The Copy Machine Must Be Broken
The December Fed meeting was remarkable-- not because the pace of monetary inflation directly caused by the Fed has been lowered slightly, but because the statement accompanying the policy change was changed quite a bit from the one issued after the October meeting. For the bulk of the past year, FOMC statements have looked like carbon copies of each other, so that the committee members might as well have phoned their votes in.
As that handy tool for Kremlinologists, the WSJ's FOMC statement tracker reveals, it was different this time. Why have so many sentences in the statement been altered? The reason is simply this: after the events following Ben Bernanke's press conference in May, when bond yields suddenly spiked and emerging market currencies as well as emerging market stock and bond markets tanked, the Fed got cold feet. Months were spent with communicating the idea that 'tapering is not tightening' and both the latest statement and Ben Bernanke's subsequent press conference were chock-full with assurances to that effect.
Specifically, it was stressed that the policy could be reversed at anytime, that 'incoming data' would continue to determine these decisions and that the Fed remains very concerned about 'inflation being too low'. The sole dissent this time came from ultra-dove Eric Rosengren, president of the Boston Fed. According to the statement:
"Voting against the action was Eric S. Rosengren, who believes that, with the unemployment rate still elevated and the inflation rate well below the federal funds rate target, changes in the purchase program are premature until incoming data more clearly indicate that economic growth is likely to be sustained above its potential rate."
The statement contained not only a slight tightening of policy in terms of the 'taper' - it contained what could be viewed as an easing move as well, in the form of a shifting of previously announced goal posts:
"The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal."
Now let us look at all the verbiage concerning the 'tapering' as such. First the technicalities:
"In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases. Beginning in January, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of$40 billion per month rather than $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.
Of course, asset purchases of $75 billion per month still constitute a sizable addition to the money supply (keep in mind that due to the Fed's modus operandi, nearly all its 'QE' purchases create not only additional bank reserves, but also new deposit money). Moreover, by keeping the reinvestment policy intact, there is no chance that the Fed's balance sheet will do anything but keep growing.
As to the reasoning behind the move: the conditions of the labor market of the recent past tell us nothing about future conditions. Furthermore, employment is well known for being a lagging indicator. We don't mean to say that we believe the inflationary policy is not in dire need of being ditched ASAP. We merely want to illustrate that there is no way to engage in 'sensible' central planning and that the Fed's 'driving forward while looking into rear-view mirror' method is especially misguided.
Next the statement informs us of the current 'state of play' regarding tapering and what events might alter it:
"The Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. However, asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases."
So they will keep 'tapering' unless they won't. The only other point worth mentioning is a remark about 'fiscal restraint', which informs us to what extent deficit spending by the government influences the Fed's decisions:
"Fiscal policy is restraining economic growth, although the extent of restraint may be diminishing."
In other words, they are expecting the body politic to resume spending money it doesn't have at the breathtaking rates we have become used to in the post crisis era. The notion that 'fiscal restraint' is somehow damaging to economic growth is of course utterly bizarre. It assumes that the government somehow exists outside the ambit of the market economy, that it possesses resources it doesn't first have to take from someone else. As Ludwig von Mises noted in Human Action:
"What the government spends more, the public spends less. Public works are not accomplished by the miraculous power of a magic wand. They are paid for by funds taken away from the citizens."
One would think that this should be blindingly obvious and that it shouldn't be necessary to spell it out. And yet, here we are, decades after Mises wrote the above and the FOMC statement still contains a reference that proves beyond a shadow of doubt that this collective of "high IQ morons" (h/t Bill Bonner) apparently actually does believe that the government possesses a magic wand. This goes to show that for all their pseudo-scientific blather, these people are the functional equivalent of voodoo priests.
While were on this subject, let us also recall what Mises had to say about 'long term budget consolidation' plans (in 'Planning for Freedom'):
"What the doctrine of balancing budgets over a period of many years really means is this: As long as our own party is in office, we will enhance our popularity by reckless spending."
And this is precisely why the FOMC correctly anticipates that 'fiscal restraint' is not going to last.
The Effects of the Policy Change - Short and Long Term
Obviously, it won't make a big difference in the short term that the Fed now buys $10 billion less of securities per month. The extent to which the trajectory of the inflationary policy is altered is, at best, marginal. However, there is first of all a plan to continue the 'tapering', so the amount must be expected to be lowered by further cosmetic quantities, which will at some point begin to add up. Note in this context also that next year's voting roster of the FOMC will include several 'hawks', so the momentum toward more 'tapering' should be sustained for a while. Even assuming that the Fed stands pat and leaves the amount of 'QE' at its new size of $75 billion per month for a while, the cumulative effect on year-on-year money supply growth will eventually be felt.
To this we should note that the year-on-year U.S. money supply growth rate has recently resumed its decline. We will take a more detailed look at the money supply in the next article, for now we just want to point out that the rate of credit expansion on the part of the commercial banks is declining as well and has been in a steady downward trend since early 2012.
Due to the weak growth rate of commercial bank credit, growth in uncovered money substitutes netted out at a negative 3.9% y/y as of September, so that the entire growth in the money supply in the year to the end of September was a result of growth in covered money substitutes and currency.
Thus, if the Fed reduces the rate at which it actively inflates via 'QE', money supply growth will at some point next year decline below the threshold that is critical for sustaining the echo bubble. This is also why we expect the 'tapering' decision to be reversed and 'QE' to eventually become even bigger than it has recently been. We wish we could be more precise about the timing and the concrete sequence of events, but this obviously depends on a number of unknowable factors (for instance, the decline in the rate of commercial bank credit expansion may reverse or it may accelerate - there is simply no way of telling for sure in advance, although we strongly suspect that this is a trend that won't be reversed easily).
The year-on-year growth rate of total commercial bank lending has been in a downtrend since early 2012. No inflationary impulses are to be expected from it.
Regarding the effect of the policy change on financial markets, in the short term, obviously not much has changed for them either. We wrote about gold in advance of the FOMC decision and remarked regarding the technical situation:
"The gold price has lately oscillated in a tight range, building a triangle. Most of the time, such triangles presage another thrust in the direction of the preceding trend, but this is not always the case (for instance, the gold market peak in 2011 was also followed by a large triangle, and the resolution was a downward rather than upward break). Let us just note here that one should not be overly surprised if another leg down develops out of this formation, but obviously the possibility for a trend change remains open as well, with support and resistance in the near term very well defined. These levels continue to be very close to the current price, so that a resolution one way or the other seems imminent - and the FOMC decision today may well provide the trigger."
A post triangle thrust in the direction of the preceding trend has indeed been triggered, and that means gold is set to test the lows of June. Whether this test will be successful remains to be seen of course. From a purely technical point of view, a break of the June low would make a test of the next major support level at around $1,040 - $1,050 highly probable.
Just as the gold market interpreted the announcement correctly as likely to lower the pace of monetary inflation, the stock market seems to have interpreted it incorrectly as meaning the exact opposite. If stock market participants continue to bid up titles to capital, then they have to be convinced that the capitalized values of the assets stocks represent will continue to grow. However, if the rate of monetary inflation declines further, this expectation will prove incorrect. As is often the case in the stock market, it seems likely that the realization will set in suddenly and vigorously, i.e., the market will look fine for a while longer and then will very quickly and with little warning give back a large portion of the gains it has made in recent years.
In his press conference, Ben Bernanke mentioned that the central bank needed 'luck' on its side. That is absolutely correct. Given the extent to which the Fed's policies have distorted prices and with them the basis of rational economic calculation, a lot of luck will be needed indeed, and the Fed isn't the only player who will need it. Currently the financial markets make it appear to the casual observer as though central planning were actually working, just as they made it appear that way during the roaring 20s, the late 1990s, the 2003-2007 real estate bubble or any other inflationary boom one cares to name. However, there are no exceptions - all inflationary booms must eventually come to an ignominious end.
The central bank incidentally cannot control where all the money it creates eventually flows. Bernanke did get 'lucky' insofar as the stock market has been the major beneficiary of the Fed's largesse over the past few years. His successor is going to be confronted with the inevitable fall-out and the longer the boom continues, the bigger and more painful the eventual adjustment will be.
Chart by: Saint Louis Federal Reserve research