low, and that the proportion of cash on the balance sheet of banks has gone from maybe 5% to around 20% (eyeballing it) in the last ten years.
Obviously, these two facts are not unconnected, since loans and cash are both assets to banks. The reason for the shift from loans to cash is very simple: QE. Banks don’t want to hold as much cash (reserves) as they are carrying, but the alternative is to lend it to people in sub-optimal loans – that is, where the interest rate charged does not compensate for the risk that the loan will not be paid back, so that the lending has a negative NPV. Moreover, the cash itself has a positive return because the Fed is paying interest on excess reserves, so that the lending has a higher hurdle to achieve than it would if this was just “normal” cash or reserves.
Understanding this dynamic is really important. So here’s how this works: if interest rates rise, but reserves have the same yield, then lending becomes more profitable and loans will increase – that is, the money multiplier will rise, with less money in the vault and more money in transactional accounts. If, on the other hand, the Fed raises the interest on excess reserves while lending rates stay unchanged, then even fewer loans will be made and banks will hold more cash relative to loans. This is one mechanism by which higher interest rates initially encourage higher inflation.
(And yes, while the total amount of reserves in the system is fixed, the total amount of loans is not, so while the Fed controls the former they do not control the latter except indirectly).
So, consider the “exit” strategy. As interest rates rise, the multiplier will increase unless the Fed hikes interest on excess reserves. But since interest rates move more flexibly, more rapidly, and often further than do policy rates, this probably means the multiplier will be determined mostly by the market (I wonder if the Fed declared the IOER to be “10-year yields minus 250bps” if that would change things?). The gap is the thing. And, if Yellen actually cuts the IOER to zero, as she has intimated is possible, then the multiplier would rise…and we don’t know by how much.
On the flip side, if the Fed tapers QE to zero, and lending rates fall, then the multiplier would tend to fall further because that gap narrows. In that case, you really could get a disinflationary scenario…though I am skeptical that long rates can fall very much when public debt is so high and the Fed is withdrawing its support for the bond market. Still, a crisis could do it. To be clear: you’d need the Fed to stop adding reserves, to neglect the IOER – or increase it – and long rates to decline substantially (at least 100bps, say). So if you are a deflationist, there are your signposts. I don’t anticipate that any of that happening, except that I imagine they will screw up the IOER strategy and they could screw that up in either direction.
And by the way, I don’t think any of that would affect inflation much in 2014, since higher housing prices are already going to be pressing core inflation higher. But it could affect 2015.
However, I digress from the other point I wanted to make that was suggested by the Sober Look article, and that is this: it continues to amaze me how well bank stocks are trading. I’ve been saying this for years – which helps to illustrate that I am a strategic investor, not a twitchy tactical guy. Return on equity equals gross margin (profit/revenue), times asset turnover (revenue/assets), times leverage (assets/equity), and for banks all three of these components are under pressure. Gross margin is under pressure from the movement of more products to electronic trading and from increasing legal bills at banks (the FX trading scandal is the latest threat of multibillion-dollar fines, adding to the LIBOR scandal and probes of the gold and silver price fixing system as sources of legal headaches for banks). Banks have been forced via the crisis to shed leverage, as a chart I recently ran illustrated. And low interest rates combined with large amounts of cash compared to loans on the balance sheet pressures the asset turnover statistic. So it isn’t surprising that bank ROEs are low (see chart of the NASDAQ bank index ROEs, source Bloomberg). 
What is surprising is that they even got this high, and market pricing seems to anticipate that they’ll keep rising. Bank stocks are actually outperforming the S&P since late 2011, and their P/E ratios are essentially where they have always been, excluding the spike when earnings collapsed in the crisis, causing P/Es to skyrocket (see chart, source Bloomberg).
Maybe all the bad news is already in the price of bank stocks, but it doesn’t look like it to me.
Inflation Consequences of QE – per Reynard
Before getting into today’s column, let me first describe my plan of attack for the month of December. I plan to have several comments this week and next week, culminating in my annual “Portfolio Projections” piece at the end of next week. Then, for the last two weeks of the month, I plan to ‘re-blog’ some of my best articles from the last four years (editing out the current events, which will no longer be topical of course). Included in that list is an article on long-run returns to equities, one on Yellen’s defense of large-scale asset purchases, an article on the Phillips Curve, one on why CPI isn’t a bogus construct of a vast governmental conspiracy, and so on. Because I don’t expect some of the places where this column is ‘syndicated’ to post the re-blogs, you should consider going to the source site to sign up for these posts.
With that housekeeping complete, I want to turn today to a scholarly article I recently stumbled on which is worth a read even once you have read my synopsis and comments. The article, written one year ago by Samuel Reynard of the Swiss National Bank, is entitled “Assessing Potential Inflation Consequences of QE after Financial Crises.” It appears to be unpublished except as a working paper, which perhaps shouldn’t be surprising since it is so decidedly clear-eyed and takes the consensus view of QE to task.
What I love about this article is that Reynard’s view is remarkably consonant with my own – the only example I can come up with of a reasonably-placed central banker espousing such commonsensical views (Daniel Thornton at the St. Louis Fed gets an honorable mention though), backed with quantitative data and clear reasoning. Here is the paper’s abstract:
“Financial crises have been followed by different inflation paths which are related to monetary policy and money creation by the banking sector during those crises. Accounting for equilibrium changes and non-linearity issues, the empirical relationship between money and subsequent inflation developments has remained stable and similar in crisis and normal times. This analysis can explain why the financial crisis in Argentina in the early 2000s was followed by increasing inflation, whereas Japan experienced deflation in the 1990s and 2000s despite quantitative easing. Current quantitative easing policies should lead to increasing and persistent inflation over the next years.”
In the introduction, the author directly tackles current central bank orthodoxy: “It is usually argued that it is sufficient to monitor inflation expectations, and that central banks can avoid accelerating inflation by quickly withdrawing reserves (or by increasing the interest rate payed on reserves) once inflation expectations start rising. The monetary analysis of this paper however shows that there has never been a situation of excess broad money (created by the banking system) which has not been followed by increasing inflation, and that the increase in inflation occurs after several years lags.”
Reynard starts with the quantity theory of money (MV≡PQ), which I have discussed at length in this column. Regular readers will know that I am careful to distinguish transactional money from base money – as does Reynard – and that the sole reason inflation has not accelerated is that money velocity has declined. This decline is not due to the financial crisis directly, but as I have shown before it is due to the decline in interest rates. This makes monetary policy problematic, since an increase in interest rates which in ordinary times (that is, when there isn’t a couple trillion of excess reserves) would cause M2 to decelerate and dampen inflation will also cause money velocity to rise – offsetting to some extent the effects of the rising interest rates on the money supply. (Among other things, this effect tends to help cause monetary policy to overshoot on both sides). Reynard’s insightful way around this problem is to “model equilibrium velocity as a function of interest rate to reflect changes in inflation environments.” That is, the monetary equation substitutes an interest rate variable, based on a long-run equilibrium relationship with velocity, for velocity itself. In Reynard’s words,
“Thus the observed money level is adjusted…by the interest rate times the estimated semi-elasticity of money demand to account for the fact that, for example in a long-lasting disinflationary environment when inflation and interest rate decrease, the corresponding increase in money demand reflecting the decline in opportunity cost is not inflationary: the price level does not increase with the money level given that equilibrium velocity decreases.”
This is exactly right, and it is exceedingly rare that a central banker has that sort of insight – which is one of the reasons we are in this mess with no obvious way out. Reynard then uses his model to examine several historical cases of post-crisis monetary and inflationary history: Switzerland, Japan, Argentina and the 1930s U.S. He finds that there are downward rigidities to the price level that cause inflation to resist turning negative (or to fall below about 1.5% in the U.S.), but that when there is excess liquidity the link between liquidity and inflation is very tight with a lag of a couple of years. Reynard’s opinion is that it is this non-linearity around price stability that has caused prior studies to conclude there is no important link between money and inflation. As Fama observed back in the early 1980s, and I observe pretty much daily to the point that it is now a prohibited topic at the dinner table, when inflation is very low there is a lot of noise in the money-inflation relationship that makes it difficult to find the signal. But the money-inflation connection at higher levels of inflation and money, and over longer periods of time, is irrefutable.
In the last section of the paper, the author assesses the effects of current QE (through November 2012) on future inflation in the U.S. His conclusion is that “Excess liquidity has always been followed by persistent increases in inflation. Current quantitative easing policies should lead to increasing and persistent inflation over the next years.” The chart accompanying this statement is reproduced below.
As you can see, the model suggests inflation of 3-4% in 2013 and 5% in late 2014. While clearly inflation in 2013 has been lower than suggested by the chart, this isn’t supposed to be a trading model. I suspect that if get 3-4% in 2014 and 5%+ in 2015 (our forecast is for 3.0%-3.6% on core inflation in 2014 and 3.3%-4.8% in 2015), the issue of whether Reynard was essentially correct will not be in question!
Time is Running Out
All the expectations for resurgent growth are running into a time problem. While the Federal Reserve continues to pump the system, hoping for that burst of energy coming out of the slump, there is really little reason to expect anything more than we have already gotten. I’ve written recently about that in the context of payroll growth and the rate of improvement in the unemployment rate. But there is also, as I say, a time problem.
The current expansion, believe it or not, is getting long in the tooth. While there have been longer expansions – the one from 1991 to 2001, fueled by a continuous decline in interest rates, a budget that was near balance or in surplus, and an asset bubble engendered by the promise of the Internet and some remarkable Wall Street pitchmen – the average postwar expansion has only been 68 months, peak to peak, or 58 months, trough to peak. According to the NBER, on which we rely to jog our memories since this was so long ago, the prior business cycle peak occurred in December 2007 and the prior trough in June 2009. So, using those average business cycle lengths, the expected date of the subsequent peak would be between August 2013 and May 2014. This latter date is especially interesting because it is approximately the current consensus on when the QE taper is expected to begin (again).
I think it’s not unreasonable to suggest that getting more than an “average” expansion in the current circumstance would be a pleasant surprise indeed. With the size of government deficits, the uncertainty engendered by the morass in Congress and the rapid proliferation of regulatory overhead (both ACA-related and other), real interest rates much closer to the likely bottom than to the likely top, and continued threat of volatility in the international political economy… it is remarkable to me that we’ve even been able to squeeze out one of “average” duration.
And all it took was a few trillions!
It is well past time when it was appropriate for the Federal Reserve to stop trying to push the economy faster. Blowing into the sail simply doesn’t work very well to make the boat go faster. It will only lead to hyperventilation.
So now we are in a situation in which the expansion is likely to begin to wind down, and very likely to do so at least partly provoked by the Fed’s tightening of policy (for lessening QE is, as we have seen from the interest rate response, clearly a tightening of policy). It may become very tempting for the Yellen Fed to continue QE as weakness manifests, but the problem is going to be that inflation is going to be heading higher, not lower, into the slowdown as the housing price inflation continues to percolate into rental prices and a weakening dollar helps other prices to firm as well.
We really are in a very dangerous situation equity market-wise, as a result of this timing issue. Over the next year inflation is going to rise, growth is (probably) going to slow, and equity earnings ex-finance are looking decidedly punk as a recent article by Sheraz Mian from Zacks Investment Research pointed out. Which is not to say, of course, that the stock market can’t or won’t continue to ramp higher…just that it is increasingly subject to sudden-breakage risk as the shelf it sits on gets higher and higher.
