Keeping the Kremlinologists Busy
Amazingly, this month's FOMC statement incorporates altogether six changes from the previous statement. Can we still call it a carbon copy? Yes, we can. We can, because that's what it essentially is. Readers can see all the alterations at a glance via the WSJ's handy 'Fed statement tracker'.
Still, with six words, respectively half-sentences changed, Kremlinologists will be very busy parsing this statement and attempting to extract its meaning. The main question will be: will they keep printing? It actually appears that the irrational 'taper fears' can now be laid to rest. We have maintained throughout the debate that the idea that the Fed would 'tighten policy' in any way, shape or form, was essentially a media hoax from the beginning. Most likely, the whole artificial debate was a 'trial balloon', to see how the markets would react. In addition, the Fed is always eager to maintain that its policy of rapid inflation is actually not inflationary, which is to say it attempts to 'manage inflation expectations'. 'Tapering' and 'exit' talk are simply part of its propaganda arsenal to that effect.
We think Peter Schiff had it exactly right when he said that the mythical 'exit' is akin to doing the old table-cloth trick, but amounts to an attempt to pull out the whole table, not just the cloth, while hoping that the glasses and plates will continue to levitate on their own. The Fed won't have much opportunity to practice to make sure that the magic trick will 'work'.
So what is there to say about the changes in the statement? We're not sure if it is better or worse when the economy is held to be expanding at a 'modest' as opposed to a 'moderate' pace. Both sound like the economy is acting like a beached whale (i.e., not expired yet, but looking like it may happen at any moment). However, growth is 'expected to pick up' from its recent pace, a forecast that is worth exactly as much as any other Fed forecast, which is to say, not much (the Fed has consistently overestimated the so-called 'recovery', which, in any case, feels more like a cyclical blip in an ongoing depression than a genuine recovery).
'Mortgage rates have risen somewhat' – they have noticed! There were no hints as to whether that will invite more intervention, but what is left unsaid is often just as important as what is being said. Why mention it at all, if it is not seen as a reason to 'do something'?
Inflation May be 'Too Low'
The 'money quote' this time around – evidently designed to thwart another dovish dissent by James Bullard – is this one:
"The Committee also recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term."
The old 'deflation' (i.e., falling prices of goods and services) is bad' meme. Luckily, so we are informed, the rate of price increases will 'return to the committee's objective'. We are not so sure about the idea that they will merely 'return' there. Private banks in the U.S. have been reducing their rate of credit expansion markedly in recent months, which is likely due to a combination of a dearth of credit demand and preparation for rising capital requirements in the wake of Basel 3 and the Fed's own, even stiffer, new capital regulations. This is essentially the 'deflation case'. On the other hand, the Fed continues to pump at a record pace, and is definitely not only creating new bank reserves, but plenty of additional deposit money in the process.
Then there is the money supply increase that has already occurred since 2008. Even though broad money supply growth has slowed to 'only' 9% year-on-year as of June, the total money supply TMS-2 now stands at over $9.5 trillion. As a reminder: at the beginning of 2008, it stood at $5.3 trillion. This massive increase in the money supply has already affected relative prices in the economy to a varying extent, and it would be naïve to rule out an eventual effect on the so-called 'general' price level, or better the exchange value or purchasing power of money in the wider sense. All the new money that has been created is held by someone in the form of cash balances. These people are exercising a demand for money - this demand in turn is in a feedback loop with actual changes in prices and expectations.
Consider for instance the following hypothetical example: someone holds on to a dedicated cash balance of $400 after he receives his monthly paycheck, so as to have $100 per week available to pay for groceries until the next paycheck arrives. If the price of his desired basket of groceries were to increase to $110 per week, his demand for the grocery-related cash balance would, ceteris paribus, increase commensurately by 10%. Now imagine similar decisions being repeated across a much broader swathe of individuals, and it becomes clear that price increases themselves can lead to an increase in the aggregate demand for money. This increase in the demand for money in turn exerts pressure on prices (again, all else equal), so that supply and demand will find a new balance. This is one part of the feedback loop mentioned above.
However, there is also the crucial element of expectations. At present, just as the Fed maintains, these expectations are 'well anchored', in spite of the fact that the money supply has increased vastly in recent years. One may well argue that they are a lot less 'well anchored' when it comes to investment assets, the prices of which have been rising sharply. However, in terms of consumer prices, most actors in the marketplace continue to expect that the inflationary policy will eventually be stopped or reversed, so no sharp price increases have taken place thus far.
However, that could easily change at some point, in fact, there is no telling how big a lag may be involved, so that recent data certainly do not provide any sort of 'proof' that such a change can be ruled out. People may one day become convinced that the inflationary policy will not only not be reversed, but will be continued indefinitely and will perhaps even be intensified. If and when that happens, the accumulated money supply inflation of the past will become highly relevant. People will then try to minimize their cash holdings, but not everyone can do so at the same time without markedly lowering the purchasing power of money. Just as is the case now, someone will still have to hold all the money that has been created – or as the case may be at that particular juncture, may actually end up 'holding the bag'.
This won't happen overnight of course – there will be plenty of opportunity to alter the course of events if this danger threatens to become ripe. However, there is also an unknowable threshold; once it has been crossed, it will be very difficult, if not nigh impossible to put the genie back into the bottle.
U.S. money supply TMS-2, via Michael Pollaro. Not enough inflation? We beg to differ – click to enlarge.
We are just mentioning this in order to point out that the long term effects of today's monetary policies cannot yet be discerned. A time is likely to come when the conduct of monetary policy will become a lot more challenging for the planners than it is today. Consider the following part of the FOMC statement:
"To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens."
While this is tied to conditions, such as certain targets in the unemployment rate being achieved and a certain upper boundary of 'CPI inflation' not being violated, it should be clear that when push comes to shove, such limitations can always be abandoned. At that juncture it may well be argued that other, more important objectives and exigencies mandate that these targets be ignored or altered (the BoE's already demonstrated flexibility regarding its 'inflation target' comes to mind in this context).
There is at least one voting member on the current FOMC board who continues to have doubts – Esther George, who dissented once again. According to the statement:
"Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations."
She is undoubtedly correct on all the points she raises. Evidently though, this makes no difference, since she is a lone voice at present.
We will discuss the market reaction to the FOMC statement soon – tomorrow there will also be an ECB rate decision, so there is yet another central planning announcement to look forward to this week. The payrolls report on Friday obviously is likely to be a market-moving event as well, so there are numerous opportunities for market volatility to increase this week.