I published my first article on Seeking Alpha in April that describes how I use indicators to measure the investing environment. This article is in response to a comment by brianklu who said it would be nice to have information about a Federal Reserve Indicator. "The Fabulous Decade Macroeconomic Lessons from the 1990s" by Alan Blinder and Janet Yellen (2001), "The Federal Reserve System A History" by Donald Wells (2004), "The Federal Reserve and The Financial Crisis Lectures By Ben S. Bernanke" (2013), provide the background to charts and indicators shown in this article. I created most charts on the St. Louis Federal Reserve Bank website using the FRED database.
I will start with a description of the role of the Federal Reserve. It has the objective to achieve stable growth in the economy, avoid recessions, and keep inflation low which it does mostly through monetary policy including raising and lowering short-term interest rates. It also has a goal to maintain financial stability such as implementing quantitative easing and being a "lender of last resort." They also supervise the banking system.
Fiscal policy is enacted by Congress through changes to taxes and tax code, entitlement programs, and discretionary spending. Fiscal policy, the strength of the economy and external factors such as globalization, to a large extent, determine the budget deficit. Fiscal and monetary policy are both used to manage the economy.
As a reference, the following chart below shows the relationship of the Federal Funds Rate (the overnight interest rate) for the past hundred years compared to Moody's Aaa Corporate Bond Yield. The Discount rate (as a proxy for the Fed Fund rate) in the 1930s and 1940s was only about 1%. Also notable, corporate bond rates are returning to the levels seen before the high inflation of the 1970s.
During the 1950s, William McChesny Martin was encouraged to follow an expansionary monetary policy which he did to some extent, but felt that the Fed's job was to "take away the punch bowl when the party was getting going." This can be seen in the previous chart where the Fed raises interest rates before nearly every recession. In the 1960s, the Federal Reserve used Operation Twist to raise short-term interest rates while lowering long-term interest rates because of a balance of payments deficit and high unemployment. The purpose was to encourage foreign investors to stay in the U.S. markets. Lower taxes with increased spending for the Vietnam War and President Johnson's "Great Society" programs helped increase inflation. The chart below shows that defense and social programs have averaged about 15% of GDP until the 2008 financial crisis when it jumped several percent. President Clinton and Congress reduced social benefits in the 1990s. The Social Security Administration estimates that by 2035, only 75% of scheduled benefits will be covered by taxes. They warn that if assets are exhausted without reform, benefits will be lowered.
High inflation means that prices tomorrow will be higher than today and consumer spending as a percent of GDP began to increase in the 1970s from 60% to 67% currently. Savings as a percent of GPD began to decrease in the 1980s, but increased after the financial crisis.
The Greenspan Era began in 1987 and ended in 2006 and is characterized by more trained economists being appointed to the board. Many events and trends started in this era including the dissolution of the Soviet Union (1991), bursting of the Technology Bubble (2000) and Housing Bubble (2006). During this time, there were only two recessions. The 1992 recession was not responsive to nearly 18 months of negative real Federal Funds rates. This was probably due to over-leveraged corporations and a weak financial system resulting from the fall out of the savings and loan industry.
The chart below shows the trade deficit getting larger starting in 1992 followed by a loss of manufacturing jobs which accelerated after 2000. The over-investment and excess capacity from China is straining the global economy.
The Great Moderation is also characterized by strong, stable growth in the economy which as the next two charts show, was fueled by increases in debt that is unsustainable going forward. In "This Time Is Different - Eight Centuries of Financial Folly" (Reinhart, Rogoff) and subsequent controversies, high levels of debt are associated with slower growth. In the chart below, the frequency and severity of recessions hide the real growth rates in the economy. In the 1950s and 1960s, average annual real GDP growth exceeded 4% while the debt to GDP declined following WWII. In the 1970s through the 1990s, while debt to GDP was relatively low, real GDP growth averaged just above 3%. For this century, real GDP growth has averaged around 2%. There are many factors for the changes in GDP growth rates including aging population, pent-up demand after WWII, ending of the Cold War, technological advances, and globalization. Note that federal debt as a percent of GDP is nearly as high as at the end of WWII.
Shown in a different context, the next chart shows the Federal Debt Held By the Public per capita adjusted for inflation along with per capita GDP. The federal debt is approximately $90,000 per employee as opposed to about $45,000 per capita.
A common belief is that high budget deficits compete for funds against the private sector increasing interest rates and slowing down the economy. The bond market rallied and bond rates fell following the passage of President Clinton's deficit-reducing budget. Taxes were increased on the upper-bracket taxpayers and on more social security benefits. "The Fabulous Decade" describes that following the 1992 recession, monetary policy was used to offset the tighter fiscal policy. As shown below, it appears the same playbook is being used following the 2008 financial crisis.
The next chart shows how credit and equity have doubled as a percent of GDP starting in the early 1980s. Since the financial crisis, some debt has shifted from Financial Business and Households to the Federal Government. For a good global description of total debt to GDP read "The Economics of Resolving the Global Debt Crisis" by Kevin Wilson. His conclusion is disconcerting in that some countries should consider devaluing their currencies as is happening, and the dollar may be a good investment. A stronger dollar would hurt U.S. exports.
The Great Rebalancing
As Mr. Bernanke describes at the start of his tenure, that the ability of banks to measure the risk they were taking and the ability of the Fed to supervise these banks was inadequate. He cites predatory lending to mortgage borrowers as a problem following the Great Moderation. Interestingly, Mr. Bernanke refers to Robert Shiller's argument that the Housing bubble started in 1998 during the Tech stock market highs and the Asian financial crisis. Mr. Bernanke states that central banks around the world will have to rethink how they manage policy and their responsibility toward the financial system. He also stated that maintaining financial stability is just as important as monetary and economic stability.
I put the following chart together after reading "Currency Wars" by James Rickards where he explains that much of the money from QE programs went overseas and that China "printed" money to maintain its currency peg. The result was inflation in China. An article by David White in Seeking Alpha states that outflows from China are expected to be a half of a trillion dollars in 2016 from a country with a GDP of $11T. These global flows of money make the Federal Reserve's job much more difficult. "The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy" by Michael Pettis is an excellent book on the challenges of the global economy. Bagehot's rule is for Central Banks to lend freely during a financial crisis at against good collateral with a penalty rate. The quality of China's loans are questionable. Also shown in the chart is the devaluation of the Chinese currency.
Mohamed El-Erian notes the similarities between the United States' efforts to increase home ownership during the 2008 financial crisis to China's efforts to provide more Chinese with a stake in a market economy. Others have alluded to China following in the path of Brazil.
Real Median Household Income is lower than the period between 1995 and Housing Bubbles (2006), but higher than the mid-1980s to the mid-1990s. In Mr. Greenspan's words, "an environment of greater economic stability has been key to the impressive growth in the standards of living… in the United States." My personal belief is that excesses existed that drove growth during the Great Moderation that were not fully realized until the Technology Bubble crumbled.
Mr. Wells said, in reference to Janet Yellen, that "she acknowledges that the lags that accompany monetary policy are rather long, and that less than half the effect is felt in the first year." He further states that she believes monetary easing should come from a forecast of where things are headed instead of current indicators. Mr. Blinder and Ms. Yellen (Fabulous Decade) describe the Federal Reserve Board's and Washington University Macro Models which were used to simulate changes in monetary policy and their impact on the economy.
The Federal Reserve has become much more transparent in its views of the economy. They create real-time forecasts of the economy which I use to supplement actual GDP data to create my indicators. Below is GDPNow from the Atlanta Fed. It is updated as data is available and accurate.
A Nowcast of the economy is also available at the NY Fed as shown below. The Fed is forecasting weak growth in the near term which is not an incentive to increase interest rates while inflation is below target.
Inflation and Real Interest Rates (Stable Prices)
The Federal Reserve was created in 1913 in a setting of frequent financial panics. The next chart shows extreme fluctuations in inflation, in an environment of two world wars and a depression, until the mid-1950s. The last 30 years have had stable inflation and fewer recessions.
Because of the balance of payments deficit and reduction of gold, in the 1960s, Congress removed gold requirements for reserves from the Fed. In the 1970s, President Nixon's Economic Stability Act and Arthur Burns' increase in the money supply exasperated high inflation and unemployment. This was accompanied by the OPEC oil embargo. Real interest rates were negative because inflation was higher than the interest rates. Real interest rates over the past decade have been negative by some measures in a low inflation, low interest rate environment which results in a lower velocity of money compared to the 1970s. Bankruptcies occurred in the early 1980s as inflation fell and money had been borrowed at high rates.
Real Interest Rates
Ed Easterling does a good job explaining the impact of inflation and deflation upon price to earnings ratios. Basically, high inflation or deflation have a negative impact on the price to earnings (P/E) ratio. The economy can grow while the P/E is declining resulting in a declining market for years. I use the St. Louis Fed Price Pressures Measures that penalize periods that have a probability of high inflation or deflation combined with the Personal Consumption Price Index. We are currently in a low inflation environment without high inflation pressures.
As the economy and stock market roared along in the second half of the 1990s, inflation remained low. There were apparent reasons for this at the turn of the century such as lower benefit costs including pension contributions and health insurance costs. The effect of these lower costs is estimated to have reduced inflation by about 1% from 1995 to 1998. The dollar appreciated making imports cheaper. The trade deficit began to grow. Savings rates fell and consumption increased. Productivity greatly increased due to technology.
In "Global Pension Crisis" Richard A. Marin (2013) describes the shortage of savings for pension funds, not just in the U.S., but globally. In 2014, Moody's estimated the 25 largest U.S. public pensions face about $2 trillion in unfunded liabilities. Under recent reform to accounting rules, governments will have to put future pension liabilities on their balance sheets. Below is a chart showing the reduction of employer contributions in the late 1990s and the increased contributions during the past 15 years.
Entering the 1980s, Paul Volker began a fight against inflation by raising the discount rate and increasing reserve requirements. The Fed conducted open market operations and allowed the federal funds rate to fluctuate within a wider range. The Depository Institutions Deregulation, Monetary Control Act passed in 1980 encouraged member banks to stay in the Federal Reserve System and to be more competitive with non-bank members giving the Fed better control over the money supply. Because of changes in regulations and how money was saved, measurements of money changed, broader measures of money such as M2 shown which consists of M1, savings deposits, money market deposits, small denominated time deposits and retail money market mutual funds became more applicable. Also shown is the velocity of M2. Money supply was increased significantly in the late 1990s helping to fuel the economy. The low velocity of money supply that exists now means that controlling the money supply will be less effective than in the past.
Required reserves are considered a monetary tool while Bank Capital provides a buffer for safety. Both have increased since the financial crisis.
In the 1980s, the Fed began to use the Fed Funds rate more to control the bank credit.
The Federal Reserve monitors employment which is now nearing the Natural Rate of Unemployment, the threshold where inflation often starts to occur. The percent of marginally attached or part-time workers is about 5 percent which is consistent with the past 20 years. These indicate the U.S. is nearing full employment, but there is still some slack. The red line is the number of unemployed people divided by job openings. The ratio has fallen from 6 unemployed people per job opening at the end of the financial crisis to about 1 now.
During 1994-1995, as unemployment was falling toward 6 percent with 2.5% inflation, the Fed began to raise the Fed rate to slow the economy. The economy experienced a soft landing. Unemployment is currently around 5 percent, but inflation is just now rising to 1%.
The Baby Boomers are exiting the workforce. The growth of the working age population is nearing zero. Japan's working age population is shrinking which is a headwind to GDP growth over the next few decades. The chart also shows the decade(s) long slowdown in industrial production.
My Labor Indicator consists of 12 sub-Indicators. Labor conditions are not as robust as in 2014. There are about $1.3 trillion in student loans that will be harder to pay back in a soft labor market.
The Federal Funds rate is inversely related to the yield curve. As the Fed raises the funds rate, short-term interest rates sometimes rise above longer-term interest rates, inverting the yield curve. As can be seen below, short-term interest rates are rising and long-term interest rates are converging which flattens the yield curve and leads to slower growth. According to FactSet, stock buybacks amount to 58% of free cash flow. Corporations are choosing to buy their own stock as opposed to investing. My Investment Indicator is declining which tends to lead to lower productivity growth.
Below is the Monetary Indicator that I use in my Investment Allocation Model. It consists of M1, M2, Federal Funds Rate, 1-year Treasury minus the Federal Funds Rate, and the St. Louis Fed Adjusted Monetary Base. There is less monetary stimulus compared to a year ago.
The Projections for the Federal Funds Rate is available at the St. Louis Federal Reserve database FRED. Mr. Wells describes the Taylor's Rule which was proposed in 1993 and is based on GDP, Potential GDP, inflation and unemployment. In a normal environment, the Fed Fund Rate should be about 4 percent. Taylor realized that the rule should be deviated during special times such as the 2008 financial crisis. Taylor said the Fed should focus on the real federal funds rate and not the nominal rate. Charles Carlstrom and Timothy Fuerst at the Federal Reserve found that the rule was less effective since 1993 and the Fed should focus on output and inflation. The chart below shows that the Fed Funds target rate, based on current methodology, is between 3 and 4 percent by 2018.
Mr. Wells states, in reference to Janet Yellen, that "she acknowledges that the lags that accompany monetary policy are rather long, and that less than half the effect is felt in the first year." He further states that she believes monetary easing should come from a forecast of where things are headed instead of current indicators.
Mr. Bernanke points out that the bursting of the housing bubble triggered a financial crisis while the Tech Bubble did not. He gives the reasons as the excessive debt taken on during the Great Moderation, excessive use of short-term financing, inability of the banks to monitor their own risk, financial instruments that concentrated risks such as credit default swaps, gaps in regulations, lack of looking at the financial system as a whole, off-balance sheet financing, and the role of Fannie Mae and Freddie Mac in creating the market for mortgage-backed securities for which they were not adequately capitalized.
In 2009, as a low Federal Funds rate failed to revive the economy, the Fed began to buy Treasury and Fannie and Freddie securities which drives the yield of the securities down and pushes money into other types of investments and increases the reserves that commercial banks hold with the Fed. These are interest earning assets of the Fed and not part of the federal deficit. Over $2 billion in profits was transferred to the Treasury in the three years following the financial crisis.
The Bank Z-Score from the World Bank for the United States is available at in the FRED database although the latest update is from 2013. It is an indication of the probability of a default of the banking system based on capitalization and returns.
I use banks tightening lending standards, delinquency rates, and financial stress as indicators related to financial stability. Currently, banks are tightening lending standards, borrowers are becoming more delinquent, and financial stress is increasing. These are warning signs of recessionary trends.
MODERATE LONG-TERM INTEREST RATES
Interest rates are impacted by the collective beliefs of bond investors and is impacted by Monetary Policy. Below is my Interest Indicator which consists of Total Bond Return, Corporate Bond Spread, Ted Spread and High Yield Spread. This indicator measures the current investment environment and is not a forecast of interest rates.
Alan Greenspan explained in 2003 that the government could buy long-term government bonds in order to fight deflation. This would raise their prices and lower their yield. This is what Mr. Bernanke did with quantitative easing. A Fed governor also suggested that if deflation did occur and inflation rates were near zero, the Fed would then expand the money supply. A previous chart on money supply does show that growth of money supply slowed after the Great Recession, but that growth increased after QE was implemented.
"The Fabulous Decade" ended with hopes of paying off the Federal debt with the budget surpluses. Mr. Blinder and Ms. Yellen said, "We leave an analysis of these fascinating issues to the chroniclers of the next decade of macroeconomic history." Alan Blinder is one of the next decade's chroniclers with "After the Music Stopped."
I don't try to predict what the Federal Reserve is going to do and am not a Fed watcher. I believe the business cycle is aged, we are near full employment, and the economy is slowing. Below are my most heavily weighted indicators. They continue to show a slowly fading economy which does show some signs of not falling off the cliff. I don't believe the Fed is in any hurry to raise short interest rates to slow the economy when it is already slowing.
This will be a pivotal year and the next President will be challenged. Budget deficits, pension, social security shortfalls, and trade deficits will have to be addressed. As John Mauldin says, at 2% GDP growth, we are bumping along the bottom and recessions will probably be more frequent.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.