This Economic Outlook will feature a continuation of an analysis of the communication coming out of Washington D.C. Regular readers may notice the proportion of the Outlook dedicated to analysis of the Federal Reserve and federal government continues to grow overtime. This is because the intent of the Outlook is not to perfectly guess unemployment rates or GDP growth rates but to develop a forecast for upcoming trends within the financial markets.
Over the last 5 years, it has become clear that the financial markets are becoming increasingly correlated with the pace of the Fed’s balance sheet efforts and less correlated with the trends in the U.S. economy. The ideal condition would be for the markets to resume their interplay with core economic conditions, but is unlikely to happen as long as the Fed is active in its efforts to engineer the future direction of the economy.
While a continually large focus on the Federal Reserve and government could seem redundant to some, it must be recognized that an increasingly precise narrative of the elephants in the room is required to understand the events before us. Unfortunately, with “Fed speak” and the constant live stream of “market news”, the language of true events has been distorted (along with the public’s understanding of market events). A well‐developed science surrounds the study of the way that words shape the way we think about things. In the field of linguistic relativity, a commonly used story is one of the Zuni Indian tribe. The Zunis use the same word for the colors yellow and orange. Compared to people from around the world, the Zunis are very poor at cognitively distinguishing between yellow and orange. This is one example of countless others that have been observed in this field.
In order to begin to understand the world of economics and the capital markets, one is required to provide a more properly and accurately stated account of events; the following quote provides for a good start:
Regular readers of our irregular publication will be aware of our thoughts on inflation, but for those who are not we would summarize them thus: inflation is not measurable.
We can summarize our views on money with similar succinctness: it is poorly understood.
And as for the economy, we know only this: it is a complex system.
From these observations can be derived a straightforward corollary on economic policy makers: trying to control a variable you can’t measure (inflation) with a tool you don’t fully understand (money) in a complex system with hidden, unobservable and non‐linear interrelationships (the economy) is a guaranteed way to ensure that most things which happen weren’t supposed to happen. ‐ Dylan Grice
Bernanke recently caught the majority of the financial world off guard when he announced that the Fed would not slow the pace of asset purchases. Since the dust has settled, there are only a few potential explanations that serve to explain what was considered unpredictable.
- Bernanke had made the tapering call as a means of facilitating Summers’ arrival as the next Fed Chairman, which never materialized. Instead, Janet Yellen was nominated as the next Fed Chairperson. It is widely believed that Yellen is likely to be even more aligned with easing than Bernanke (which is quite an accomplishment).
- Bernanke never intended to slow the pace of asset purchases and was using communication to keep excessive risk taking at bay. Bernanke used the tapering talk as a head‐fake to bring in excessive risk taking as his last major policy effort that will never be officially recognized.
- The Fed thinks the economy is doing much worse than what is commonly believed.
First, it must be reminded that before Bernanke spoke, the market was fully expecting the Fed to reduce the pace of asset purchases by $20‐35 billion per month and that these expectations were fully reflected in the financial markets. If the Fed had made the decision to slow asset purchases from $85 billion per month to $60 billion per month, no one would have blinked.
Nobody will convince me that the collective brains at the Federal Reserve wouldn't have figured out that, after all the talk, failing to taper would damage their credibility enormously. So one has to wonder, how bad must things really be in order that they would sacrifice their credibility so willingly? After all, they could have gone ahead with the Taper and then found another way to throw the market a bone later if they had to, but instead they chose to blink in the face of their toughest moment since the tarp was pulled off the printing press in the Fed basement back in 2008.
‐ Grant Williams
Indeed, after looking at the following chart, one can easily observe that, from the standpoint of looking at the overall size of the Federal Reserve balance sheet, the difference between tapering and not tapering is negligible.
It is intimidating to look at the below chart and realize that the Federal Reserve didn’t think the economy could afford even a minimal slowdown in asset purchases. Also, in looking at the chart, one must wonder, “Is it really necessary that the Federal Reserve hold $5 trillion in assets when (if) the economy appears to be doing fine?” The chart also serves as a reminder that the economy, at one point in time, was able to survive without the Fed intervening.
“Politicization [of the Federal Reserve] is a skin‐deep phenomenon; with every change in Administration there is some commensurate change, usually incremental, in [monetary] policy application. Bureaucratic capture, on the other hand, marks a more or less permanent shift in the existential purpose of an institution. The WHY of the Fed – its meaning – changed this week. Or rather, it’s been changing for a long time and now has been officially presented via a song‐and‐dance routine.
What Bernanke signaled this week is that QE is no longer an emergency government measure, but is now a permanent government program. In exactly the same way that retirement and poverty insurance became permanent government programs in the aftermath of the Great Depression, so now is deflation and growth insurance well on its way to becoming a permanent government program in the aftermath of the Great Recession. The rate of asset purchases may wax and wane in the years to come, and might even be negative for short periods of time, but the program itself will never be unwound.”
– Ben Hunt, Economist
Knowing that Bernanke’s service at the Federal Reserve is near an end, it is important to hear Janet Yellen’s point of view:
“While I think we all agree, Mr. President, that more needs to be done to strengthen this recovery, particularly for those hardest hit by the Great Recession, we have made progress… while we have made progress, we have farther to go. The mandate of the Federal Reserve is to serve all the American people, and too many Americans still can’t find a job and worry how they will pay their bills and provide for their families. The Federal Reserve can help, if it does its job effectively. We can help ensure that everyone has the opportunity to work hard and build a better life.”
‐Janet Yellen, new Chairwoman of the Federal Reserve, October 9th
While this statement confirms much of what Ben Hunt suggests (and what this Economic Outlook has been declaring for over a year), it couldn’t be further from what is traditionally correct. The Federal Reserve’s official mandate is to keep inflation at modest and stable levels and to keep cyclical unemployment low.
“It is likely the Fed is not able to sell assets. The Fed may have no choice but to hold everything until maturity. The maturity date of those assets will be this country’s best friend and worst enemy. While the Fed refers to the country’s problems as cyclical and short term in nature; this “fix”, whether bad or ugly, is now a structural element of the economy. The extra liquidity, whether it works well or not at all, is irretrievable.”
‐ 2nd quarter 2013 Economic Outlook
By stating that the Fed is monitoring for the appropriate conditions to slow down the pace of asset purchases while also playing down the accuracy of the unemployment rate, Bernanke was able to justify keeping the money flowing at its current pace while showing that the Fed has its finger on the trigger to slow purchases (in effort to keep risk bubbles in check).
“An interesting conversation might occur if the economy reaches 6.5% unemployment while our jobs‐to population ratio remains depressed. To prevent tightening amidst weak employment dynamics, the Fed would likely need to explain why 6.5% unemployment is not strong enough to warrant monetary tightening. Either they would move the goalposts to a lower unemployment target or explain the truth behind the headline unemployment rate.
When it comes to employment measures, the jobs‐to‐population ratio is clearly better than the unemployment rate, and it is probable the Fed will have one of three choices:
- Stick with the unemployment rate even if it means tightening policy amidst a very weak employment market,
- Set monetary policy according to true employment dynamics and communicate why broader measures of employment need to be used instead of the unemployment rate, or
- Simply target a lower unemployment rate.
For the sake of the economy, one would hope the Fed would pick the second choice.”
‐ 2nd quarter 2013 Economic Outlook
“Last time I gave 7% as an indicative number to give you some sense of, you know, where that might be. But as my first answer suggested, the unemployment rate is not necessarily a great measure in all circumstances of the state of the labor market overall. For example, just last month, the decline in the unemployment rate came about more than entirely because of declining participation, not because of increased jobs. So what we will be looking at is the overall labor market situation, including the unemployment rate, but including other factors as well. But in particular, there is not any magic number that we are shooting for.”
‐ Fed Chairman Ben Bernanke, September 18, 2013
In the pursuit of forecasting future trends in the financial markets, one subtle but critical differentiation must be made; an analyst must differentiate between thoughts of what is LIKELY to happen versus thoughts of what SHOULD happen. The analyst must unfortunately place the majority of his or her fixation on what it LIKELY to happen. Do not mistake a forecast (LIKELY) for continued easing to mean that it is the ideal policy response (SHOULD).
It is acknowledged that, without QE1, the scale of the global recession could have been distinctly greater. Yet, the policy of ever‐increasing Central Bank balance sheets in a world with positive GDP growth and positive inflation is an unnecessary gamble.
To be astute observers of our own environment, we must attempt to analyze our surroundings from multiple perspectives. The first perspective is the easiest to make; this is done simply by having open eyes and ears. Additional perspectives are more difficult to achieve as they require the additional element of having an open mind. Try to examine the essence of today’s Federal Reserve and its communication pattern while severing any former understanding of central banks and monetary policy.
One observation that comes to mind bears a subtle, yet important point of differentiation from what is assumed to be the role of a central bank. As Ben Hunt suggests, the Federal Reserve, without a vote or any public declaration, has now set quantitative easing as the norm; only to be ceased if inflation is too high and unemployment is too low!
Looking back across the last five years, the given the path of communication from the Fed, it is difficult to avoid the conclusion that the nation has been arriving at a new monetary policy equilibrium that was pre‐determined years ago and that the path of Fed communication has been on a deliberately incremental evolution. Had the Fed came out in January 2010 and declared that quantitative easing would triple in size before being held as a permanently growing program in unimaginably large quantities, the public may not have stood for it. Yet, here we are.
If this is truly the case, it is almost unanimously bad for savers and long term investors, yet it is coincidentally good for those who are mostly interested in protecting 4‐year timeframes.
Something is wrong with the fact that, when we were 24 hours from hitting the debt ceiling (which Treasury Secretary Jack Lew reported would bring the financial system to its knees!) the S&P 500 was only 2.3% away from its all‐time high! Is it possible that the financial markets (and the public) have grown that comfortable with the prospect of living on the edge of the cliff?
Seeing that the financial markets are holding up so well amidst unprecedented fiscal and political challenges and monetary policy uncertainty, one of two conditions must hold true:
- The financial markets now have a much more stable foundation compared to the last several years, or
- The financial markets are in a confidence bubble.
The below charts highlighting the debt bubble would suggest the second scenario is accurate. Compared to the debt limit debate in 2011, the capital markets were essentially asleep at the wheel this time around. Despite dire catastrophic warnings from the U.S. Treasury Secretary, the volatility index hardly registered any abnormality. How could this be?
One may ask the question, "What's wrong with a lack of volatility?" In others words, some may view the lack of stock market volatility as a positive event. This begs the question, "If something 'bad' happens yet doesn't cause a 'problem', is it truly 'bad'?" To answer that question, the following saying comes to mind: "What is rewarded will be repeated"; or at a minimum, a bad action that is not punished, will be repeated.
These are important factors to consider because it will be less than 60 days before the nation gets caught up in this debate again. Looking back on the debt ceiling limit, ask yourself the following questions:
During the debt ceiling debate, did politicians exhibit good or bad behavior?
Was this behavior rewarded or punished?
This begs serious consideration, because each American voter, whether knowingly or not, is essentially a Board member of the American governance system. How is this true?
In corporations, there are principals and there are agents. Principals are the primary stakeholders in the corporations; those people that have “skin in the game”. Agents are people who see to the operations of the corporation; the managers. A natural flaw to this framework is that agents occasionally subordinate the best interest of the principals for their own self(ish) interests. This has been evidenced in recent history by management power struggles, excessive executive compensation, and managers manipulating financial statements intending to meet investor expectations.
The closer the linkage between the principals and the agents, the slimmer the probability for abuse. The closer the linkage between the reward systems for the agents and the best interest of the principals, the slimmer the probability for abuse. In corporations, when there is a wide gap between principals and agents, a board of directors serves to oversee the direction of the business to ensure that it is being operated in the best interests of the principals.
Looking back on the American public’s governance system, several questions emerge. First, let us establish that, in this system, American citizens are the principals and elected politicians are the agents.
- Are the goals of the principals and agents aligned?
- What possible reward or punishment systems are in place to enforce the principals' objectives?
- Are these reward or punishment systems clearly established and consistently applied?
- Are the time horizons of the agents and the time horizons of the principals congruent?
- How far removed are the agents from the principals (geographically, demographically, ideologically)?
These are important questions to ask, because without a vote or even a public declaration, our civil servants in Washington D.C. are sailing our ship in a different direction from the path that had been previously charted, and likely in a different direction than what many Americans desire.