If you stay with me on a wonkish trip we will walk a path that is not well worn. We’ll be in search of questions few have asked to find answers hidden in plain sight. In the end my hope is you will feel as Robert Frost did in writing, “Two roads diverged in a wood, and I- I took the one less traveled by, And it made all the difference.”
An Answer in Search of a Question
When we formulate questions to produce a predetermined answer we have it backwards. Questions become redundant and useless when predicated upon generally accepted principals and predetermined outcomes. We fail to explore and exclude too many wonders when we travel only the well-worn trails.
Sadly, alarmingly, the field of economics has worn a rut in all-too familiar roads, roads built with good intentions, long ago, to observe the landscape of the day. The ‘tried and true” breeds a comfortable familiarity that lulls us into confident complacency.
Landscapes evolve with the seasons and years, sometimes changing too slowly to recognize. If we fail to explore what is beyond accustomed territory or climb the next mountain we limit the knowledge of our changing environment. One day we may wake to find we have been struck by a preventable calamity, if only we had explored beyond familiar horizons.
Fed Economists Are Stuck in the Rut
Let’s consider the words of 20th century medical science pioneer, Albert Gyorgyi. “Discovery consists of seeing what everybody has seen and thinking what nobody has thought.” Discovery requires new perspective and new questions. The Fed keeps asking the same questions, applying the same tired formulas and coming to the same conclusions.
(Few of us need reminding that for 7 years the Fed policy rate was locked at zero. Many believe the Zero Bound Policy has set the stage for a potential bout of runaway inflation. Against this backdrop we explore current and emerging thoughts about policy and the path of interest rates.)
Two postulates dominate Fed thinking and monetary policy today. The first dates to the 1960’s and the next, the 1990’s.
The Phillips Curve contends that there is an inverse relationship between the rate of unemployment and inflation. (Lower unemployment = higher wages = higher inflation.)
The Taylor Rule stipulates that for each one-percent increase in inflation the Fed should raise policy rates by more than one percent.
Traditional economics teaches that shifts in monetary policy work with an inexact lag; the outcome is assured but the timing is uncertain. The Fed’s confidence in the predictive powers of the Phillips Curve has policy rates rising in anticipation of higher wages and higher inflation.
While neither worrisome increases in wages nor inflation has materialized consensus at the Fed is that it is only a matter of time.
By Fed orthodoxy the next step in monetary practice is to pre-empt the forces of inflation by implementing the Taylor Rule lest they fall behind the curve and free the inflation Jeanie.
What If...
What if innovative technologies and a globalized workforce compromise or invalidate the Phillips Curve? What if the reason unemployment is declining is precisely because wages are low and stagnant? If the Phillips Curve is compromised would the progression to implementation of the Taylor Rule be misguided and potentially damaging? What would be the consequences of a misguided increase in policy rates?
A few economists have begun to ask these questions and posit answers. While still influenced by traditional thinking these economists raise important points in a long overdue dialogue.
Former Fed Chair Ben Bernanke and two economists from the Federal Reserve Board, Michael Kiley and John Roberts have been exploring the inadequacy of economic modeling and the potential consequences of rising rates tipping the US/ global economy into recession.
With far less than the traditional 500 basis point cushion available and the questionable efficacy of quantitative easing, Kiley and Roberts argue central bankers must prepare for policy rates at the Zero Bound for extended periods and with greater frequency in coming business cycles.
The August 1, 2018 FOMC Meeting included a presentation by Kiley and Roberts examining the risks of returning to the Zero Bound policy in response to the next recession. The two economists reiterated the points they made to the Brookings Institute in April of 2017, summarized above.
Minutes of the August FOMC meeting reveal how “active inertia” limits Fed thinking. The minutes shine light on how few options the rate setting committee has available to achieve its mandate of price stability and full employment. The minutes show the FOMC members are prepared to address the next economic disruption with the same rules and tools it used during the Great Recession. While recognizing the rules and tools have” limits to their effectiveness” and might cause negative economic consequences the rate setting committee pushes ahead on the path most traveled.
The Fed’s balance sheet remains bloated, holding $4 Trillion in securities purchased during the three phases of Quantitative Easing, leaving little room for additional purchases. Recent tax cuts create deficits that limit future fiscal options for stimulating a floundering economy. Should rates hit zero again the politicians and policy makers had better have an alternate plan. Attempts to circumvent market forces have exhausted monetary and fiscal policy options.
“If you only have a hammer every problem looks like a nail.” Abraham Maslow
The Federal Reserve was created in 1913 in response to recurring recessions and bank crises that were destabilizing America. In the absence of any real plan from the Federal Government legendary banker, J.P. Morgan and others stepped into the financial and economic breach to create a backstop that would calm savage business cycles and protect depositors from financial ruin. A national Central Bank would stand behind community banks in turbulent times assuring liquidity and safety.
As the needs of the nation and the economy evolved from an agrarian to manufacturing base monetary policy emerged as a tool to smooth economic cycles. The “hammer” chosen achieve policy goals was short term interest rates. When you look to bankers for a solution to social and economic woes you are certain to find a “cost of funds” resolution at the ready.
We accept interest rate manipulation by central banks as a viable and valid tool for maintaining economic stabilization because it has functioned with reasonable success in the past. The obvious exceptions include the inflation of the 1970’s and the financial crisis and deep recession of 2008.
Are the tools of Central Bankers in need of refinement?
The 21st century global economy continues to evolve making the Phillips Curve and Taylor Rule appear quaint and obsolete. The evolutionary path from farming to factories to a lightly regulated finance-based economy exposed weaknesses in the banking system and the folly of self-regulation. The next phase of evolution, The Fourth Industrial Revolution will bring the full force of technology to bare on labor markets. It’s difficult to see how simple mechanisms and rules will apply.
We have come to see interest rates as a function of policy rather than market forces. Let’s look at interest rates as a function of the earnings potential stored in money rather than a string to be pulled by policy puppeteers.
Interest Rates are Rent
When we begin to see an interest rate not as a variable to be ratcheted up or down to manipulate economic activity but as a reflection of the value stored in money in a particular economic environment we can change perspective and ask new questions.
With interest rates near zero and banks flooded with over $2 Trillion why was the economy so slow to recover? Why was there so little new loan demand when banks were practically giving money away? Why were Fortune 500 companies flush with cash making so few investments in personnel and technology?
These questions perplexed Treasury and Fed officials including Ben Bernanke, Timothy Geithner and Hank Paulson, the architects of the largest bailout in US history.
What did they miss?
The value stored in money in that dismal economic environment was viewed as less than near zero by potential qualified borrowers. Even at historically low-cost, renting money to invest in the real economy, meaning infrastructure, training and technology was perceived as unprofitable. The cost of funds exceeded the potential return on investment.
True to form our leaders could not escape the active inertia afflicting both judgement and outcome. QE 1,2 and 3, the Twist and other policies merely added more liquidity in an attempt to magnify the negligible impact of near zero rates. And still the rent was too high to encourage investment in the economy.
Where did this "stimulus" go?
After emerging from the deep dive of The Great Recession the US economy limped along from the 4th quarter of 2009 through second quarter of 2018 at an average year over year growth rate of 2.1%. This is a pretty anemic rate of return on the trillions of near-free dollars pushed into the US financial system.
A look into the equity markets from the panic lows of early 2009 to the recent record highs gives us a hint about the distribution of the money supply. The DOW, from trough to peak is up 303%, 15.75% per year, the NASDQ is up 526%, 21.3% per year.
While renting money to invest in the real economy seemed fraught with too much risk the stock market attracted record sums. When comparing the investment opportunity in the markets to the real economy the perceived value stored in the money supply was significantly higher when directed to stocks.
Pavlov's Fed
The traditional role of the securities markets is to provide investors an opportunity to participate in the ownership and debt funding of public companies. Logic would dictate that the markets and the underlying economy it funds would be roughly equal.
Since the early 1990’s global securities markets have tripled in size from near parity with the economy to more than 360% of global GDP. Leverage, derivatives and massive increases in corporate debt have all played a role in the explosion. But when assessing the value stored in the money supply one must assess the risk and potential return on investment. How did investors come to believe that investing in securities was a lower risk bet than the underlying companies? Looked at another way, the value stored in the money supply was perceived to be significantly higher when deployed in the markets versus the real economy.
CEO’s incentive packages, the vast sums of excess cash in corporate coffers and the tax advantages of borrowing to buy shares all add momentum to the distribution of money supply to stocks and away from investment in people and equipment. Short term gains in the value of company stock leads to increased pay and career longevity for today’s executives. As incentives drive behavior share buybacks are contributing to the disparity in stored value perception.
This disparity has serious implications for policy makers manipulating interest rates according to the “needs” of the economy without proper consideration for the impact on markets.
From Fed Chairs Greenspan (1987-2006) to Bernanke (2006-2014) and Yellen (2014-2018) the securities markets have enjoyed a strong degree of protection from loss. What came to be known as the Greenspan “Put” was the knowledge that should stocks waiver the Federal Reserve would amp up money supply and lower borrowing costs to support equities. Bernanke and Yellen were well known enthusiasts of the “Put” strategy and markets grew in accordance with this assumption.
The Fed and other financial regulators were trained to focus more on how the economy might pose risk to the markets rather than how markets can swamp the economy. The fall of Lehman Brothers should have corrected the syllabus.
Risk
Dodd-Frank, the Volker Rule and a number of consumer lending protections emerged after the financial meltdown in 2008 to restore order to banking, markets and the economy. These regulations curtailed some of the worst behavior at financial institutions but also ate into profits. Risk migrates away from regulation and lurks in the shadows of the financial system.
Corporations now hold as much debt as they did on the eve of the 2008 crisis. This is troubling but of greater concern is the private lending and levered loan markets. Opaque and growing, we see these markets as the canary in the credit market coalmine. There is a $2 Trillion market in leveraged loans and junk bonds. Much of this lending is outside the traditional banking sector, beyond the purvey of regulators. Today the banking sector, envious of shadow banking profits, is tip-toeing back to these murkier but highly profitable opportunities.
Markets now dwarf and threaten the US and global economy as never before. Small wonder that the Fed requested the presentation by Kiley and Roberts regarding the risk of returning to zero policy rates in the years to come. Memories fade and lobbyist persist. Regulations are out of favor at a time when risk seeks asylum.
A New Idea
R* is economist jargon for the neutral rate of interest that neither spurs nor restricts growth and stabilizes the economy at the Fed’s targets for inflation and employment. All of this assumes there is a neutral rate that singlehandedly achieves these numerous and varied goals and that the rate can be achieved through policy manipulation of markets rates.
Fast* is the moniker economists have given to an interest rate that promotes stability in financial markets. Mohamed El-Erian wrote in a Bloomberg article on August 27, 2018, “there is a possibility that interest rate and balance sheet policy stance that delivers on the dual mandate of employment and inflation may not be consistent with financial stability.”
Recognition of this premise forces Fed policy makers to acknowledge the limitations of current policy mechanisms. Manipulating an interest rate creates disequilibrium in the economy and markets. The distortions appear when markets are 3.5 times greater than the underlying economy. Distortions occur when money supply growth exceeds the capacity of an economy to create opportunity. When a capitalist evaluates opportunities, he is guided by the stored value in his money supply. Flooding financial institutions with credit and cash can only dilute the value stored in the existing money supply. The real economy suffers while market speculation under the umbrella of the “Put” is energized.
Where do we go from here?
The flattening yield curve is spurring debate at the Fed about the pace of rate hikes. How much is too much? Existing home sales are slowing noticeably in what is the most interest rate sensitive sector of the US economy. Tighter credit spreads and deteriorating credit quality in the levered loan market attracts investment from hedge funds, mutual funds and insurance companies who must compete for customers in a yield hungry world. Will tax cuts prime the pump of capitalism or merely provide a sugar rush that peters out? Emerging markets are struggling with debt service costs on dollar denominated debt. Exchange rates create gaps in the stored value of their home currencies and the dollar. With each US rate hike the gap widens and the burden on these fragile economies increases, a day of reckoning draws a bit closer.
The estimate of R*, if such a unicorn exists, is judged to be about 3%. Is that rate neutral for the economy and the markets? Not likely. We fear a prolonged return to zero far more than any breakout in wage push inflation. We urge clients to protect returns on their resources by tying investment maturities to liability streams. Avoid the uncertainty of callable securities and the lure of cash. Exploding speculative bubbles, global recession and years of zero rates can do far more damage to a public funds portfolio than lagging the yield of money markets.
We’ve taken a walk on the road less traveled. Our goal is to provide an opportunity for discovery and a chance to think what nobody has thought. Thanks for joining.
Happy Fall!
Disclaimer
The opinions presented within this white paper are the viewpoint of Institutional Capital Management, Inc. (ICM) at the time of distribution and are subject to change. The information contained is prepared from data sources generally believed to be reliable and available to the public, but no representation is made as to accuracy or completeness. This white paper is for general information purposes only and is not intended to provide specific advice or recommendation, nor is it an offer to purchase or sell any securities.
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