Crazy Talk Coming Out of the Fed

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Includes: DIA, QQQ, SPY, TIP, VXX
by: Michael Ashton

One day after finally putting my major paper to rest (until the second draft) and three days before my vacation begins, the market decided to reward me with almost nothing to talk about.

Oh sure, Stanley Druckenmiller is out and GM is back in, but markets were (and have been) almost dormant. Stocks followed on their melt-up from Tuesday (on low volume) with a small 0.2% rally (on similarly low volume). Bonds were slightly lower. The main incongruity continues to be the VIX, which sits Cheshire-Cat-like up there at 24, grinning away. What does he know that I don’t know? I wonder.

Today is Initial Claims day (Consensus: 478k from 484k). The Claims release has been a very interesting ride recently, and every week that the figure continues to rise will raise the blood pressure of economists who thought the dead-cat bounce from the Lehman lows was a recovery. I pointed out last week (here) that over the last 20 weeks, the consensus estimates have been too low 15 times, and after revisions the score is 17-3. This week’s consensus forecast, though, is the highest since late last year. Eventually, economists will catch up. Honestly, the rise in ‘Claims is suspicious, because while the job market is definitely not improving most metrics also seem to not be getting much worse either. I think the hypothesis that the underlying rate of Claims remains in a 450-480k range is still my null hypothesis; another week or two above 480k, however, and I will feel more comfortable rejecting that null.

It would also help if the Philly Fed index (Consensus: 7.2 from 5.1) confirmed the weak state of hiring. Obviously, economists don’t really expect that.

Today, Thursday, the Treasury will also announce the size of the 30y TIPS auction, with the Street estimates fairly wide-ranging from $5bln to $8bln. However many they bring, it likely isn’t enough. I suspect they will be timid and bring $6-7bln or so, but the market needs more.

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A friend recently sent this interesting inflation-related article. I think that if we all took the time to do this sort of experiment for ourselves, ShadowStats would lose all of its customers and I wouldn’t have to respond, with metronomic regularity, to questions about whether inflation is actually running 7% per year higher than the official statistics report. I am sorry for sounding cross. I suppose that everyone needs to make a living; it’s just that making a living by perpetrating bad math trends isn’t my idea of a rewarding career.

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So long as I am grumpy anyway, I ought to comment on some of the crazy talk coming out of the Fed. Recently I brought up Bullard’s article, which I thought was fairly important in that it laid out the supporting academic argument for a resumption of quantitative easing. But there were some odd ideas in the paper; Bullard didn’t seem to agree with them, but apparently other Fed officials do.

For example, yesterday Minneapolis Fed President Narayana Kocherlakota gave a lengthy and valuable speech about how he sees the economy. For example, he noted that because much of the current unemployment is (he believes) structural, he doesn’t think monetary policy can do much about it and he doesn’t expect the ‘Rate to decline very rapidly. I agree with him on this.

But he makes what I think are some disturbing errors when he talks about the Fed’s current policies. He argues that at some point the Fed will need to raise rates even if inflation expectations are negative in order to avoid forcing inflation expectations to remain negative. Here is his explanation of how this bit of gymnastics works:

Given that interpretation, central banks then respond to deflation by easing monetary policy in order to generate extra demand. Unfortunately, this conventional response leads to problems if followed for too long. The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation. Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say,neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.

Long-run monetary neutrality is an uncontroversial [editor's note: not exactly], simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation.

Well, this bothers me because it comes from someone who should know better.

The problem is that an equals sign doesn’t clearly point in one direction of causality. Consider the Fisher equation, which is (1+n)=(1+r)(1+i)(1+p), where n is the nominal rate, r is the real rate, i is expected inflation, and p is the risk premium.

If we don’t have any idea about causality, then we could believe that a rapid rise in nominal rates could cause a sharp increase in the risk premium or in expected inflation. And, indeed, this is what Kocherlakota is arguing. But that’s nonsense: the equation states that nominal rates represent a real return on money, plus a compensation for expected inflation over the holding period, plus a premium for the variance of that risk. A low demand for money, resulting in low real rates, or low expected inflation, cause nominal rates to be lower. Declining nominal rates don’t cause inflation expectations to decline! (If they did, then Volcker was a moron. I guess he should have immediately dropped rates to 2% to rein in inflation). The causality runs the opposite direction down the equality. (Side note: programmers have long noted the ambiguity of the equals sign, which is why in many languages the preferred mode of assignment isn’t “a=b” but rather “a<-b”. I think I am going to start writing the Fisher equation that way from now on.)

If the Fed holds nominal rates constant, then it is mathematically the case that (ignoring the risk premium) the movement in the other two variables must be mirror-images of one another (but this is true no matter what level they hold the nominal rate at). This is where Kocherlakota gets confused. His argument is basically:

  1. The Fed controls nominal rates (true).
  2. The real rate will go towards 1-2% naturally (speculative).
  3. Therefore, if nominal rates are held low, inflation expectations will respond so that deflation is baked in (ridiculous).

The question boils down to whether forcibly setting interest rates is likely to move the real rate or expected inflation. Which is exogenous? Kocherlakota believes that real rates are exogenous and that expected inflation varies procyclically with interest rate policy. But as I said, that’s absurd, and if it’s true then Volcker had it all wrong.

I suspect that Kocherlakota is confusing the actual real rate with the so-called required real rate, which should vary with the economy. When the economy is expanding, the required real rate rises because demand for capital is rising relative to the supply of capital. The equilibrium required real rate is exogenous – it is set by capital supply and demand. But that’s not the real rate that the Fed is affecting. When the Fed is easing policy, it is offering to supply capital at a lower price than the equilibrium required return; that is, it is forcing a de facto negative real rate by increasing the supply of capital, and this stimulates growth because more capital can be deployed profitably if it is borrowed at a negative real rate. When the Fed is tightening policy, it is sopping up capital that would otherwise be deployed and thus raising the market real rate. This is why the Fed can’t just declare rates to be changed, in normal times, but must effect open market operations: it must actually change the supply of capital in order to affect the market clearing price.

But none of that changes the equilibrium required real return, which over a full cycle will average out to a very low number for a very safe, short-term investment (Kocherlakota says 1-2%). The Fed controls growth and inflation by moving the effective real rate away from the equilibrium required real return. If the Fed raises rates to 1%, 2%, or 10%, it will not raise expected inflation. It will raise the real cost of money in the market, which will lower growth and lower inflation.

I often hear that a Depression is not possible now, because a Depression requires a policy error and we’re too smart for that. Not that we haven’t already had enough policy errors to count for something, but when I read a speech like this I say “yep, that would qualify!”