The Markets Go to Rehab: The Interview

Earlier this week I had the pleasure to discuss a recent post, “The Markets go to Rehab”, with Malcolm Palle, founder of the Mining Maven. If you would like to listen to the interview, you can click on the Soundcloud box below.

Recent market action highlights that the markets are increasingly dependent on an easy money environment. The question for investors is whether the Fed will stay the course (continue to tighten monetary conditions, i.e. send the markets to rehab) or buckle under the pressure and fail to shut off the tap. The issue is complicated by the extraordinary expansion of the monetary base over the past eight years and the problems that will be created if the Fed does not reverse this expansion.

Economic Challenges and Market Extremes

February 16, 2016

In periods of heightened market volatility, one of the great challenges for investors is keeping their eye on the big picture. While there are many immediate and much discussed threats to the global economy, including weakness in China, geopolitical conflict in the Middle East and a possible banking crisis in Europe, the key threats to the long-term economic prosperity of the Western World have changed little over the past few months.

The view of The Money Enigma is that the United States, Europe and Japan have balance sheet problem. Over the past twenty to thirty years, policy makers have attempted to “borrow growth” from future periods through a combination of unsustainable monetary and fiscal policy. This “frontloading” of economic growth and the distortions associated with this frontloading represent the greatest threat to the economic future of these regions.

In the first section of this week’s article, we will discuss some of the long-term charts that illustrate this point. Avid followers of macroeconomics will be familiar with many of these long-term economic charts. However, while familiarity may breed complacency, familiarity doesn’t make these charts any less extraordinary.

In the second section of this article, we will consider the implications of these problems for financial markets more generally, including a handful of key charts that indicate extraordinary divergences and extremes by historical standards. Some of these charts may be less familiar and hopefully they will cast some light on the opportunities that are present in the markets today.

The Big Economic Picture: Trouble in Paradise

The first chart may not seem to shout “trouble” but if you look closely it does highlight a serious issue: the rate of long-term economic growth appears to have slowed markedly in the United States.

Source: Trading Economics, US GDP annual growth

Over the past ten years, the US has struggled to reach previous trend levels of economic growth: recent peaks in growth are lower, while the recent trough in growth was the worst in 50 years. Put simply, trend growth seems to have fallen by roughly 1% per annum over the past decade.

While the difference between 2% and 3% real economic growth might not seem like much, a small difference in the economic growth rate compounded over a long period of time makes a tremendous difference to general economic wellbeing. As Nobel Prize winning economist Robert Lucas, Jr. noted when he was discussing the difference in economic growth rates across different countries, “The consequences for human welfare involved in questions like these are simply staggering: once one starts to think about them, it is hard to think about anything else.”

This pattern of lackluster growth can be seen more clearly in other major countries such as France. France is a relative success story in Europe, i.e. it is doing better than Spain, Italy and the other Mediterranean states, and yet economic growth is anaemic.

Source: Trading Economics, France GDP Annual Growth Rate

More notably, Japan has spent the past twenty years struggling to generate any sort of sustained economic growth.

Source: Trading Economics, Japan GDP Annual Growth Rate

What makes this slowdown in economic growth all the more remarkable is that it has largely occurred during a time when unprecedented fiscal and monetary policy has been implemented, policy explicitly designed at boosting rates of economic growth. In simple terms, the Western World has been taking huge risks with its balance sheet in order to keep its income statement looking healthy.

We can see this marked balance sheet deterioration across a range of charts. First, let’s look at the explosion of government debt in the United States.

Source: research.stlouisfed.org

While the chart above will be very familiar to most, it is still a remarkable chart. In the wake of the 2008 economic crisis, Federal government debt in the United States skyrocketed to levels not seen since the end of WWII. Nearly eight years since the crisis began, there has been no significant reduction in that debt.

This situation is echoed in Europe where, despite all the talk about austerity, virtually no progress has been made in reducing public debt.

Source: ECB

Concerns about the sustainability of the fiscal situation in Europe have begun to resurface again as indicated by CDS spreads across a range of countries. In the chart below, Deutsche Bank calculates the annual probability of default on government debt using the yield on 5-year CDS spreads.

Source: Deutsche Bank

Meanwhile, the fiscal situation in Japan goes from the absurd to the ridiculous with total public debt as a ratio of GDP continuing to surge higher.

Source: Trading Economics

While many (Keynesian) economists believe that current levels of government across the Western World are sustainable, the view of The Money Enigma is that these levels of government debt do pose a real risk to the value of the fiat currencies issued by these major nations (“Does the National Debt Impact the Value of the Dollar?”).

Government debt plays a critical but complex role in the determination of the rate of inflation (“Government Debt and Inflation”). If the markets suddenly decide that current levels of public debt are not sustainable, then it could result in a sudden surge in the rate of inflation across the Western World.

Meanwhile, not only have governments issued more debt, but they have also issued more “equity”. Over the past eight years, the US monetary base has quintupled in size. The view of The Money Enigma is that this expansion in the monetary base represents, in effect, a massive issuance of equity (see “Money as the Equity of Society”). More specifically, the Fed has massively expanded the number of claims against the future economic output of the United States.

Source: research.stlouisfed.org

Critically, while the Fed argues that it has begun the process of “normalizing” monetary policy, the Fed has made no progress to date in reducing the size of the monetary base. Indeed, the view of The Money Enigma is that the current round of interest rate rises by the Fed are largely just a distraction from the real issue, namely, the size of the US monetary base (“The Interest Rate Rabbit and the Base Money Elephant”).

In summary, the West has a balance sheet problem. The explosion in government debt and base money that has occurred over the past ten years is unprecedented in peacetime history. Not only has this balance sheet recklessness failed to drive a marked acceleration in the rate of economic growth, but it has also created an environment of increasing reliance upon government intervention in the financial markets.

The Markets: Some Fascinating Charts

In last week’s post, “The Markets Go to Rehab”, we discussed the increasing reliance of markets on the easy money policies of the major central banks. Nowhere is this dependency seen more clearly than in a chart of the S&P 500 relative to the US monetary base.

A quick look at this chart would suggest that fundamentals no longer matter, i.e. the direction of the equity market is solely determined by Fed policy. However, if fundamentals still do matter (and eventually they will), then the US equity markets do have one key problem ahead of them: valuation.

The problem for equity markets is not so much that the price/earnings ratio of the market is still relatively high by historical standards, but that corporate profit margins are extended at a time that revenue growth is hard to come by. More specifically, profit margins not only appear to have peaked, but remain very high when judged against historical standards.

Source: research.stlouisfed.org

While the US equity market is close to one extreme, the global commodities market is flirting with another. Unfortunately, long-term indices than can accurately present a clear picture of the overall commodities market are rare. Nevertheless, the following inflation-adjusted chart of the oil price does provide some sense of where commodities are in a long-term historical context.

Source: MacroTrends

While it is true that the oil price is not at all time record lows in inflation-adjusted terms, the point needs to be made that “Peak Oil” is still a real phenomenon in the sense that large, low-cost deposits are becoming harder to find and those that exist are being gradually depleted. In this context, the price of oil does look low by historical standards. [Those that would argue that shale represents a source of low cost oil clearly have never read a cash flow statement or balance sheet].

Oil also looks cheap in the context of gold. The gold to oil ratio is at a new high, indicating that oil is very cheap in gold terms, at least measured by history.

Source: MacroTrends, gold to oil ratio

The flipside of this coin is that gold is expensive in crude oil terms. However, gold appears to be cheap relative to other major financial assets, most notably, equities

Source: MacroTrends, gold to S&P 500

Finally, a good measure of the pessimism in the gold sector is the performance of gold stocks relative to the commodity itself.

Source: MacroTrends, XAU to gold ratio

This last chart indicates that gold stocks are very cheap relative to gold, at least measured by this rough historical standard. More surprisingly, gold stock valuations remain subdued despite the fact that the oil price, a major input cost, has collapsed.

The Markets Go to Rehab

February 9, 2016

“My name is The Market and I’m a Fedaholic.”

Since the Fed raised interest rates in December, many market participants must be feeling as though they just went cold turkey. In less than two months, the S&P500 is down nearly 10%, the VIX has surged and the gold price, the barometer of falling economic confidence, has risen sharply off its lows.

The bad news is that this is just the beginning of a long and painful process. Over the past ten years, global markets have become addicted to a combination of drugs. Now, for the first time in nearly a decade, the market is facing the real possibility that those drugs are denied.

The first drug is low short-term interest rates. In truth, the markets have been experimenting with this drug for many years, so much so that much of its potency has worn off.

The second drug, a far more dangerous and potent drug, is monetary base expansion. Monetary base expansion has been used by the Fed to suppress long-term interest rates. Long-term rates have a far more potent impact on equity markets than short-term rates because the long-term risk free rate is a key input into the required cost of long-term risk capital, a key factor in the determination of stock prices.

Any attempt to wean the market from these drugs is going to be difficult. Indeed, saying that it will be “difficult” is like saying that breaking an addiction to heroin is “difficult”.

Breaking and recovering from a serious drug addiction is a process, a long and painful process. Breaking the markets addiction to the Fed drug cocktail will involve many difficult and painful steps and is unlikely to be a simple, linear process.

Moreover, equity market investors who think, “the worst may be over”, are in for a rude shock. We will discuss the economics of this in more detail shortly, but first a simple analogy.

Let’s imagine that the market is the drug addict and the addict is being dragged off to rehab. The view of The Money Enigma is that the Fed’s action in December was the equivalent of getting the addict into the car and fastening the seat belt. Not only have the markets not begun the process of rehabilitation, they haven’t even reached the rehab center.

The first series of Fed rate hikes that are expected this year (2016) are the equivalent of getting the addict to the door of the rehab center. But the real rehabilitation process doesn’t begin until the Fed begins to reduce the size of the monetary base.

The big question for investors over the next two years is not so much whether the Fed will drive the markets to the rehab center, i.e. whether the Fed will raise the fed funds rate by 100-150 basis points, but whether the Fed will have the courage to get the markets out of the car and into the rehab center when they arrive at the door, i.e. will the Fed actually reduce the size of the monetary base.

If the Fed buckles under the pressure of the screaming addict in the back seat of the car and decides not to drag the addict out of the car, or worse, turns the car around before they even get to the rehab center, then the long-term future for the addict becomes dire. We will discuss this alternate future at the end of this article, but first, let’s discuss the market’s addiction to “easy money” and the path to sobriety.

The Growth of an Addiction

It has been widely noted by many market commentators that the direction of the global equity markets has become increasingly dependent upon Federal Reserve policy over the years.

Back in the 1990s and 2000s, the market became increasingly reliant on the economic stimulus created by manipulations in the fed funds rate. As Washington became increasingly dysfunctional and unable to provide clear leadership regarding economic stimulus, the markets turned to the their friends at the New York Fed and convinced the Fed that their primary role was to smooth out the economic cycle, particularly on the downside.

The Fed, under the leadership of Alan Greenspan, was more than happy to take on its new celebrity status and the Greenspan Fed created an art form of justifying sharp moves in the fed funds rate under the premise that “the Fed knows best”.

For our purposes, what is interesting about this first drug (manipulation of the short-end of the interest rate curve) is that it primarily operated through the impact it would have on lending and economic growth. In other words, this drug operated somewhat indirectly upon stock prices: lower interest rates drove higher lending and economic growth that boosted confidence in the long-term cash flows of equity securities.

The problem with this first drug is that the addict (the markets) became so accustomed to it that lost its potency. During the 2008 crisis, the Fed cut the fed funds rate to zero, but this alone wasn’t enough to provide the rush that the market (and the economy) needed to overcome the fallout from the excesses that had occurred over the previous two decades (notably, Tech Boom 2000 and Housing Boom 2006).

What was the Fed to do? They came up with a new drug: quantitative easing or “QE”.

Quantitative easing is a much more potent drug than simple fed funds rate manipulation because it acts as a direct shot in the arm for the equity markets. Whereas old school fed funds rate manipulation tended to act indirectly upon the financial markets, QE had a very direct impact upon the securities markets.

Why is this the case? Well, in order to understand how QE acts on stock prices, we need to go back the basics of securities valuation. Those that are interested in a detailed discussion of this topic should read “Has the Fed Created the Conditions for a Market Crash?” But for now, we will just touch on the key points.

In essence, the price of a business depends upon the sum of the discounted future cash flows of that business. There are two keys items that determine this calculation: (a) the future cash flows of the business and (b) the discount rate.

As discussed earlier, manipulation of the fed funds rate operated primarily by influencing the first item in that calculation, expected future cash flows. When the fed lowered short-term interest rates, economic growth would rise and people become more optimistic about the long-term path of future cash flows for the market.

QE is different because it acts directly upon the second item in our calculation, the discount rate. Why does QE have a greater impact on the discount rate than changes in the fed funds rate? QE is more potent because stocks are long duration assets, i.e. the value of the typical stock depends critically upon long-term expected cash flows.

What is the discount rate used to discount these long-term future cash flows? The long-term required return on risk capital. QE acts by forcing down the long-term risk free rate, thereby lowering the long-term required return on risk capital.

In other words, QE acts as a direct shot in the arm for equity markets. By expanding the monetary base and using this money to buy long-term government debt, the Fed forces up not only the price of “safe” assets (debt) but also the prices of “risky” assets (stocks).

If you don’t believe that this theory is plausible and you doubt the impact of monetary base expansion on the stock market, then I would encourage you to have a hard look at this next chart that plots the recent growth in the monetary base against the recent performance of the S&P 500 (all data is from the St. Louis Fed).

The Markets are Tweaking

The view of The Money Enigma is that the recent volatility experienced in global financial markets represents just the beginning of a long withdrawal process. In simple terms, the markets are “tweaking” as they begin to come off the “easy money” high.

Indeed, there is a strong analogy that can be made between the use of monetary base expansion and the markets dependence upon that stimulus and the experience of the typical methamphetamine addict. More specifically, monetary base expansion (or “money printing”) is a potent drug that creates exhilarating highs and debilitating lows.

We can apply the seven stages of addiction model for methamphetamines to the market cycle associated with easy money. As described in an article published in July last year, “Monetary Base Expansion: The Seven Stages of Addiction”, there are seven stages in the easy money cycle.

In the first stage, “the Rush”, the immediate pressure of an economic crisis is relieved by central bank intervention in the markets, i.e. creating money and using this money to buy bonds.

In the second stage, “the High”, the markets are in a more optimistic state and decide that the risks of monetary intervention (drug use) are low, i.e. “this time is different” and “we can handle it”.

In the third stage, “the Binge”, the overconfidence created by the first experimentation (QE1) leads to a period of poorly controlled use of the drug (QE23/QE3), or a “binge”. Typically, this is the point where the user becomes delusional and aggressively overconfident. (Does the chart below suggest any of this type of behavior in the last few years?)

Today, we find ourselves in the fourth stage, “Tweaking”.

Tweaking occurs as the level of the drug in the users system begins to decline below a critical level. For the markets, the Fed’s first interest rate rise in December triggered the realization that the easy money drug cocktail is going to be slowly withdrawn. In essence, the Fed has bundled the markets into the car and told them they are going to rehab.

In the tweaking phase, addicts become increasingly nervous and erratic. The market volatility over the past couple of months is symptomatic of this kind of behavior. But this is unlikely to be the worst part of the experience.

In the fifth phase, appropriately called “the Crash”, the positive impacts of the drug wear off and the addict, at least temporarily, becomes unable to complete the simplest of tasks, i.e. market failure occurs, at least temporarily.

What would it take for the markets to enter the “Crash” phase? It isn’t entirely clear. Will the Fed need to reduce the size of the monetary base before the cost of capital resets and the markets fall accordingly? Or will simply the promise of monetary base reduction and a few more interest rate rises be enough to trigger such an event?

Nevertheless, while the precise path to recovery may not be clear, the markets will need to go through the recovery process at some point, a process that involves not just a “Crash” phase, but also prolonged “Hangover” and “Withdrawal” phases.

Undoubtedly, there are those that will argue that the market is a discounting mechanism and the withdrawal of monetary stimulus is “priced in”. While this may be true about the upcoming series of Fed rate hikes, it seems unlikely to be true when applied to the possible reversal of QE over the next 3-5 years. Not only is a reversal of QE a more distant possibility, but also it still isn’t clear that market participants really understand how QE acts on the long-term cost of risk capital and how a reversal of QE will significantly raise this cost of capital, thereby placing the equity markets under enormous pressure.

If it doesn’t sound like a good future, it isn’t. But, what happens if the Fed doesn’t “normalize” monetary policy, i.e. if the Fed doesn’t raise rates and substantially reverse QE? What if the Fed doesn’t force the markets into rehab? What if the Fed doesn’t even make it to the rehab center? Well, then a worse long-term fate awaits the markets.

The Addict that Didn’t Make It

In the media, we hear a lot of stories about addicts that have recovered from their terrible and self-inflicted drug addictions. What we don’t hear about as often are the ones that don’t make it. Amy Winehouse, writer of the song “Rehab”, was one the famous exceptions to this rule.

Perhaps this bias in the media has contributed to the idea, not endorsed by The Money Enigma, that “drugs are OK, I can deal with it, after all, I can always go to rehab and get clean just like the celebrities do”.

Interestingly, this same sense of recklessness and self-confidence seems to be a hallmark of the historical experimentation with money printing. No society starts the process of money printing believing that it will all end in disaster. Rather, money printing is always presented as a necessary solution to a crisis and, at least in the initial phases, it is generally met with widespread popular approval.

Unfortunately, monetary base expansion is an experiment that seldom ends well. Just like drugs, the problem with monetary base expansion wouldn’t be so serious if the experiment was truly a “one off”. But inevitably, experiments with temporary expansions in the monetary base end up becoming permanent addictions to higher levels of money creation.

If you go back to early 2009, you might remember that QE1 was promoted by the Fed as an emergency solution to a crisis that genuinely threatened global financial markets, i.e. it was a temporary response to a temporary problem. Similarly, QE2 and QE3 were advertised as temporary measures to get the US economy back on track. All of these were noble goals, but the problem is that, nearly seven years later, none of these “temporary” measures have been reversed.

Why does this matter? Well, the problem with permanent expansions of the monetary base is that, sooner or later, they have a severely negative impact on the value of fiat money and, as the value of fiat money falls, prices as expressed in money terms rise.

The view of The Money Enigma is that fiat money represents a proportional claim against the future economic output of society (see “Theory of Money” section). What this means in practice is that the value of fiat money depends upon expectations regarding the long-term future path of two variables: real output and the monetary base. The value of fiat money is positively correlated to long-term expectations regarding real output and negatively correlated to long-term expectations regarding the size of the monetary base.

If an expansion in the monetary base is expected to be temporary, then this will have little impact on the value of fiat money. However, if an expansion in the monetary base is expected to be permanent in nature, then this will have an immediate negative impact on the value of money.

Moreover, if an expansion in the monetary base that was advertised as “temporary” suddenly becomes “permanent”, then the value of money can collapse quite quickly, triggering a dramatic acceleration in the rate of inflation.

And here, in a nutshell is the problem for the Fed and the addict in the back seat of the car. If the Fed sends the markets to rehab, it will be an unpleasant experience for financial markets and the economy, but at least a “survivable” experience. However, if the Fed flinches and fails to send the markets to rehab, then the dollar will collapse and the rate of inflation in the US will soar. In this second scenario, the Fed will lose control of the economic agenda and the markets will find that living with the drug is worse than living without it.

What Causes Deflation? Is Deflation Likely to Occur?

February 2, 2016 – The Money Enigma

Over the past few years, the word “deflation” has become as popular as the word “inflation” in discussions of financial market risk. But does deflation really represent a risk to the world economy at this time?

The view of The Money Enigma is that inflation poses a much greater risk to the global economy than deflation at this point in time. While severe deflation is a real possibility under a gold standard, such as existed in the 1930s, the fact is that severe deflation is an unlikely outcome under a fiat money regime.

In order to understand why this is the case, we will attempt to answer a few basic questions about deflation.

First, what are the primary causes of deflation? Second, why is deflation more likely to occur under a gold standard than it is under a fiat money regime? Third, what factors are likely to prevent an outbreak of severe deflation across Western economies over the next few years?

Deflation: Why Do Prices Fall?

Let’s begin with some basic microeconomics.

Every price is a relative expression of market value. More specifically, a price measures the market value of one good in terms of the market value of another good. Therefore, at the most basic level, a price can fall for one of two reasons: either, (a) the market value of the first good falls, or (b) the market value of the second good rises.

Think about this in simple terms. Imagine you live in a barter economy with no money and two goods, apples and bananas.

If one apple is three times more valuable than one banana, what is the price of apples in banana terms? Clearly, it is three bananas. If the market value of an apple is three times the market value of one banana, then you will have to offer three bananas in order to buy one apple. The ratio of exchange, bananas for apples, is three to one. Hence the price of apples in banana terms is three.

Now, why might the price of apples, as measured in banana terms, fall?

Well, there are two possible reasons.

First, apples may become less valuable. If apples become less valuable, then it will require fewer bananas to purchase an apple and the price of apples in banana terms will fall.

This much is obvious. What is less obvious is that the price of apples may fall for a second and just as important reason: bananas may become more valuable.

If bananas become more valuable, then it will require fewer bananas to purchase an apple. For example, if there is a sudden shortage of bananas, then we might find that apples and bananas are now of equal value. What happens to the price of apples? It falls. If bananas become more valuable such that one banana and one apple are now of equal value, then the price of apples will fall from three bananas to one banana!

In summary, the basic microeconomic principle is that in any exchange of two goods, the price of the transaction depends upon the market value of both the primary good (in this case apples) and the measurement good (in this case, bananas).

Now, let’s apply this principle to a modern money-based economy.

The price of a good, in money terms, depends upon both the market value of the good itself and the market value of money.

Therefore, in a money-based economy, the price of a good will fall if either, (a) the value of the good itself falls, or (b) the value of money rises.

Let’s think about point (b) for a moment. The price of an apple in money terms depends upon both the value of apples and the value of money. Let’s imagine that today an apple is twice as valuable as a dollar. What is the price of apples? The answer is two dollars.

Now, what happens if, all else remaining equal, money becomes more valuable? For example, one year later the value of a dollar, as measured in absolute terms, has doubled while the value of an apple has remained the same. What is the new price of apples? The answer is one dollar. One dollar is now just as valuable as one apple.

In this example, the price of apples falls, not because apples became less valuable in an absolute sense, but because apples became less valuable in a relative sense, i.e. relative to the value of money.

The key point is that, at a microeconomic level, the price of a good can fall for one of two different reasons: either, (a) the market value of the good falls, or (b) the market value of money rises. Readers who are unclear on this point are encouraged to read “The Measurement of Market Value: Absolute, Relative and Real” and “A New Economic Theory of Price Determination”.

Moreover, we can extend this microeconomic concept to a macroeconomic discussion of deflation.

In simple terms, falling prices across the economy can be caused either by (1) a fall in the market value of goods and services, or (2) a rise in the market value of money.

Once again, the first part of that statement is rather obvious. If there were a sudden collapse in aggregate demand, then you would expect good and services to become “less valuable”. In the diagram below, a sudden shift to the left in the aggregate demand curve will lead to a fall in the overall market value of goods (denoted “V_G”).

However, what most economists and market commentators fail to do is to think about the implications of a weak economy on the right hand side of the diagram immediately above. While a weak economy will almost certainly lead to a fall in the market value of goods (V_G falls), a weak economy could also lead to fall in demand for money leading to a lower market vale of money (denoted “V_M”). Importantly, if the value of money V_M falls more than the value of goods V_G, then the ultimate outcome is not deflation but inflation!

Deflation: Gold Standard versus Fiat Money Regimes

The problem with most “inflation or deflation” debates is that the participants don’t recognize the simple notion that price is a relative expression of market value.

Any meaningful discussion of deflation must consider not only the forces acting upon the market value of goods (oil price, output gap, etc.), but also the forces acting upon the market value of money (expectations regarding future output growth and base money growth).

More specifically, any genuine discussion regarding the prospect for deflation needs to recognize that while deflation is a real possibility under monetary systems based on the gold standard, widespread and persistent deflation represents a very unlikely event under most fiat money regimes.

Nowhere is this better illustrated than in a comparison of inflationary outcomes in the United States in the early 1930s and the late 1970s.

While economists may debate the exact circumstances surrounding these two different periods, the fact is that both periods where characterized by severe economic weakness, falling economic confidence and rising rates of unemployment. Yet the inflationary outcomes in both periods were vastly different: in the 1930s, prices collapsed; in the 1970s, prices soared.

While many economists may attempt to blame rising prices in the 1970s on OPEC and the oil shock, the view of The Money Enigma is that these two different periods experienced two very different outcomes primarily because of the different nature of the monetary regimes that existed at that time.

In the 1930s, the United States operated on a gold standard. The value of each US Dollar was fixed to a certain amount of gold. In effect, this meant that the market value of each US Dollar was tied to the market value of gold: if the value of gold rose, then the value of the Dollar rose.

In the early 1930s, the “perfect storm” for deflation occurred. First, there was a sudden collapse in aggregate demand, a collapse that was triggered by the excesses of the 1920s. This collapse in aggregate demand led, as one would expect, to a massive decline in the market value of goods and services generally.

In itself, this event was highly deflationary. However, another important factor was in play at that time. As the financial system became increasingly unstable, demand for gold rose: as the market value of gold rose, the market value of the US Dollar also rose! Why? The market value of money rose because the value of money was directly tied to the value of gold.

Now, think about this in the context of our earlier discussion. If the price level is a relative measure of the market value of goods and the market value of money, then what creates the “perfect storm” for deflation? A collapse in the value of goods and a surge in the value of money!

In the early 1930s, the gold standard created the perfect set up for a collapse in prices. First, aggregate demand collapsed, leading to a fall in the market value of goods (V_G falls). Second, demand for gold rose due to financial instability, leading to a rise in the market value of gold and a commensurate rise in the market value of money (V_Mrises). The value of goods, as measured in money terms collapsed, and the US economy entered a period of severe deflation.

Now, let’s contrast this with what happened in the late 1970s.

In the 1970s, the US economy experienced both an aggregate demand and aggregate supply shock. In terms of our Goods-Money Framework, the aggregate demand and aggregate supply curves both shifted to the left. The net impact on the market value of goods V_G was probably a modest rise.

However, the view of The Money Enigma is that the modest rise in the market value of goods during the 1970s can not fully explain the high levels of inflation that were experienced during that time. Rather, some other factor was at play: a fall in the market value of money V_M.

Why did the value of money fall in the 1970s? Well, in 1971, President Nixon ended the convertibility of gold into dollars. Suddenly, the value of the US Dollar was no longer tied to the value of gold and the value of the US Dollar began to decline sharply. As economic confidence in the long-term prospects of the United States declined, the US Dollar began to loss value.

The key point is that in the 1970s, under a fiat regime, economic weakness led to a decline in long-term economic confidence and a decline in the value of money. In contrast, in the 1930s, under a gold standard, economic weakness actually led to a rise in the value of money because the value of money was tied to the value of gold.

This difference explains, more than any other factor, why high levels of inflation plagued the 1970s, while the 1930s experienced severe deflation.

In summary, in order to have a sensible discussion regarding the risk of deflation, we must consider not only the obvious impact of a fall in aggregate demand upon the value of goods, but the nature of the prevailing monetary regime and how economic weakness may impact the value of money under that regime.

The Likelihood of Deflation in 2016 and Beyond

While many market commentators are obsessed by the possibility of deflation, the fact of the matter is that a prolonged period of deflation is a very unlikely under the current fiat money regime that exists in the United States.

As we look ahead into first half of 2016, there is little doubt that economic weakness, most notably a slowing of growth in China and a fall in oil prices, will contribute to a decline in the market value of goods. However, these factors are unlikely to be sufficient to drive a severe decline in prices in the United States.

A prolonged and/or severe period of deflation requires another key factor that is unlikely to occur over the next few years: a rise in the value of money.

As discussed above, one of the primary drivers of the deflation that occurred in the 1930s was a rise in the value of money. In the early 1930s, the value of money was tied to the value of gold. The financial instability of the early 1930s drove up the value of gold and, consequently, the value of money, creating a perfect storm for deflation.

This outcome is very unlikely to occur over the next few years. Indeed, the view of The Money Enigma is that we are much more likely to experience the exact opposite of this, i.e. the US will experience a rapid decline in the value of money and a surge in prices.

The key difference between the 1930s and today is this: in the 1930s, the value of money was tied to the value of gold; today, under the existing fiat money regime, the value of money is directly linked to confidence in the long-term economic future of society.

Over the past few years, the US Dollar has been riding high on optimism regarding the long-term economic outlook for the United States. In essence, most people are optimistic regarding the 30-year economic outlook for the United States, despite the structural weaknesses that were exposed in the 2008 financial crisis and the government credit rating crisis in mid-2011.

However, recent events suggest that optimism in regards to the long-term economic outlook may have peaked. More specifically, the beginning of monetary policy “normalization” by the Federal Reserve has already disturbed the financial markets, despite the fact that this first move by the Fed represents at best what might be described as a “baby step”.

As the Fed continues on its current path, it is almost inevitable that economic disruption will occur and the markets will begin to question the long-term future of the United States. If confidence in the long-term future of the US is damaged, then the value of the US Dollar could decline sharply and prices, as expressed in USD terms, could rise suddenly.

Why is the value of fiat money tied to confidence in the long-term future of society? In essence, the view of The Money Enigma is that fiat money represents a proportional claim on the future output of society. As long-term confidence weakens, a proportional claim on the long-term future output of society becomes less valuable.

Readers who are interested in this general concept should read the “Theory of Money” section of the website and/or a recent post titled “What Factors Influence the Value of Fiat Money?”

Under a fiat money regime, a period of global economic weakness is a necessary, but not sufficient, condition to generate deflation. Therefore, a prolonged period of deflation in the United States is unlikely over the next few years. Rather, it is much more likely that the US Dollar will decline in value over the next few years, at least as measured in absolute terms, and that inflation in the United States will accelerate.

Markets are Tweaking, Gold is Rising: The Interview

January 26, 2016

Earlier this week, I had the pleasure to sit down with Malcolm Palle at the Mining Maven and talk about markets, economics and some of the opportunities that are emerging in the commodity and mining sectors.

In the first part of the interview, Malcolm and I discuss the recent volatility in global financial markets. As discussed in an article last year titled “Monetary Base Expansion: The Seven Stages of Addiction”, I believe that global financial markets have become addicted to monetary base expansion and a low interest-rate environment. As the Fed gradually withdraws this drug, the markets are going to enter a “tweaking” phase, a phase that I believe began recently. If the Fed really commits to “normalizing” monetary policy, then markets will probably experience the “crash” and “withdrawal” phases that accompany the withdrawal of any hard drug.

In the second part of the interview, we discuss the recent rise in the price of gold. The view of The Money Enigma is that the gold price is inversely related to the level of confidence in the long-term economic future of society (see “What Determines the Price of Gold?”). Presently, confidence in the long-term prospects of the US are at high. But if this confidence wanes, then the gold price is likely to climb back towards the $1,500/oz level.

In the final part of the interview, we discuss some of the opportunities in the commodities and mining space. In particular, mining equities represent a fascinating opportunity at this stage of the cycle, but the challenge is to identify those companies that can execute in this environment and take advantage of the depression-style conditions that exist across the sector.

What Determines the Value of a Currency?

January 19, 2016

The view of The Money Enigma is that the value of a fiat currency is primarily determined by market confidence in the long-term economic future of the nation that issued that currency.

When confidence in a nation’s long-term economic prospects are strong, the value of its currency tends to be well supported. However, if confidence is damaged, for example by war or economic mismanagement, then the value of the currency will fall. In an extreme scenario, one where the economic survival of a nation is questioned, the value of a currency can collapse resulting in a condition known as “hyperinflation”.

Ultimately, fiat currency is only as good as the society that issues it. In this article, we shall explore why this is the case and why the value of a nation’s currency tends to fluctuate with perceptions regarding its economic future.

However, before we attempt to answer the question “what determines the value of a currency?” we need to answer two fundamental questions. First, why does the value of the currency matter? Second, why does fiat currency have any value at all?

Why Does the Value of the Currency Matter?

The value of the currency plays a critical role in the determination of foreign exchange rates and the price level.

The fiat currency in your pocket has value, i.e. it is “valuable” in the ordinary sense of that word. If fiat currency didn’t possess the property of market value, then you wouldn’t accept it in exchange for your services and others wouldn’t accept it from you in exchange for their goods and services.

If we measured the value of the fiat currency in your pocket in terms of a “standard unit” for the measurement of market value, i.e. in terms of a good that was invariable in the property of market value, then we would be able to observe that the value of that fiat currency rises and falls independently of the value of goods and services and all other currencies.

However, in practice, we don’t measure the value of currency in terms of a theoretical “standard unit”. Rather, we measure the value of the currency in terms of goods and other currencies that are themselves variable in value.

More specifically, we tend to measure the value of a currency in terms of either, (a) another currency, or (b) a basket of goods and services.

The value of one currency as measured in terms of another is known as a “foreign exchange rate”. A foreign exchange rate measures the value of one currency in terms of the value of a second currency.

The value of a currency as measured in terms of a basket of goods is known as the “purchasing power of money”. The purchasing power of money is the inverse of the “price level”, i.e. the price level measures the value of the basket of goods in terms of the value of currency.

A fall in the value of a currency will tend to have two important impacts. First, it will tend to lead to a fall in the price of that currency as measured in terms of other currencies. Second, it will lead to a decline in the purchasing power of money, i.e. prices for most goods will tend to rise.

Why is this the case? Well, if you think about it in simple terms, if each unit of currency in your pocket is suddenly “less valuable”, then, all else remaining equal, you would expect to have to give up more of it in order to obtain the things you want. It doesn’t matter whether those things are goods, services or other currencies: if the currency in your pocket is suddenly less valuable, then you will have to offer more of it to obtain those other items.

The relationship between the value of money and the price level is discussed in more detail in a recent article titled “Ratio Theory of the Price Level”.

In simple terms, Ratio Theory states that the price level can be calculated as a ratio of two values: the value of goods (the numerator) and the value of money (the denominator). All else remaining equal, as the value of money falls, the price level rises.

In summary, fluctuations in the value of money play a key role in the determination of foreign exchange rates and the price level. But why does the paper money in your pocket have any value at all? In order to answer this question, we need to examine the evolution of money.

Why Does Fiat Currency Have Any Value?

If you do a quick search on the question “why does fiat money have value?” you will find a whole range of answers, none of which are particularly compelling.

Indeed, mainstream economics struggles to provide a sensible answer to this question because it treats fiat money as an “exception”. What does this mean? Well, it means that rather than treat fiat money just like any other asset, economists try to invent new schemes and theories that apply solely to fiat money and not to any other assets. Inevitably, this creates a whole series of problems and objections, none of which have been successfully resolved.

Fortunately, there is a simple paradigm that can be used to explain why any asset, including fiat currency, has value: the real asset/financial instrument paradigm.

The real asset/financial instrument paradigm has its roots in accounting, rather than economics, and it is used to explain how any particular asset derives its value.

In essence, the real asset/financial instrument paradigm states that assets can only derive their value in one of two ways. Real assets derive their value from the physical properties. In contrast, financial instruments derive their value from their contractual properties.

In simple terms, if an asset doesn’t derive its value from its natural or intrinsic properties, then the only way it can derive its value is if it creates an obligation on a third party to deliver something of value.

Fiat currency is not a real asset. Rather, fiat currency is a financial instrument and derives it value from its implied contractual properties. More specifically, fiat currency represents a liability of society and claim on the future output of society.

In order to understand this point, it helps to think about how money evolved over time. [Readers that are interested in a more in-depth discussion of the evolution of money should read “The Evolution of Money: Why Does Fiat Money Have Value?”]

The first form of money used by early societies was “commodity money”, i.e. a commodity that found acceptance as a medium of exchange and unit of account. This early form of money was a real asset and derived its value from its natural physical properties. Over time, precious metals such as gold and silver became the most popular form of commodity money and were widely accepted across international borders.

At some point, kings and governments began to issue paper notes that represented promises to deliver gold and/or silver on request. This first paper money, know as “representative money” derived its value from its contractual properties. Suddenly, money was a financial instrument, i.e. it had value because it created an obligation on a third party (the king) to deliver something of value (gold/silver).

Ultimately, representative money, money backed by a real asset, limited the amount of money that kings and governments could create. Therefore, at some point, the gold convertibility feature was removed and “representative money” suddenly became “fiat money”.

In theory, this creates a problem. By removing the gold convertibility feature, the explicit contract that governed paper money was rendered null and void. So why did paper money maintain any value at all?

The view of The Money Enigma is that paper money only maintained its value when the gold convertibility feature was removed because the explicit contract that governed paper money was replaced by a new implied-in-fact contract or what some might call a “social contract”.

The key question is what is the nature of this new implied social contract? If fiat money is a financial instrument and can only derive its value contractually, then it must represent a liability to a third party. So, how is that third party and what obligation does it create against them?

What Determines the Value of Fiat Currency?

The view of The Money Enigma is that fiat currency derives its value from an implied social contract. Fiat currency is an asset to its holder because it represents a liability to society. Although government is the legal issuer of fiat currency, from an economic perspective, fiat currency is a liability of society and represents a claim against the future output of society.

More importantly, fiat currency represents a proportional or variable claim against the future output of society. What does this mean? Well, it helps to think about the general nature of financial instruments.

In general terms, a financial instrument represents either a fixed or proportional claim to some future economic benefit. For example, a corporate bond represents a fixed claim to the future cash flows of a business. In contrast, a share of common stock represents a proportional claim to the future residual cash flows of a business.

What determines the value of common stock? There are two key drivers. First, the expected cash flows that will be generated by the business: a share of common stock is a claim to those cash flows, so clearly the future level of those cash flows matters. Second, the expected number of shares outstanding in the future: if the market expects shares outstanding to skyrocket in the future, then each share will claim a smaller proportion of future cash flows and, all else remaining equal, will be worth less.

We can apply these same ideas to fiat currency.

Fiat currency represents a proportional claim on the future output of society. More specifically, the expected proportion of future output that fiat money will claim in any future period depends upon the expected future size of the monetary base at that time.

Now we can answer our key question: “What determines the value of fiat currency?”

If fiat currency represents a proportional claim on future output, there are two key drivers that influence the current value of fiat money.

The first is obvious: the value of fiat currency is positively correlated to the outlook for future output growth. If fiat currency represents a proportional claim against future output, then its value must be tied to optimism regarding the ability of the economy to grow.

The second is less obvious: the value of fiat currency is inversely related to expectations regarding the future size of the monetary base. If fiat currency represents a proportional claim against the future output of society, then its value will rise if people start to believe that long-term monetary base growth will be restrained and its value will fall if people suddenly believe that long-term monetary base growth will accelerate.

If this seems like a complicated idea, then consider what drives the price of common stock.

Ultimately, the price of common stock depends upon expectations regarding the long-term future path of earnings per share. Similarly, the value of fiat currency depends upon expectations regarding the long-term future path of real output per unit of money.

What does this mean in practice?

In practical terms, this theory implies that the value of fiat currency is primarily determined by confidence in the long-term economic future of the nation that issued that currency.

When confidence in the long-term economic future of society is high, people tend to expect solid real output growth to be accompanied by a disciplined expansion of the monetary base. This type of environment is very supportive for the value of fiat currency.

In contrast, if confidence in the long-term economic future of society is damaged, then people might reasonably expect lackluster economic growth or even economic contraction to be accompanied by aggressive expansion of the monetary base. This type of environment can lead to a significant fall in the value of the currency, an outcome that is typically reflected in both foreign exchange rates and the price level (prices rise across the economy).

One of the compelling aspects of this theory of fiat currency is that we can use it to build an expectations-based valuation model for fiat currency (see slide below). In turn, this can be used to build expectations-based solutions for foreign exchange rates, the price level and the velocity of money.

Readers who are interested in this valuation model for money should read the “Theory of Money” section of this website and an older post titled “A Model for Foreign Exchange Rate Determination”.

Author: Gervaise Heddle

Interest on Reserves: Bad Economic Policy, Bad Social Policy

January 12, 2016

Let’s start with a few uncomfortable facts.

If the Federal Reserve maintains the fed funds rate at its current level (0.25%) for the rest of 2016 and there are no further interest rate rises during 2016, then the Fed will donate more money to foreign and domestic banks during the course of 2016 than the US Government will spend on the entire National School Lunch Program.

If the Fed raises interest rates to 1.0%, then the Fed will give away nearly as much money to foreign and domestic banks in a year as the US Government spends on the Federal Pell Grants program. The Pell Grant program is a massive $40+ billion per year program that provides needs-based grants to over 5 million college students, or one third of the entire college student population.

If the Fed raises interest rates to 2.5% by using interest on reserves, as is current practice, and if it maintains banks reserves at roughly current levels (as the Fed has indicated it will for the time being), then the Fed’s new bank welfare program will be as large as the US Government’s entire food stamps program.

Yes, you read that right.

If the Fed raises interest rates to 2.5%, a level that is low by historical standards, then the Fed will pay out 2.75% on its $2.67 trillion in reserves, or roughly $73.5 billion per year to foreign and domestic banks.

In contrast, the Supplemental Nutrition Assistance Program (“SNAP”) that provides food assistance to roughly 46.5 million Americans, including one in every four children in the United States, cost taxpayers an almost identical $74.1 billion per year in FY 2014.

The worse aspect of all this is that, from an economic perspective, the Fed’s new bank welfare program, otherwise known as “interest on reserves”, is totally unnecessary.

While there is no question that the Fed must begin the process of reversing nearly a decade of excessively easy monetary conditions, the Fed doesn’t need to do it by handing out money to banks. Rather, the Fed should begin the process of tightening monetary policy by unwinding another implicit subsidy to corporate America, namely “quantitative easing”.

If the Fed unwinds QE, i.e. reduces the size of the monetary base by selling assets from the Fed’s bloated balance sheet, then long-term interest rates will begin to rise. If the Fed waits until this process of balance sheet reduction is largely complete, then the Fed will not need to use interest on reserves (“IOR”) and reverse repurchasing facilities (“RRP”) to raise the fed funds rate and will not have to donate billions of dollars every year to banks.

“Interest on Reserves”: A Little Background

The first point that needs to be made about the “interest on reserves” program is that the practice of paying interest on reserves is new.

Why does this matter? Well, prima facie, it raises an obvious question. If the Fed spent nearly 100 years raising interest rates without finding it necessary to pay interest on the reserves held by banks at the Fed, then why does it suddenly need to do this now?

Throughout the history of the Federal Reserve System, major banks in the United States have been required to hold a minimum amount of reserves at the Fed. In effect, this was money that the Fed forced commercial banks to put in the “penalty box” in anticipation of the mistakes that the banks would inevitably make, i.e. being too aggressive in making loans.

Historically, the Fed never paid interest on these reserves. Indeed, the Fed had no authority to pay interest on reserves until Congress passed the Financial Services Relief Act of 2006.

Did this inability to pay banks interest on their reserves at the Fed impede the ability of the FOMC to raise interest rates prior to 2006? No. For decades, the Fed was able to raise interest rates without paying interest on reserves, i.e. the Fed was able to raise the fed funds rates without directly handing money over to banks.

So, what changed? If you ask FOMC members today, they will claim that they need to pay interest on reserves in order to be able to raise the fed funds rate. But why is this the case? And does this claim by the Fed represent the whole truth or a disingenuous half-truth?

Technically, the justification used by the Fed for the introduction of interest on reserves is as follows:

“This (the introduction of interest on reserves) was important for monetary policy because the Federal Reserve’s various liquidity facilities initiated during the financial crisis caused upward pressure on excess reserves and placed downward pressure on the Federal funds rate. To counteract these pressures, on October 6, 2008, the Federal Reserve Board announced that it would begin paying interest on depositary institutions’ reserve balances.” [See “Federal Reserve Bank of San Francisco, Dr. Econ online section”]

OK, now let me translate that.

In response to the financial crisis of 2008, the Fed introduced a series of extraordinary and unorthodox policy measures, most notably quantitative easing or “QE”. In essence, quantitative easing entailed the creation of roughly $4 trillion in new money by the Fed and that money was then used by the Fed to purchase fixed income government securities.

By purchasing trillions of dollars worth of fixed income securities, the Fed forced down interest rates across the entire US government yield curve, making it very difficult to raise short-term interest rates using traditional means. Moreover, the banking system was suddenly awash with “excess liquidity”, most of which found its way into something called “excess reserves” held at the Fed. With so much money sloshing around in the “excess reserves” bucket, i.e. reserves held at the Fed that are not technically required to be held there, it made it all but impossible for the Fed to raise the fed funds rate using traditional means.

In other words, the Fed suddenly couldn’t raise the fed funds rate using conventional means because it had boxed itself into a corner. The Fed had pushed interest rates so low across all maturities that the only way it could raise the fed fund rate was by paying banks interest on the reserves that they kept at the Fed.

Now, let’s reexamine the claim that the Fed must use interest on reserves in order to raise interest rates. Is this the whole truth or a disingenuous half-truth?

Clearly, it is a half-truth. Yes, it is true to say that if the Fed maintains the current size of its balance sheet, then it can only raise the fed funds rate by using the interest on reserves facility.

But, this avoids the key issue.

Namely, why is the Fed trying to raise the fed funds rate at a time when its balance sheet is overloaded? Why doesn’t the Fed get out of this mess the same way it got into it, i.e. sell the assets it acquired through the QE program, allow the yield curve to normalize and then raise the fed funds rate using conventional methods?

It would be one thing for the Fed to pursue this erroneous policy (interest on reserves) if it had no social consequence. But it does have a social cost. In essence, it is a “Reverse Robin Hood” policy. The interest on reserves program introduced in 2008 by the Fed takes money from ordinary American taxpayers and gives it to banks. Not just domestic banks, but also foreign banks.

Is It Real Money?

There may be some people who read this article that might claim that the money the Fed gives to banks under the interest on reserves program is somehow not the same as the money that the US government spends on social welfare programs, i.e. the two aren’t comparable because one is real money being “given away” (food stamps) while the other is just some fancy handwork of ivory tower economists.

This claim is nonsense.

The fact of the matter is that the money that the Fed donates to the banks under the interest on reserves program is identical to the money that the US government uses to fund social welfare programs.

To be clear, I am not making any value judgments here. Rather, this is simply a question of accounting. Let me explain.

If you go to page 105 of the Fed’s FY 2014 annual report and look at the financial statement on that page, you will see at the bottom of that statement a line called “Earnings remittances to the Treasury”.

What are “Earnings remittances to the Treasury”? In effect, this is the profit that the Fed makes for the year. What does the Fed do with its profit? It sends it to the Treasury. [How does the Fed make a profit? It buys bonds and earns interest on those bonds, less a few staff costs.] Looking at our table, we can see that the Fed sent the Treasury $96.9 billion in FY 2014. Somewhere in the Treasury’s FY2014 accounts, you will find a matching entry recognizing the receipt of those funds from the Fed.

The key point is that any “profit” made by the Fed is sent back to taxpayers via a remittance to the Treasury.

What impact does the interest on reserves program have on this profit? Clearly, if the Fed pays interest on reserves to banks, then this is money that must be deducted from its annual profit. Consequently, the US Treasury receives less money from the Fed.

In essence, paying banks interest on the reserves they hold at the Fed has the same impact on the finances of the US government as any other hike in government spending. It is simply more money that the American taxpayer has to hand over to cover the random misadventures of policy makers.

[Note: this actually slightly understates the adverse impact of the interest on reserves program because it adds an additional cost to taxpayers: namely, short-term government debt becomes more expensive to issue as short-term interest rates rise in line with the fed funds rates].

The bottom line is that if the Fed does nothing else this year, then based on its current policy setting (0.25% interest rate and roughly $2.7 billion in reserves), the Fed will give away more than $13 billion to foreign and domestic banks. This $13 billion is real money. It is money that could be used to finance the entire annual cost of the National Schools Lunch Program (the program cost $11.6 billion in FY 2012).

[How does the math work? The key point to remember is that the interest rate the Fed pays on reserve balances is 25 basis points more than the fed funds rate, i.e. if the fed funds rate is 0.25%, then the Fed actually pays 0.5% on all bank reserves held at the Fed. Why? Good question. The answer is we don’t know. Theoretically, it allows the Fed to keep interest rates in a “range”. But frankly, 25 basis points seems unnecessary. Put it this way: if the Fed lowered the premium from 25 basis points to 5 basis points it would save taxes payers $5 billion per year!]

Perhaps more astoundingly, is how quickly the numbers get really serious if the Fed continues on its current path.

While the numbers should be treated as indicative only, the fact is that if the Fed maintains the current size of the monetary base and bank reserves remain at current levels, and if the Fed raises the fund funds rate to 2.5%, a level that is low by historical standards, then the Fed will give away roughly $70-80 billion per year. That is a lot of money by any standards. In fact, it’s enough to pay for the entire Supplement Nutrition Assistance Program, formerly known as the Food Stamp Program.

Why is the Fed Avoiding the Key Issue?

While the social justice argument against the Fed’s new interest on reserves program is strong, there is an even stronger case to be made when it becomes clear that the entire program is not only unnecessary but represents bad economic policy.

If you listen to most market commentators, then you probably believe that the key issue facing the Fed today is whether the Fed should raise interest rates, or more specifically, the feds fund rate. It isn’t.

As discussed in last week’s post, “The Interest Rate Rabbit and the Base Money Elephant”, the Fed may want the markets to believe that its actions on the fed funds rate are the key to monetary policy, but in truth these actions are a diversion from the real issue. The real issue is this: “Why isn’t the Fed reducing the size of the monetary base?”

Over the past eight years, the Fed has quintupled the size of the monetary base. This is an extraordinary action and represents a massive departure from historic practice. As discussed earlier, this action led to a decline in both short-term and long-term interest rates. Moreover, it put tremendous downward pressure on the fed funds rate to the point that traditional measures that were used to raise the funds fund rate are no longer effective.

The question that needs to be answered by the Fed is why doesn’t the Fed begin the process of tightening monetary policy by reversing out of this situation the same way got into it, i.e. by reducing the monetary base before its raises the fed funds rate?

Instead of adopting new methods to raise the fed funds rate (interest on reserves and reverse repurchasing facilities), why doesn’t the Fed simply unwind its balance sheet, allow the market for US government debt to operate freely and then begin the process of raising the fed funds rate in the traditional manner, i.e. without throwing money at the banks?

The view of The Money Enigma is that the Fed should begin the process of tightening monetary policy by dramatically reducing the size of the monetary base. Such a reduction in the monetary base would have largely the same desired impact on the economy as any hike in the fed funds rate. Moreover, there are two compelling economic reasons for why an immediate reduction of the monetary base is required.

First, the dramatic expansion in the monetary base has created a series of severe financial market distortions, or what some might call “bubbles”. By using newly created money to buy government bonds, the Fed has reduced the required rate of return on assets, thereby boosting prices of both less risky assets (bonds) and high-risk assets (stocks). While the immediate beneficiaries of this largesse might be happy today, this type of financial market distortion endangers the efficient operation of markets and the long-term economic future of our society.

The second reason is more theoretical, but far important. It is a subject that was addressed at length in a post written nearly nine months ago titled “The Case for Unwinding QE”.

In essence, the current level of the monetary base heightens the risk that, at some point in the next five years, the value of the US Dollar will collapse and the rate of inflation will surge.

At this point in time, markets believe that the dramatic expansion of the monetary base is only “temporary” in nature, i.e. the Fed will reduce the size of the monetary base eventually. However, if markets start to realize that the current level of the monetary base is more “permanent” in nature, then this could precipitate a sudden decline in the value of the dollar and a surge in prices.

Why is this the case? Well, the view of The Money Enigma is that fiat money is a proportional claim on the future output of society. In simple terms, this means that, over long periods of time, the value of a fiat currency tends to track the “real output/base money” ratio. If we are sitting here ten years from now and the monetary base is still at its current level while real output has only grown modestly, then it is very likely that the value of money will have fallen significantly.

Readers who wish to read more about this theory are encouraged to visit the “Theory of Money” section of the website and/or read a post titled “Does Too Much Money Cause Inflation?”

In summary, given these social and economic considerations, it is astounding the Fed is choosing to adopt interest on reserves as a key policy, rather than simply reversing QE and reducing the size of its balance sheet. It may be that the Fed simply wants to appear to be “doing something”. But “doing something” isn’t the same as “doing the right thing”.

The Interest Rate Rabbit and the Base Money Elephant

January 5, 2016

As we begin 2016, the key question investors should be asking themselves is whether the Fed can pull off the magic trick of the century. Can the Fed convince the markets that the elephant in the room doesn’t exist by pulling a rabbit out of the hat?

It’s a complicated magic trick. The first part of the trick involves pulling a rabbit out of the hat, i.e. raising the Fed Funds rate in an environment where the entire yield curve has been pressed against the floor. Normally, raising the Fed Funds rate, or the short-term interest rate, is a simple matter. However, this previously simple action is now a complex problem that involves new hidden mirrors such as “interest on reserves” and the “reverse repurchasing facility”.

The second part of the trick is even more complicated. In essence, the Fed is attempting to make the elephant in the room disappear, or at least disappear as an issue for investors. The elephant in the room is the bloated balance sheet of the Fed, otherwise known as the monetary base.

Over the past eight years, the Fed has quintupled the size of the monetary base through successive rounds of quantitative easing. Now, it seems that the Fed wants to keep its cake and eat it too: the Fed wants to keep its bloated monetary base, but wants investors to pretend that it doesn’t matter or forget about it entirely.

How do you distract people from the elephant in the room? Well, you make them focus on the rabbit. By being seen to be “doing something” on interest rates, the Fed hopes that markets will be distracted from the fact that they are “doing nothing” about the monetary base.

Why does the size of the monetary base matter? There are two key reasons:

The size of the monetary base determines the long-term required rate of return on capital. As the Fed increased QE, it brought down the required rate of return on capital, pushing up asset prices across the economy. If the Fed reverses QE, i.e. reduces the size of the monetary base, then this process will go into reverse.
The expected size of the monetary base determines the value of money and, consequently, plays a critical role in determining the rate of inflation. Fiat money represents a proportional claim against the future output of society. If people suddenly expect the monetary base over the next 20-30 years to be much higher than they previously anticipated then the value of money collapses and prices soar.

This week we will explore these issues by examining a little Fed history (what the Fed did and why) and dispelling a couple of misconceptions regarding the operation of monetary policy.

Monetary Policy Misconceptions

While monetary policy is a poorly understood topic at the best of times, there are two specific misconceptions regarding monetary policy that we need to address in the current environment.

The first misconception is that “the interest rate matters, but the size of the monetary base does not”. More specifically, there is a misguided view held strongly by many in the economics profession that the fed funds rate is somehow far more important to economic outcomes than the size of the monetary base.

The second misconception is one that has popped up more recently regarding the nature of the Fed’s first interest rate rise. More specifically, John Hussman recently argued that by raising interest rates by 25 basis points, the Fed has, in effect, reduced the monetary base by an enormous $1.7bn. It hasn’t. Rather, the recent interest rate decision does very little to unwind a decade of monetary excess and aggressive Fed policy.

However, in order to understand these points, we need to examine a little history and discuss some basic economic theory.

The first point to make, particularly for those not familiar with financial markets, is that while economists like to talk about “the interest rate”, in practice there exists a whole series of different interest rates on US government debt. Typically, the interest rate on a 30-year bond is higher than that on a 5-year bond, and the rate on a 5-year bond is higher than that on a 12-month or 3-month Treasury bill. This series of interest rates on government debt of different maturities is called the yield curve.

Historically, the Federal Reserve has focused its efforts on controlling short-term interest rates, i.e. it has focused on manipulating the short-end of the yield curve. The general principle was that lowering short-term interest rates would encourage banks to lend and drive economic growth, whilst raising short-term interest rates would have the opposite effect.

While this approach to monetary policy seemed to work fine for many years, over the course of 2007/2008 the Fed pushed short-term interest rates down to the lowest point they could… i.e., zero.

The problem was that this extraordinary policy response didn’t resolve the financial crisis that was occurring at that time (Lehman collapse, US housing market debacle, etc.) Therefore, the Fed needed a new way to stabilize markets and boost the economy. The answer: quantitative easing.

What is quantitative easing? Well, “quantitative easing” is a fancy way of saying “creating money and then using this newly created money to buy long-term government securities, thereby pushing down long-term interest rates”.

In essence, the Fed decided that if manipulating short-term interest rates no longer worked, then they would have to start directly manipulating long-term interest rates.

Sounds easy. So why didn’t the Fed always manipulate long-term interest rates? Well, the problem with manipulating the long-end of the government securities market is that it is a really big market. You remember those signs for the national debt clock? $20 trillion and counting? Well, it’s that market. More specifically, three-quarters of that market matures in more than one year. Manipulating a $15 trillion market takes a lot of money. As it turns out, about $4 trillion.

In order to lower long-term interest rates, the Fed had to create $4 trillion in money that never existed before and use this money to buy up some of the $20 trillion of outstanding US government debt. Buy enough long-term government debt and eventually the price of long-term debt rises and the interest rate on long-term debt falls.

If this sounds like a “big deal”, then your right… it is. What is strange is that standing here now in 2016, over seven years after QE began, many economists, including those at the Fed, seem to be preoccupied by short-term interest rates rather than long-term interest rates. Indeed, the message from the Fed seems to be “watch my left hand (the Fed Funds rate and the short end of the yield curve) but not my right hand (the monetary base and the long end of the curve)”.

Is this fair? Does the short end of the curve matter more than the long end of the curve to economic consequences? No. In fact, there is a good case to be made that the long end of the interest rate curve is more important to economic outcomes than the short end of the curve. Why? Well, to answer this question, it helps to remember why the Fed embarked on successive rounds of QE in the first place.

Long-Term Interest Rates and Asset Prices

The first round of QE, “QE1”, was primarily targeted at stabilizing financial markets. By the end of 2008, the entire US mortgage market had stopped working. By creating money and using this money to purchase mortgage-backed securities, the Fed helped this key pillar of the economy to get back on its feet.

Unfortunately, the Fed didn’t stop there. Rather, the Fed launched two more rounds of QE, “QE2” and “QE3”. Those rounds focused almost entirely on purchasing long-term government securities.

Why did the Fed do this? Arguably, the immediate financial crisis was resolved by QE1. So, why spend another $3 trillion in these subsequent rounds? The answer was to boost the economy. But how? What was the transmission mechanism from lowering long-term interest rates to higher economic growth? In a word: speculation.

By lowering the long-term risk-free rate, i.e. the long-term interest rate on US government securities, the Fed effectively lowered the long-term required rate of return across all asset classes, including the riskiest asset classes such as equities and venture capital.

Long-term interest rates matter far more to the price of most of assets than short-term interest rates. Why? Well, most assets are long-duration assets: equities, property and a substantial portion of fixed income securities are long duration assets. The value of these assets depends primarily upon discounted cash flows that will be received in the distant future. What is the rate used to discount these long-term cash flows? The long-term required rate of return on risk capital. What is a key factor in determining the long-term required rate of return on risk capital? The long-term, risk-free rate, i.e. the long-term interest rate on US government debt.

So, what happened when the Fed embarked on QE2 and QE3? Global asset prices soared. Why? Because, in effect, the Fed had artificially lowered the long-term required rate of return on risk assets.

The expansion of the Fed’s balance sheet and the associated manipulation of long-term interest rates has had a very significant impact on asset prices and, consequently, the real economy over the past seven years. By lowering the long-term interest rate and the required return on risk capital, the Fed has encouraged new business formation (shale oil and fintech bubbles) and the creation of jobs.

The problem the Fed faces today is that what works on the way up also works on the way down.

If the Fed begins to reverse QE and reduce the size of the monetary base, then it will have to sell government securities off its balance sheet, thereby forcing down the price of those securities and forcing up the long-term interest rate on government debt and, consequently, the required return on all risk assets. The result: a collapse in asset prices.

All of this raises an obvious question: why reduce the monetary base at all? If expanding the monetary base boosts asset prices and economic activity, then why should the Fed “normalize” the size of the monetary base?

Money isn’t Free… Even for the Fed

The view of The Money Enigma is that the role of the monetary base in the determination of the price level is one of the most poorly understood issues in economics.

At a general level, the relationship between money and prices has been explored in several posts, most notably “Does Too Much Money Create Inflation?” and “A New Perspective on the Quantity Theory of Money”. However, those that are interested in a specific argument for why the Fed must normalize the monetary base should read an article written six months ago, “The Case for Unwinding QE”.

We won’t go into all of the details of the arguments contained in those articles today, but at a simple level, the view of The Money Enigma is that expectations regarding the long-term future path of the monetary base are critical in the determination of (a) the value of money, and (b) prices as expressed in money terms.

More specifically, a permanent expansion of the monetary base carries with it a definitive cost: a devaluation of money and a rise in all prices as expressed in money terms.

Note that I emphasize the word “permanent” in the above sentence. By now, everyone knows that a central bank can dramatically expand the monetary base without causing a sudden increase in prices in the short run. However, this is also balanced by the strongest empirical observation in economics, namely that, in the long run, growth in the monetary base that is in excess of the growth in real output will lead to a commensurate rise in prices.

So, why does monetary base expansion cause inflation on some occasions but not on others? In essence, the issue boils down to one of expectations. If the market expects the monetary base expansion to be temporary, then this should have very little impact on the value of money. Conversely, if the market expects a monetary base expansion to be permanent, then this leads to an immediate fall in the value of money.

Currently, the market expects the recent expansion of the Fed’s balance sheet to be “temporary” in nature. However, if the Fed doesn’t begin to reverse QE in the near future, then expectations could change. More specifically, the market may begin to recognize that the recent expansion of the Fed is more permanent in nature. Such a shift in expectations would lead to a significant fall in the value of money and a rise in prices across the economy.

Why do long-term expectations regarding the monetary base matter to the value of money? Well, in simple terms, fiat money is only as good as the society that issues it. If a society must rely on expansion of the monetary base to support itself, then that society and its currency are in trouble.

In more technical terms, the view of The Money Enigma fiat money is the “equity of society” in that it represents a proportional claim on the future output of society, just as a share of common stock represents a proportional claim on the future cash flows of a company.

Rising expectations regarding long-term real output growth boost the value of each claim (the value of money rises and prices fall). Conversely, rising expectations regarding the number of claims to future output, i.e. the future size of the monetary base, reduces the value of each claim (the value of money falls and price rise).

The other way to think about it is this.

What is the difference between “QE” and “monetizing the deficit”? The short answer is “expectations”. If the Fed’s intention is to buy government debt and keep it, then it is “monetizing the deficit”. In contrast, if the Fed’s intention is to buy some debt and then sell it at a later date, then it is not.

The problem is that it is a fine line. You can’t buy government debt and never sell it and call it a “temporary” market intervention. If the Fed doesn’t unwind QE, then it is has monetized the deficit. There is simply no other way to look at it. Problematically, monetizing the deficit always ends with the same result: a collapse in the value of money and a surge in the rate of inflation.

In summary, while the Fed may be successfully using the interest rate rabbit to distract the markets from the base money elephant for now, this situation won’t last forever. If the markets suddenly realize that the Fed isn’t serious about “normalizing” monetary policy, i.e. reducing the size of the monetary base, then it will take a lot more than a rise in short-term interest rates to prevent a collapse in the dollar and an outbreak of high inflation.

“25 Basis Points” does not equal “$1.7bn Monetary Base Reduction”

There has been a story doing the rounds of social media lately that states that the recent rate rise by the Fed is the equivalent of a massive reduction in the monetary base. This isn’t right and I want to explain why.

I believe that the story originated with John Hussman, economist and fund manager. I have read Hussman’s work for years and I greatly admire his work. In a recent post, “Reversing the Speculative Effect of QE Overnight”, Hussman repeats his view that “the immediate first step of the Federal Reserve in normalizing monetary policy should have been to reduce the size of its balance sheet”. I completely agree with this view.

However, Hussman further argues in regards to the Fed’s recent 25bp interest rate rise that “from the standpoint of investors, the overall effect is just as if the Fed had suddenly removed every dollar of quantitative easing since 2009 ($1.7 trillion).

Hussman bases his view on the principle that supply and demand for money determines “the interest rate” which Hussman defines as the 3-month Treasury bill yield. Therefore, if the Fed raises this rate by 25bp, then, according to his chart, it is the equivalent of the Fed reducing the monetary base by $1.7 trillion.

As regular readers would know, the view of The Money Enigma is that supply and demand for money does not determine the interest rate. Rather, supply and demand for the monetary base determines the market value of money. [See “Supply and Demand for Money: Where Keynes Went Wrong”]

So what determines “the interest rate”? Supply and demand for each government security determines the interest rate on that particular government security. More specifically, supply and demand for 3-month bills determines the rate on 3-month securities and supply and demand for 10-year notes determines the rate of 10-year notes, etc.

The Fed uses the money it creates (the monetary base) to intervene in those markets. As discussed earlier, the Fed intervened in the short end of the market and drove short-term rates to zero. Then, when that wasn’t effective, it intervened in the long-end of the curve, an act that required a massive expansion of its balance sheet.

Hussman’s analysis lumps these two very distinct markets into one (the short-end of the curve and the long-end of the curve). It must be remembered that the Fed didn’t spend $1.7 trillion to push down the 3-month bill rate. It spent that money to push down the interest rate on 5-year, 10-year and 30-year debt.

Today, the Fed wants to raises short-term interest rates. In doing this, it has two choices. Either (a) reduce the size of the monetary base and let the entire yield curve rise, or (b) artificially manipulate short-term rates using interest on reserves and the reverse repurchase facility.

The Fed has chosen option (b). The view of The Money Enigma is that the Fed has chosen option (b) primarily to avoid the risk that Hussman raises: the Fed doesn’t want to raise the long-term cost of capital and thereby reverse the speculative effect of QE.

While I agree with Hussman that global equity markets are overvalued in a historical context, the primary driver of this overvaluation is Fed suppression of the long-term required return on capital. At some point, the Fed will have to blink and allow the long-term required return on capital to rise: that will be a bad day for stocks.

In summary, the Fed finds itself between a rock and a hard place. If the Fed reduces the size of the monetary base, global asset prices will fall markedly. However, if the Fed does not reduce the monetary base, then at some point expectations regarding the “temporary” nature of QE will shift, the value of money will fall and inflation will accelerate.

Using complicated mechanisms such as IOR and RRP to raise short-term interest rates might distract the markets and the mainstream media for a few months, but it won’t solve the big issue: what to do with the elephant in room.

Author: Gervaise Heddle

Most Popular Articles of 2015

December 22, 2015

As 2015 draws to a close, I wanted to thank all the readers who have supported The Money Enigma in its first year and highlight some of the articles that readers found most interesting in 2015.

#10: The Value of Money: Is Economics Missing a Variable?

Just slipping into the Top 10 list is an article regarding the “value of money”. If money has value and if the value of money is an important factor in the determination of prices in money terms, then why doesn’t economics officially recognize the value of money as a variable in its equations?

#9: Monetary Base Expansion: The Seven Stages of Addiction

Is printing money our great modern addiction? In this article it is argued that there are striking parallels between the methamphetamine addiction cycle and the economic/market cycle that occurs following a dramatic expansion of the monetary base.

#8: What Determines the Price of Gold?

Does 2015 represent the low point for the gold price? While there are many theories regarding the price of gold, the view of The Money Enigma is that there is one key driver of major bull and bear markets in gold: long-term economic confidence. Bull markets in gold tend to begin when people are too optimistic about the long-term economic future of society.

#7: The Case for Unwinding QE

While the near-term costs of reducing the monetary base may seem to outweigh the benefits, there is a terrible risk associated with the path of inaction.

#6: What Factors Influence the Value of Fiat Money?

What determines the value of money? Why does the value of money fluctuate and tend to fall over long periods of time? And why does the value of a fiat currency sometimes fall precipitously? The view of The Money Enigma is that fiat money represents a proportional claim on the future output of society. Over long periods of time, an increase in the monetary base relative to real output will reduce the value of the proportional claim and lead to rising prices across the economy. Over short periods of time, it’s all about changes in expectations…

#5: Does “Too Much Money” Cause Inflation?

Does printing money cause inflation? And if it does, why didn’t QE trigger inflation? This popular article tackles these complex issues and argues that it is not “too much money” per se that causes inflation, but the expectation of “too much money” relative to future output that matters.

#4: Why Does Money Exist? Why Does Money Have Value?

One reader commented that this post “should be studied line by line”. Frankly, I couldn’t agree more.

#3: Government Debt and Inflation

Government debt has a critical role to play in the determination of the price level. More specifically, the market’s assessment of the sustainability of government debt and deficits has a direct impact on the value of the fiat money issued by that society and, consequently, the rate of inflation.

#2: The Risk of Hyperinflation in the United States

This very popular article asks a simple question: “Is there a risk of hyperinflation in the United States?” Ultimately, fiat money is only as good as the society that issues it…

#1: A New Economic Theory of Price Determination

The most popular article of 2015 challenges the fundamentals upon which modern economics is built. The most important article of the year and a must read for those that care about the science of economics…

Gold and Interest Rates: Interview with Malcolm Palle

Earlier this week, I spoke to Malcolm Palle at www.miningmaven.co.uk about the outlook for gold in a rising interest rate environment.

As discussed in one of my recent posts, “Can the Gold Price Rise as the Fed Raises Interest Rates”, I believe that the first rate rise by the Fed could mark the low point for the gold price and the beginning of a new bull market in gold.

Malcolm and I discuss the rationale for this view in the Mining Maven interview which you can listen to below.

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