The Bubble Economy

This is where the easy credit goes. A slush fund for Wall St. and Silicon Valley…

Full article here.

Money, money, money: Silicon Valley speculation recalls dotcom mania

Venture capitalists and private equity investors keep the bubble going with their millions

by Rana Foroohar

Financial Times
July 17, 2017

…It’s a bubble that is different — but the same — as the last time. In 2000, start-ups like pets.com were able to go public and jack up share prices even as they were losing hundreds of millions of dollars. The digital ecosystem has since grown, changed and deepened. Today it is harder for companies to receive funding just by sticking “.com” behind their names.

But now, as then, you do not necessarily need profits or paying customers to draw investor interest but rather “users” in a hot market niche. Compelling narratives develop around these sectors (wearables, electric cars, the “sharing” economy). Companies send market signals about their own “value” with announcements that play off these narratives, for example, Uber’s $680m purchase of self-driving truck firm Otto).

Venture capitalists and private equity investors keep the bubble going by buying into it at higher and higher valuations. The smartest ones guarantee their own success by taking rich advisory fees along the way and exiting before disaster via the secondary market for private shares. And this is, as behavioural economist Peter Atwater recently pointed out to me, unusually liquid thanks in part to central bank-enabled easy money.

The virtual money, generated by valuations that are based as much on narrative as fact, is used to salaries: it can cost upward of $2m in cash and stock options to recruit a driverless-car engineer in the Valley. These then distort the price of property, services and labour. You’ll weep when you see the prices of depressing ranch-style homes off Highway 101, which runs through Silicon Valley. The whole cycle is straight-up “madness of crowds”, as described by Charles Mackay in 1841.

It’s The Fed, Stupid! Again.

Really, I wish we could get serious…

Trump Tees Up a Necessary Debate on the Fed

Sixty percent of stock gains since the 2008 panic have occurred on days when the Fed makes policy decisions.

By RUCHIR SHARMA

Wall Street Journal, Sept. 28, 2016 6:43 p.m. ET

The press spends a lot of energy tracking the many errors in Donald Trump ’s loose talk, and during Monday’s presidential debate Hillary Clinton expressed hope that fact checkers were “turning up the volume” on her rival. But when it comes to the Federal Reserve, Mr. Trump isn’t all wrong.

In a looping debate rant, Mr. Trump argued that an increasingly “political” Fed is holding interest rates low to help Democrats in November, driving up a “big, fat, ugly bubble” that will pop when the central bank raises rates. This riff has some truth to it.

Leave the conspiracy theory aside and look at the facts: Since the Fed began aggressive monetary easing in 2008, my calculations show that nearly 60% of stock market gains have come on those days, once every six weeks, that the Federal Open Market Committee announces its policy decisions.

Put another way, the S&P 500 index has gained 699 points since January 2008, and 422 of those points came on the 70 Fed announcement days. The average gain on announcement days was 0.49%, or roughly 50 times higher than the average gain of 0.01% on other days.

This is a sign of dysfunction. The stock market should be a barometer of the economy, but in practice it has become a barometer of Fed policy.

My research, dating to 1960, shows that this stock-market partying on Fed announcement days is a relatively new and increasingly powerful feature of the economy. Fed policy proclamations had little influence on the stock market before 1980. Between 1980 and 2007, returns on Fed announcement days averaged 0.24%, about half as much as during the current easing cycle. The effect of Fed announcements rose sharply after 2008 when the Fed launched the early rounds of quantitative easing (usually called QE), its bond purchases intended to inject money into the economy.

It might seem that the market effect of the Fed’s easy-money policies has dissipated in the past couple of years. The S&P 500 has been moving sideways since 2014, when the central bank announced it would wind down its QE program.

But this is an illusion. Stock prices have held steady even though corporate earnings have been falling since 2014. Valuations—the ratio of price to earnings—continue to rise. With investors searching for yield in the low interest-rate world created by the Fed, the valuations of stocks that pay high dividends are particularly stretched. The markets are as dependent on the Fed as ever.

Last week the Organization for Economic Cooperation and Development warned that “financial instability risks are rising,” in part because easy money is driving up asset prices. At least two regional Fed presidents, Eric Rosengren in Boston and Esther George in Kansas City, have warned recently of a potential asset bubble in commercial real estate.

Their language falls well short of the alarmism of Mr. Trump, who in Monday’s debate predicted that the stock market will “come crashing down” if the Fed raises rates “even a little bit.” But it is fair to say that many serious people share his basic concern.

Whether this is a “big, fat, ugly bubble” depends on how one defines a bubble. But a composite index for stocks, bonds and homes shows that their combined valuations have never been higher in 50 years. Housing prices have been rising faster than incomes, putting a first home out of reach for many Americans.

Fed Chair Janet Yellen did come into office sounding unusually political, promising to govern in the interest of “Main Street not Wall Street,” although that promise hasn’t panned out. Mr. Trump was basically right in saying that Fed policy has done more to boost the prices of financial assets—including stocks, bonds and housing—than it has done to help the economy overall.

The increasingly close and risky link between the Fed’s easy-money policies and financial markets has been demonstrated again in recent days. Early this month, some Fed governors indicated that the central bank might at long last raise interest rates at its next meeting. The stock market dropped sharply in response. Then when decision time came on Sept. 21 and the Fed left rates unchanged, stock prices rallied by 1% that day.

Mr. Trump was also right that despite the Fed’s efforts, the U.S. has experienced “the worst revival of an economy since the Great Depression.” The economy’s growth rate is well below its precrisis norm, and the benefits have been slow to reach the middle class and Main Street. Much of the Fed’s easy money has gone into financial engineering, as companies borrow billions of dollars to buy back their own stock. Corporate debt as a share of GDP has risen to match the highs hit before the 2008 crisis.

That kind of finance does more to increase asset prices than to help the middle class. Since the rich own more assets, they gain the most. In this way the Fed’s policies have fueled a sharp rise in wealth inequality world-wide—and a boom in the global population of billionaires. Ironically, rising resentment against such inequality is lifting the electoral prospects of angry populists like Mr. Trump, a billionaire promising to fight for the little guy. His rants may often be inaccurate, but regarding the ripple effects of the Fed’s easy money, Mr. Trump is directly on point.

It’s the Fed, Stupid!

A Messaging Tip For The Donald: It’s The Fed, Stupid!

The Fed’s core policies of 2% inflation and 0% interest rates are kicking the economic stuffings out of Flyover AmericaThey are based on the specious academic theory that financial gambling fuels economic growth and that all economic classes prosper from inflation and march in lockstep together as prices and wages ascend on the Fed’s appointed path.

Read more

The FED That Rules the World

Financial markets exhibit centripetal forces, sucking in all the capital from the periphery to the center. That’s why our financial centers have become the repository of capital wealth. As NYC is to Peori or Decatur; the US$ economy is to the rest of the world. As the FED screws up the world’s monetary system, dollar holders will be the least hurt. A very unneighborly result that usually leads to military conflicts.

From the WSJ:

The Dollar—and the Fed—Still Rule

Americans may think the U.S. is in hock to China, but Beijing’s economic fate lies in Washington’s hands.

By Ruchir Sharma
July 28, 2016 7:20 p.m. ET

When Donald Trump recently declared that “Americanism, not globalism, will be our credo,” he was expressing the kind of sentiment that animates not only his new Republican coalition, but nationalists everywhere. From the leaders of Russia and China to the rising European parties hostile to an open Europe, these nationalists are linked by a belief that in all matters of policy, their nation should come first.

This world-wide turning inward, however, comes in a period when countries are more beholden than ever to one institution, the U.S. Federal Reserve. Every hint of a shift in Washington’s monetary policy is met with a sharp response by global markets, which in turn affect the U.S. economy more dramatically than ever.

The Fed has been forced to recognize that it can no longer focus on America alone. When the Federal Open Market Committee voted in January 2015 to hold interest rates steady, its official statement explicitly noted, for the first time, that it was factoring “international developments” into its decisions. Since then the Fed, including this week, has frequently cited international threats, from Brexit to China, as reason to continue with hyper-accommodative monetary policy.

Though Mr. Trump argues that America must tend to its own affairs because it is weak, the Fed’s evolving role shows the limits of this argument. The U.S. may have slipped as an economic superpower, falling to 23% of global GDP from 40% in 1960. But as a financial superpower Washington has never been more influential. Forecasts of the dollar’s downfall have completely missed the mark.

Since the 15th century the world has had six unofficial reserve currencies, starting with the Portuguese real. On average they have maintained their leading position for 94 years. The dollar succeeded the British pound 96 years ago, and it has no serious rival in sight.

In the past 15 years, total foreign currency reserves world-wide rose from under $3 trillion to $11 trillion. Nearly two thirds of those reserves are held in dollars, a share that has barely changed in decades. Nearly 90% of global trade transactions involve dollars, even in deals without an American party. A Korean company selling TVs in Brazil, for instance, will generally ask for payment in dollars.

Because the Fed controls the supply of dollars, it reigns supreme. Its influence has only grown since the financial crisis of 2008. As the Fed began experimenting with quantitative easing to inject dollars into the system, tens of billions flowed out of the country every month. The amount of dollar loans extended to borrowers outside the U.S. has doubled since 2009 to $9 trillion—a record 75% of global nonresidential lending. Many of those are in the form of bonds, and bond investors are highly sensitive to U.S. interest rates.

That helps explain why any sign of Fed tightening, which reduces the supply of dollars, sends global markets into a tizzy. Earlier this year, for example, Chinese investors were shipping billions abroad every month, searching for higher yields. The Fed had been expected to raise short-term interest rates later this year, but it backed off that commitment in February, when China appeared headed toward a financial crisis.

Had the Fed tightened, China’s central bank would have been pressured to follow, crippling the flow of credit that is keeping the Chinese economy afloat. So instead the Fed held steady, effectively bailing out Beijing. Though many Americans still see the U.S. as deeply in hock to China, the fact is that China is even more reliant on easy money to fuel growth—putting the country’s economic fate in Washington’s hands.

The Fed is thus caught in a trap. Every time the U.S. economy starts to perk up, the Fed signals its intent to start returning interest rates to normal. But that signal sends shock waves through a heavily indebted global economy and back to American shores. So the Fed delays rate increases, as it did in June and again this week.

The rest of the world recognizes the Fed’s power as well. As soon as quantitative easing began, finance ministers from Brazil to Taiwan warned about the risks of unleashing torrents of dollars. They said it would drive up the value of currencies in the emerging world, destabilize local financial markets, undermine exports and economic growth.

The Fed was initially skeptical. Its then-chief Ben Bernanke argued that the central bank’s policies were a boost for every country. Other officials stated bluntly that the rest of the world wasn’t their problem. “We only have a mandate to concern ourselves with the interest of the United States,” Dennis Lockhart, president of the Atlanta Fed, said in 2013. “Other countries simply have to take that as a reality and adjust to us if that’s something important for their economies.”

The Fed has since discovered the world, which matters more than ever to the American economy. In the past 15 years the share of U.S. corporate revenues that come from foreign markets has risen from a quarter to a third. The more interconnected global markets become, the more rapidly financial instability in the rest of the world ricochets to hurt the U.S.

In the immediate aftermath of the financial crisis, the Fed’s loose policies may have temporarily stimulated growth world-wide. But those policies have come back to haunt it. Fed officials ignored the resulting excesses, including the credit and asset bubbles building around the world. Now every time the Fed tries to tighten, the dollar starts to strengthen and global markets seize up, forcing the Fed to retreat. It’s unclear how to end this cycle, but this much is apparent: The financial hegemony of the U.S. has never been greater, making the Fed the central bank of the world.

Blog Note: the world is screwed and we’re part of it.

Economic Policy Report Card: C-

Today’s headlines:

Still anemic: U.S. growth picks up to only 0.8%

U.S. economic growth between January and March was 0.8% compared to the same time frame a year ago. That’s better than the initial estimate of 0.5%, which came in April, but still pretty sluggish.

unemployment-grads-cartoon1

US created 38,000 jobs in May vs. 162,000 expected

Job creation tumbled in May, with the economy adding just 38,000 positions, casting doubt on hopes for a stronger economic recovery as well as a Fed rate hike this summer.

The Labor Department also reported Friday that the headline unemployment fell to 4.7 percent. That rate does not include those who did not actively look for employment during the month or the underemployed who were working part time for economic reasons. A more encompassing rate that includes those groups held steady at 9.7 percent.

The drop in the unemployment rate was primarily due to a decline in the labor force participation rate, which fell to a 2016 low of 62.6 percent, a level near a four-decade low. The number of Americans not in the labor force surged to a record 94.7 million, an increase of 664,000.

growth chart

We’ve been predicting such disappointing results of ineffectual monetary and fiscal policies since this blog began back in August of 2011. And providing corroborating evidence along the way. Yet our policy experts continue to double-down on failed policies.

The problem is that when a nation inflates asset bubbles like we did with commodities, houses, stocks, and bonds over the past 20 years, there is no silver-lining policy correction that does not involve some  economic pain for the body politic. We had that awakening in 2008, but since then we have merely jumped on the same train by pumping out cheap credit for 8+ years.

Perhaps a medical metaphor works here. When prescribing antibiotics to combat an infection one can use small doses to avoid side-effects or one large overkill dose to knock-out the offending bacteria. The first treatment is the conservative, prudent approach that seeks a gradual recovery. The second risks a sudden shock to the system that kills off the infection so the patient can begin healing.

In medicine we’ve discovered that the gradual treatment can enable the bacteria to evolve and resist the antibiotics, making them ineffectual. In a nutshell, this is what we have done with economic policy, especially monetary policy that has distorted interest rates for more than 15 years.

The conservative approach marked by bailouts and government bail-ins has kept the patient flat on his back for 8 years. The more disciplined approach would have shocked the economy severely but gotten the patient out of the recovery room much quicker. We’ve seen that with other countries, like Iceland, that were forced to swallow their medicine in one quick dose.

But, of course, that would have meant a lot of politicians would have lost their cozy jobs. That may happen anyway after the next election.

Disconnects

…between central bank policies, economic growth and unemployment. Stockman distinctly and colorfully explains why we are experiencing 1-2% growth these days. I’m not sure any of the candidates for POTUS have a good answer for this…It’s a sad commentary on our intellectual and political leaders.

Losing Ground In Flyover America, Part 2

In fact, the combination of pumping-up inflation toward 2% and hammering-down interest rates to the so-called zero bound is economically lethal. The former destroys the purchasing power of main street wages while the latter strip mines capital from business and channels it into Wall Street financial engineering and the inflation of stock prices.

In the case of the 2% inflation target, even if it was good for the general economy, which it most assuredly is not, it’s a horrible curse on flyover America. That’s because its nominal pay levels are set on the margin by labor costs in the export factories of China and the EM and the service sector outsourcing shops in India and its imitators.

Accordingly, wage earners actually need zero or even negative CPI’s to maximize the value of pay envelopes constrained by global competition. Indeed, in a world where the global labor market is deflating wage levels, the last thing main street needs is a central bank fanatically seeking to pump up the cost of living.

So why do the geniuses domiciled in the Eccles Building not see something that obvious?

The short answer is they are trapped in a 50-year old intellectual time warp that presumes that the US economy is more or less a closed system. Call it the Keynesian bathtub theory of macroeconomics and you have succinctly described the primitive architecture of the thing.

According to this fossilized worldview, monetary policy must drive interest rates ever lower in order to elicit more borrowing and aggregate spending. And then authorities must rinse and repeat this monetary “stimulus” until the bathtub of “potential GDP” is filled up to the brim.

Moreover, as the economy moves close to the economic bathtub’s brim or full employment GDP, labor allegedly becomes scarcer, thereby causing employers to bid up wage rates. Indeed, at full employment and 2% inflation wages will purportedly rise much faster than consumer prices, permitting real wage rates to rise and living standards to increase.

Except it doesn’t remotely work that way because the US economy is blessed with a decent measure of free trade in goods and services and virtually no restrictions on the flow of capital and short-term financial assets. That is, the Fed can’t fill up the economic bathtub with aggregate demand because it functions in a radically open system where incremental demand is as likely to be satisfied by off-shore goods and services as by domestic production.

This leakage through the bathtub’s side portals into the global economy, in turn, means that the Fed’s 2% inflation and full employment quest can’t cause domestic wage rates to rev-up, either. Incremental demands for labor hours, on the margin, are as likely to be met from the rice paddies of China as the purportedly diminishing cue of idle domestic workers.

Indeed, there has never been a theory so wrong-headed. And yet the financial commentariat, which embraces the Fed’s misbegotten bathtub economics model hook, line and sinker, disdains Donald Trump because his economic ideas are allegedly so primitive!

The irony of the matter is especially ripe. Even as the Fed leans harder into its misbegotten inflation campaign it is drastically mis-measuring its target, meaning that flyover American is getting  an extra dose of punishment.

On the one hand, real inflation where main street households live has been clocking in at over 3% for most of this century. At the same time, the Fed’s faulty measuring stick has led it to keep interest pinned to the zero bound for 89 straight months, thereby fueling the gambling spree in the Wall Street casino. The baleful consequence is that more and more capital has been diverted to financial engineering rather than equipping main street workers with productive capital equipment.

As we indicated in Part 1, even the Fed’s preferred inflation measuring stick——the PCE deflator less food and energy—has risen at a 1.7% rate for the last 16 years and 1.5% during the 6 years. Yet while it obsesses about a trivial miss that can not be meaningful in the context of an open economy, it fails to note that actual main street inflation—led by the four horseman of food, energy, medical and housing—–has been running at 3.1% per annum since the turn of the century.

After 16 years the annual gap, of course, has ballooned into a chasm. As shown in the graph, the consumer price level faced by flyover America is now actually 35% higher than what the Fed’s yardstick shows to the case.

Flyover CPI vs PCE Since 1999

Stated differently, main street households are not whooping up the spending storm that our monetary central planners have ordained because they don’t have the loot. Their real purchasing power has been tapped out.

To be sure, real growth and prosperity stems from the supply-side ingredients of labor, enterprise, capital and production, not the hoary myth that consumer spending is the fount of wealth. Still, the Fed has been consistently and almost comically wrong in its GDP growth projections because the expected surge in wages and consumer spending hasn’t happened.

growth chart

Statistical Fixations

Martin Feldstein is nowhere near as excitable as David Stockman on Fed manipulations (link to D.S.’s commentary), but they both end up at the same place: the enormous risks we are sowing with abnormal monetary policies. The economy is not nearly as healthy as the Fed would like, but pockets of the economy are bubbling up while other pockets are still deflating. There is a correlation relationship, probably causal.

The problem with “inflation targeting” is that bubble economics warps relative prices and so the correction must drive some prices down and others up. In other words, massive relative price corrections are called for. But inflation targeting targets the general price level as measured by biased sample statistics – so if the Fed is trying to prop up prices that previously bubbled up and need to decline, such as housing and stocks, they are pushing against a correction. The obvious problem has been these debt-driven asset prices, like stocks, government bonds, and real estate. In the meantime, we get no new investment that would increase labor demand.

The global economy needs to absorb the negative in order to spread the positive consequences of these easy central bank policies. The time is now because who knows what happens after the turmoil of the US POTUS election?

Ending the Fed’s Inflation Fixation

The focus is misplaced—and because it delays an overdue interest-rate rise, it is also dangerous.

By MARTIN FELDSTEIN
The Wall Street Journal, May 17, 2016 7:02 p.m. ET

The primary role of the Federal Reserve and other central banks should be to prevent high rates of inflation. The double-digit inflation rates of the late 1970s and early ’80s were a destructive and frightening experience that could have been avoided by better monetary policy in the previous decade. Fortunately, the Fed’s tighter monetary policy under Paul Volcker brought the inflation rate down and set the stage for a strong economic recovery during the Reagan years.

The Federal Reserve has two congressionally mandated policy goals: “full employment” and “price stability.” The current unemployment rate of 5% means that the economy is essentially at full employment, very close to the 4.8% unemployment rate that the members of the Fed’s Open Market Committee say is the lowest sustainable rate of unemployment.

For price stability, the Fed since 2012 has interpreted its mandate as a long-term inflation rate of 2%. Although it has achieved full employment, the Fed continues to maintain excessively low interest rates in order to move toward its inflation target. This has created substantial risks that could lead to another financial crisis and economic downturn.

The Fed did raise the federal-funds rate by 0.25 percentage points in December, but interest rates remain excessively low and are still driving investors and lenders to take unsound risks to reach for yield, leading to a serious mispricing of assets. The S&P 500 price-earnings ratio is more than 50% above its historic average. Commercial real estate is priced as if low bond yields will last forever. Banks and other lenders are lending to lower quality borrowers and making loans with fewer conditions.

When interest rates return to normal there will be substantial losses to investors, lenders and borrowers. The adverse impact on the overall economy could be very serious.
A fundamental problem with an explicit inflation target is the difficulty of knowing if it has been hit. The index of consumer prices that the Fed targets should in principle measure how much more it costs to buy goods and services that create the same value for consumers as the goods and services that they bought the year before. Estimating that cost would be an easy task for the national income statisticians if consumers bought the same things year after year. But the things that we buy are continually evolving, with improvements in quality and with the introduction of new goods and services. These changes imply that our dollars buy goods and services with greater value year after year.

Adjusting the price index for these changes is an impossibly difficult task. The methods used by the Bureau of Labor Statistics fail to capture the extent of quality improvements and don’t even try to capture the value created by new goods and services.

The true value of the national income is therefore rising faster than the official estimates of real gross domestic product and real incomes imply. For the same reason, the official measure of inflation overstates the increase in the true cost of the goods and services that consumers buy. If the official measure of inflation were 1%, the true cost of buying goods and services that create the same value to consumers may have actually declined. The true rate of inflation could be minus 1% or minus 3% or minus 5%. There is simply no way to know.

With a margin of error that large, it makes no sense to focus monetary policy on trying to hit a precise inflation target. The problem that consumers care about and that should be the subject of Fed policy is avoiding a return to the rapidly rising inflation that took measured inflation from less than 2% in 1965 to 5% in 1970 and to more than 12% in 1980.

Although we cannot know the true rate of inflation at any time, we can see if the measured inflation rate starts rising rapidly. If that happens, it would be a sign that true inflation is also rising because of excess demand in product and labor markets. That would be an indication that the Fed should be tightening monetary policy.

The situation today in which the official inflation rate is close to zero implies that the true inflation rate is now less than zero. Fortunately this doesn’t create the kind of deflation problem that would occur if households’ money incomes were falling. If that occurred, households would cut back on spending, leading to declines in overall demand and a possible downward spiral in prices and economic activity.

Not only are nominal wages and incomes not falling in the U.S. now, they are rising at about 2% a year. The negative true inflation rate means that true real incomes are rising more rapidly than the official statistics imply. [Sounds good, huh? Not quite. Read Stockman’s analysis.]

The Federal Reserve should now eliminate the explicit inflation target policy that it adopted less than five years ago. The Fed should instead emphasize its commitment to avoiding both high inflation and declining nominal wages. That would permit it to raise interest rates more rapidly today and to pursue a sounder monetary policy in the years ahead.

inflation-vs-employment

Has the Fed Been Feeding the Zombies?

There’s little that is technically wrong with this exposition of Fed policies that puts it pretty much between a rock and a hard place. But why not question whether the Fed is really the problem rather than the solution? How did we arrive at a zombie economy? Was it excess credit and debt that ended up being unproductive? Perhaps costlier credit would have prevented unproductive investments (like new cars financed with home re-fis? Or stock/housing prices that had a tenuous relationship to income and earnings?). I suspect that by propping up prices the Fed has merely been feeding the zombies instead of letting them die off…

Reprinted from Barrons:

How the Fed Fights the Zombie Economy With Easy Money

Reinvesting the principal and interest from bonds purchased in the quantitative-easing program gives the Fed more leverage over the economy.

April 16, 2016

[IllustratIon: Martin Kozlowski]

The rabbi and philosopher Shimon Green, founder of the Bircas Hatorah center in Jerusalem for the study of ancient wisdom, has observed that the fear of zombies is cross-cultural: “The fear stems from our own fear of living hopeless lives…a fear that our lives are nonproductive, and that we are the walking dead.”

Many fear that the U.S. economy is “the walking dead”—that the economy is a charade produced by an elixir of low interest rates administered by the Federal Reserve. In an effort partly intended to dispel that fear, the Fed raised the federal-funds rate in December.

With inflation languishing below its 2% target, the Fed began a process of interest-rate normalization, thereby demonstrating confidence in the economy. Raising the fed-funds rate was supposed to encourage expectations of higher growth, which resulted, in part, from the Fed’s recognition of considerable improvements in labor markets.

When the Fed raised rates, it said it was reasonably confident that inflation would rise to meet its objective, describing the impact of energy prices as transitory and predicting that they would pick up in 2016.

While 2016 got off to a rocky start with oil and stock prices declining, both have rebounded and are now trading at levels comparable to December. The Fed continues to project confidence, and the Federal Open Market Committee recently announced that it is on course to continue to raise rates.

The official dot plot of members’ expectations shows that they expect two rate hikes in 2016 and a fed-funds rate of 3% by mid-2018. This contradicts market expectations for a more muted path forward.

While the Fed sends a message of confidence, pointing to decreases in unemployment, a pickup in average hourly earnings, and core consumer-price-index inflation exceeding 2%, it is aware that inflation continues to run below its longer-run objective.

The Fed is also mindful of the potential for adverse shocks that could derail the economy. The International Monetary Fund last week lowered its global growth forecast, saying that the sluggish pace of growth leaves the world economy more exposed to risks.

The Fed needs to remain accommodative while continuing to raise the fed-funds rate. While that rate is a short-term one charged between banks for overnight money, longer rates have the greatest impact on asset purchases (like buying a home).

Thus, the Fed pursued quantitative easing, purchasing longer-term securities to directly lower long-term yields. It intended to encourage growth more directly.

The QE program effectively ended in 2014, but longer-term rates have continued to decline. Since the Fed raised fed-funds rates in December, 30-year yields have gone down from 3% to 2.5%.

THUS THE END OF QE and a rising fed-funds rate do not necessarily spell the end of easy money. The Fed continues to buy long bonds by reinvesting principal and interest from its maturing securities. Its balance sheet is about $4.5 trillion, of which approximately $1.5 trillion matures in fewer than seven years.

An oft-overlooked paragraph in FOMC statements promises to continue the reinvesting until the normalization of federal funds is “well under way.”

It is no surprise that the Fed’s balance sheet grew for over a year after QE ended. Reinvestment can keep pressure on longer-term rates as the Fed deploys its reinvestment across the curve. Its role in monetary policy will grow as short-dated bonds mature.

The Fed’s reinvestment policy is vital, considering the impact of rising rates and a shrinking balance sheet on fiscal policy. In 2007, the government paid $430 billion in interest on $9 trillion of debt. In 2015, the total interest paid on $19 trillion was about $402 billion. Like many Americans, Treasury has more debt and pays less interest.

If that is not enough to encourage the Fed to keep interest rates low, consider that Treasury effectively pays zero interest on T-bonds that the Fed keeps on its balance sheet (most of the interest Treasury pays to the Fed is given back to Treasury as profit). Higher rates and a shrinking balance would certainly create new burdens that might not be offset by economic growth.

Fiscal realities and the fear of adverse economic shocks drive the Fed to keep long rates lower. Vice Chairman Stanley Fischer recently said a larger balance sheet is accommodative and reduces risks to the economy. This would explain why the yield curve has flattened since December, as the market digested the distinction between higher fed-funds rates and an easy long-rate policy.

Raising the fed-funds rate demonstrates confidence in the economy; lowering long-term rates may be what is necessary to make that perception a reality. Former Fed Chairman Ben Bernanke recently described longer-term “rate targeting” as a possible tool that the Fed could use to stimulate growth. With rate targeting, the Fed would peg long-term interest rates while creating a ceiling for long-term Treasury debt. Though he declared that such an “exotic” approach is not likely in the foreseeable future, he pointed out that “public beliefs about these tools may influence expectations.”

If the Fed continues to emphasize that it will be reinvesting in long bonds for some time, it can change public perception of rising short rates to navigate long rates lower without using exotic tools. On the path to normalization, the Fed then would maintain the flexibility to raise the fed-funds rate while keeping long rates low. [So we move into an inverted yield curve? That is supposed to signal tightening credit.] 

Such an accommodative stance would help our economy grow while relieving some of the fiscal pressure. This is how the Fed’s balance sheet can buy time until we arrive at a point where the inflation data confirm that we are not zombies after all. [So, inflation is going to save us? Why, instead, does a little deflation scare the Fed so much? Because we are over-leveraged with cheap credit?]

Why…

…Aren’t Presidential Candidates Talking About the Federal Reserve?

Yes, why? Much of our economic and financial lives are being guided by an unelected board of Federal Reserve governors who have been flying blind for about 8 years now…manipulating interest rates and asset markets to what end? Nobody seems to know, except to try to prevent a financial reckoning for previous misguided policies. A less charitable interpretation is the financial industry’s desire to keep the casino open as the only game in town.

By Jordan Haedtler

In an election fueled by populist anger and dominated by talk of economic insecurity, why aren’t any of the presidential candidates talking about the Federal Reserve?

After nearly a decade of high unemployment, severe racial and gender disparities and wage stagnation, voters are heading to the ballot box in pursuit of a fairer economy with less rampant inequality. In California and New York, low-wage workers are celebrating historic agreements to raise the minimum wage to $15 per hour. And the economy and jobs consistently rank among the top concerns expressed by voters of all political stripes.

One government institution reigns supreme in its ability to influence wages, jobs and overall economic growth, yet leading candidates for president have barely discussed it at all. The Federal Reserve is the most important economic policymaking institution in the country, and it is critical that voters hear how candidates plan to reform and interact with the Fed.

Related: The Federal Reserve Bank, Explained [Well, kind of.]

The Fed too often epitomizes the problems with our economy and democracy over which voters are voicing frustration: Commercial banks literally own much of the Fed and are using it to enrich themselves at the expense of the American working and middle class. When Wall Street recklessness crashed the economy in 2008, American families paid the price.

At the time, JP Morgan Chase CEO Jamie Dimon sat on the board of the New York Federal Reserve Bank, which stepped in during the crisis to save Dimon’s firm and so many other banks on the verge of collapse. Although the Fed’s actions helped Wall Street recover, that recovery never translated to Main Street, where jobs and wage growth stagnated.

Commercial banks should not govern the very institution that oversees them. It’s a scandal that continues to threaten the Fed’s credibility. An analysis conducted earlier this year by my parent organization, The Center for Popular Democracy, showed that employees of financial firms continue to hold key posts at regional Federal Reserve banks and that leadership throughout the Federal Reserve System remains overwhelmingly white and male and draws disproportionately from the corporate and financial world.

Yellen-and-Rate-Hike-cartoon

When the Fed voted in December to raise interest rates for the first time in nearly a decade, the decision was largely driven by regional Bank presidents — the very policymakers who are chosen by corporate and financial interests. In 2015, the Fed filled three vacant regional president position, and all three were filled with individuals with strong ties to Goldman Sachs; next year, 4 of the 5 regional presidents voting on monetary policy will be former Goldman Sachs insiders. Can we trust these blue-chip bankers to address working Americans’ concerns?

Yet despite the enormous power it wields and the glaring problems it continues to exemplify, the Fed has received little attention this election cycle. As noted by Reuters last week, two of the remaining candidates for president, Hillary Clinton and John Kasich, have been mute on what they would do about the central bank. Donald Trump’s sporadic statements about the Fed have been characteristically short on details, prompting former Minneapolis Federal Reserve Bank President Narayana Kocherlakota to call for Clinton, Trump and all presidential candidates to clarify exactly how they plan to oversee the Fed’s management of the economy. Ted Cruz has piped up about the Fed on a few occasions, although his vocal endorsement of “sound money” and other policies that contributed to the Great Depression warrant clarification. [One expects that none of the candidates really understand the arcana of central banking and prefer to leave well enough alone.]

The most detailed Fed reform proposal from a presidential candidate to date was a December New York Times op-ed in which Bernie Sanders wrote that “an institution that was created to serve all Americans has been hijacked by the very bankers it regulates,” and urged vital reforms to the Fed’s governance structure.

On Monday, Dartmouth economist Andy Levin, a 20-year Fed staffer and former senior adviser to Fed Chair Janet Yellen and her predecessor Ben Bernanke, unveiled a bold proposal to reform the Federal Reserve and make it a truly transparent, publicly accountable institution that responds to the needs of working families. [That’s pretty vague, as the interests of all are best served by a monetary policy that insures the stability of the price level and value of the currency as a unit of exchange and store of value. Employment growth is best addressed through fiscal policy.]

The New York primary provides a perfect opportunity for the remaining presidential candidates to tell us what they think about the Federal Reserve. Candidates in both parties should specify whether they support Levin’s proposals, and if not, articulate their preferred approach for our federal government’s most opaque but essential institution.

As Trump, Cruz and Kasich gear up for a potentially decisive primary, they would do well to respond to the many calls for clarity on the Fed. And on Thursday night, Sanders and Clinton will have the chance to clarify their stances on the Fed when they debate in Brooklyn, just a few miles away from Wall Street and the global financial epicenter that is the New York Federal Reserve Bank.

As New York voters get ready to decide which of the remaining candidates would make the best president, they will be asking themselves which candidate will better handle the economy. The candidates’ positions on the Fed must be part of the equation.

Over Fed

America’s Bank – A Review

Interesting book review with highlights of the history of the Federal Reserve. We should keep in mind that all financial crashes are rooted in excess credit creation. Unconstrained credit creation has now become the primary strategy of our central banks.

An All Too Visible Hand

When Wilson signed the Federal Reserve Act into law in 1913, the very idea of a macroeconomy—something to be measured and managed—was yet to be invented

By James Grant

The Federal Reserve is America’s problem and the world’s obsession. When will Janet Yellen choose to lift the federal-funds rate from its longtime resting place of zero, thereby upending or not upending (it depends on whom you ask) individuals and markets in all four corners of the earth? Her subjects await a sign. While tapping their feet, they may ponder how things ever came to this pass. How, indeed, did such all-powerful body come into existence in the first place—and why?

Roger Lowenstein’s “America’s Bank,” which chronicles the passage of the 1913 Federal Reserve Act, is victor’s history. Its worldview is that of today’s central bankers, the bailers-out of markets, suppressors of interest rates and practitioners of money conjuring. In Mr. Lowenstein’s telling, what preceded the coming of the Federal Reserve was a financial and monetary dark age. What followed was the truth and the light.

It sticks in the craw of good Democrats that, in 1832, their own Andrew Jackson vetoed the rechartering of the Second Bank of the United States, the predecessor of the Federal Reserve. Just as galling is the fact that Old Hickory’s veto message is today counted as one of America’s great state papers. In it, Jackson denies to Congress the power to delegate its constitutionally given duty to “coin money and regulate the value thereof.” To do so, Jackson affirmed, would render the Constitution a “dead letter.”

America’s Bank

By Roger Lowenstein

Mr. Lowenstein contends that, in the creation of the Federal Reserve 80 years later, Congress and the people commendably put that hard-money Jacksonian claptrap behind them. Mandarin rule is the way forward in monetary policy, he suggests—the Ph.D. standard, as one might call it, under which former tenured economics faculty exercise vast discretionary power over the value of money and the course of interest rates, financial markets and business activity. Give Mr. Lowenstein this much: As the world awaits the raising of the Fed’s minuscule interest rate, the questions he provokes have never been timelier. Not for the first time the thoughtful citizen must wonder: What’s money and who says so?

When Woodrow Wilson signed the Federal Reserve Act into law in 1913, the dollar was defined as a weight of gold. You could exchange the paper for the metal, and vice versa, at a fixed and statutory rate. The stockholders of nationally chartered banks were responsible for the solvency of the institutions in which they owned a fractional interest. The average level of prices could fall, as it had done in the final decades of the 19th century, or rise, as it had begun to do in the early 20th, without inciting countermeasures to arrest the change and return the price level to some supposed desirable average. The very idea of a macroeconomy—something to be measured and managed—was uninvented. Who or what was in charge of American finance? Principally, Adam Smith’s invisible hand.

How well could such a primitive system have possibly functioned? In “The New York Money Market and the Finance of Trade, 1900-1913,” a scholarly study published in 1969, the British economist C.A.E. Goodhart concluded thus: “On the basis of its record, the financial system as constituted in the years 1900-1913 must be considered to have been successful to an extent rarely equalled in the United States.”

The belle epoque was not to be confused with paradise, of course. The Panic of 1907 was a national embarrassment. There were too many small banks for which no real diversification, of either assets or liabilities, was possible. The Treasury Department was wont to throw its considerable resources into the money market to effect an artificial reduction in interest rates—in this manner substituting a very visible hand for the other kind.

Mr. Lowenstein has written long and well on contemporary financial topics in such books as “When Genius Failed” (2000) and “While America Aged” (2008). Here he seems to forget that the past is a foreign country. “Throughout the latter half of the nineteenth century and into the early twentieth,” he contends, “the United States—alone among the industrial powers—suffered a continual spate of financial panics, bank runs, money shortages and, indeed, full-blown depressions.”

If this were even half correct, American history would have taken a hard left turn. For instance, William Jennings Bryan, arch-inflationist of the Populist Era, would not have lost the presidency on three occasions. Had he beaten William McKinley in 1896, he would very likely have signed a silver-standard act into law, sparking inflation by cheapening the currency. As it was, President McKinley signed the Gold Standard Act of 1900, which wrote the gold dollar into the statute books.

The doctrine that interest rates are the Federal Reserve’s to manage has come to be regarded, at least by the mandarins, as settled science. It was not so when the heroes of Mr. Lowenstein’s story were conspiring to create a new central bank. Abram Piatt Andrew Jr. took to the scholarly journals to denounce the government’s attempts to pin down money-market interest rates.

Indiana-born, Andrew came East to study, taught economics at Harvard and lent his talents to the National Monetary Commission in 1909 and 1910—the group that conducted the field work to prepare for the grand banking reform. Somewhere along the line, he conceived the idea that the money market should be free of federal manipulation. As prices had been rising—a gentle inflation had begun just before the turn of the 20th century—interest rates should have followed prices higher. That they did not was the complaint that Andrew laid at the doorstep of the government.

Andrew contended that the Treasury Department—under Lyman J. Gage, who served from 1897 to 1902, and his successor, Leslie M. Shaw, who resigned in 1907—“succeeded in keeping the money rate of interest below the rate which would have been ‘normal’ or ‘natural.’ . . . They had kept alive a continuously excessive demand for credit by making it available at less than the normal cost. They had sown the wind and their successor was to reap the whirlwind.”

It is an indictment that comes ready-written against the Federal Reserve’s policy today. Interest rates are prices. Far better that they be discovered in the marketplace than administered from on high. One has to wonder what Andrew would say if he were spirited back to earth to read a random edition of this newspaper in the seventh year of the Fed’s attempt to create prosperity through the technique of zero-percent interest rates. He might want a quiet word with Ms. Yellen.

Andrew is not the only vivid personality in this tale of unintended consequences. Mr. Lowenstein entertainingly limns a gallery of them: Paul Warburg, a German-banker immigrant eager to import European ideas into his adopted country; Carter Glass, an irritable Virginia newspaperman turned congressman (later senator) and currency reformer; Nelson Aldrich, a suspiciously affluent Rhode Island senator and central-bank exponent; Robert Owen, a former Indian agent from the Oklahoma Territory who pushed the Federal Reserve Act through the Senate; William Gibbs McAdoo Jr., the Treasury secretary who married the boss’s daughter; that boss himself, Woodrow Wilson; and Frank Vanderlip, president of what today is Citigroup.

Vanderlip, not alone among his fellow agitators for a central bank, was keen on the gold standard and “fervent,” as Mr. Lowenstein puts it, in his “denunciations of government control.” Here is a fine piece of irony. Government control is exactly what the authors of the Federal Reserve Act unintentionally achieved, though Andrew, at least, might have anticipated this public-policy reversal. He noticed that, under Leslie Shaw’s meddling stewardship in the early years of the 20th century, the Treasury had shifted government deposits to private institutions in times of crisis. “Outside relief in business, like outdoor charity,” as Mr. Lowenstein quotes him saying, “is apt to diminish the incentives to providence, and to slacken the forces of self-help.”

Centralized government control arrived in force with the Banking Act of 1935. It established the centralization of monetary power within the Federal Reserve Board in Washington, and it repealed the so-called double-liability law on bank stocks: No more would the holders of common stocks in failed banks be assessed to help defray the debts of the institutions in which they had invested. Anyway, there would be precious few failures to deal with, proponents of the new thinking contended. Knowing that the Federal Deposit Insurance Corp. stood behind their money, depositors would give up running; they would rather walk to the bank.

The new doctrines repulsed H. Parker Willis, a key player during the organization of the Fed and later a professor of banking at Columbia University. “It is far better, both for the depositor and the banker,” said Willis of the FDIC, “that the actual net irreducible losses growing out of bank failure should fall where they belong. The universal experience with this kind of insurance—if it may be called—has pointed to the danger of increasing losses as the result of bad banking management induced by belief in deposit guarantee.”

Willis didn’t imagine the half of it. On top of deposit insurance evolved the notion that some banks—Citi, for instance—were too big to fail. They must be nurtured through subsidy and bank-friendly monetary policy: low money-market interest rates, for example. It happened that the Citigroup that evolved from Vanderlip’s National City Bank became a ward of the state in 2008. The massive federal bailout of Citi exacted many costs, including a level of regulatory micromanagement that Vanderlip could not have begun to conceive.

J.P. Morgan Chase, which did not fail in 2008, recently went public to describe the intensity of the federal oversight it labors under. More than 950 employees, it revealed, are dedicated to complying with 750 requirements laid down by 21 government entities to achieve and maintain capital adequacy. The Fed itself is high among those demanding overseers. The workers shuffle 20,000 pages of documentation and manipulate 225 econometric models.

The rage to micromanage spans the world. “It can’t be,” the head of Sweden’s Nordea Bank was quoted forlornly saying last year in the Financial Times, “that the only purpose of banking is to stop banks from going bankrupt.” Oh, yes it can.

One thinks back to the supposed financial dark ages when, in 1842, New Orleans bankers, setting down a kind of operational manifesto, succeeded in committing the essentials of safe and sound banking practice to one side of one page. They prospered by simple maxims—e.g., do what you will with your own capital but do not abuse the depositor’s funds—well after the Civil War. Some may protest that banking has become more complex since those days. The boggling, 23,000-page length of the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 (complete with supporting rules) would suggest that it has become 23,000 times more complex. I doubt that.

The legislation to which President Wilson affixed his signature in 1913—Mr. Lowenstein observantly notes that he signed with gold pens—included no intimation of the revolutionary techniques of monetary control that would come into being after 2008: zero-percent interest rates, “quantitative easing,” and central-bank-sponsored bull markets in stocks and real estate, among others.

The great value of “America’s Bank” is the comparison it invites between what lawmakers intend and what they achieve. The act’s preamble described a modest effort “to provide for the establishment of the Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper and to establish a more effective supervision of banking in the United States and for other purposes.” “And for other purposes”—our ancestors should have known.

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