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It's easy to show that public institutions such as the Federal Reserve and Congressional Budget Office (CBO) are routinely blindsided by economic developments. You only need to compare their past predictions to real events to see these organizations' deficiencies.

More importantly, we can demonstrate that their struggles are all but certain to continue. This may sound like a difficult task, but we'll argue that it's easier than you think. Using historical data and basic economic concepts, we'll explain not only why the establishment view is wrong but that the underlying principles are fundamentally flawed. The implication is that existing policies are destined to fail.

To make our case, we'll start with the CBO's current forecasts for real per capita GDP (economic growth net of inflation and population growth):

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Our regular readers already know that the CBO is abnormally bullish on near-term growth, based on its long-standing assumption that the gap between actual and potential output will swiftly close. But this won't be our focus here. In fact, we'll assume the CBO gets this part of its outlook right. We'll be shocked if it does, but let's pretend.

We'll then examine the forecasted path for interest rates:

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The interest rate outlook is an offshoot of the policy establishment's overall approach. Monetary stimulus is expected to be removed as it guides the labor market toward full employment, allowing interest rates to return to normal levels. At that point, natural economic forces are believed to be strong enough to preserve a normal, healthy economy. Establishment economists have near complete faith that this is a sound and reliable process.

But closer examination reveals a few cracks. Consider that the chart above shows quite a jump in interest rates, which begs the question: How will the economy weather such a development?

We'll look to history for possible answers. We calculated the change in rates on three month Treasury bills for every eight quarter period since 1953, which breaks down like this:

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We then reviewed past economic outcomes conditioned on the rate buckets above. Note that the forecasted 2015 to 2017 rate change of 3.2% (the leap from 0.2% to 3.4% in Chart 2) falls in the final bucket. Therefore, this bucket is especially relevant to the economy's likely performance in the next rate cycle. We circled it in the charts below:

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While the results speak for themselves, I'd be remiss if I didn't add qualifiers. For one, the sample sizes fall as you move from left to right across the charts. Moreover, history doesn't always foretell the future; this time could be different.

But the thing is: the data makes perfect sense. Higher interest rates have obvious effects on risk taking and debt service costs. It stands to reason that the economy won't just sail through the large rate hikes needed to restore historic norms.

If anything, the charts likely understate the future effects of rising rates, because today's debt levels are far higher than average historic levels. Any normalization must also include a wind-down of unconventional measures such as quantitative easing, which presents additional challenges.

Yet, the official outlook calls for steady improvement both through and beyond the rate jump. As shown in Chart 1, the CBO predicts that per capita GDP growth will accelerate to over 3% before settling back to a trend rate of 1.2%. Forecasts for 2018 and 2019 average a healthy 1.5%, despite the figures in Chart 5 showing virtually no growth after large interest rate increases in the past.

Here's the corresponding outlook for employment, followed by two more reasons to expect forecasts to fail:

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(See here for background on the corporate leverage multiples and here for more on the stock valuation figures.)

In a word, the CBO's projections are preposterous. They ignore effects that are clear in the data and obvious in real life. But the charts reveal more than just forecasting flaws at a single governmental institution. More broadly, the assumption of a smooth and lasting return to normality is standard practice for mainstream economists, particularly those at the Fed.

Essentially, economists are hardwired to focus on the near-term effects of policy stimulus, while overlooking long-term effects that are often far more important. Standard models fail to account for either natural cyclicality or the payback seen in Charts 4 to 6. Although establishment economists often speak about sustainable growth, they really mean any growth that restores GDP to where they believe it should be. They don't seriously contemplate the unsustainable growth that occurs when the economy is over-stimulated through credit and financial asset channels. And the charts above demonstrate these deficiencies.

Worse still, this analysis doesn't tell the whole story. We could have easily tripled the chart sequence with other indicators of Fed-fueled credit and asset market froth - from record margin debt to lax loan covenants to soaring public debt - that also show heightened risks of another bust.

We suggest giving some thought to the data shown above and considering its message for the future. Send it to the smartest people you know and get their opinions. In the meantime, here are our conclusions:

1: Even if the economy returns to full employment under existing policies, it won't remain there after (and if) interest rates normalize.

2: Based on today's debt and valuation levels (charts 8-9, for example), rising interest rates will have an even harsher effect than suggested by the 60 year history (charts 4-6).

3: Contrary to the establishment's "sustainable recovery" narrative, the most plausible outcomes are: 1) interest rates normalize but this triggers another bust, or 2) interest rates remain abnormally low until we eventually experience the mother of all debt/currency crises.

Conclusion 3 restated: We're stuck in an Escher economy (see below), thanks to the impossibility of the establishment economic view, and this will remain the case until the existing structure collapses and is rebuilt on stronger policy principles.

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Source: Revealing The Escher Economy That's Embedded In The Establishment Interest Rate View