Wednesday, January 1, 2014

My Predictions For 2014

I will review the accuracy of my predictions for 2013, and make new predictions for 2014. 

My 2013 Predictions
Here are my predictions from a year ago*, and what actually happened:
1.Dow up by 2000 points from 13000 to 15000. Actual: up 3600 points to16600.
2. Monetary base to grow by $1 trillion. Actual: up $1 trillion. (I don’t distinguish between the monetary base and the Fed’s overall balance sheet; they’re about equal.)
3. Nominal growth above 5% by yearend. Actual: 6% nominal growth in the third quarter (which I expect to be lower in the fourth quarter).
4. Lower bond prices. Actual: bond prices fell by 15%.

Overall I did well. I got the directions right, and my predictions were pretty good. I placed my faith in QE3, and my faith was rewarded, at least on the surface. But my predicted chain of causality proved to be seriously flawed. I based my scenario on an acceleration in money growth, which didn’t happen. Money growth slowed in 2013, despite $1 trillion in additional QE. Had I known that money growth would decline, my predictions would have been very different.  

So, as it turned out, my predictions were right but for the wrong reasons. How can we explain such positive macro outcomes despite a decline in money growth? 

I have emphasized the role of credit growth in facilitating money growth. Credit growth did pick up last year (bullish), but had no apparent impact on money growth! So that explanation doesn’t work.

There is no doubt about the decline in money growth: it is reflected in all of the aggregates, both official and unofficial. There is no mistake. And an increase in velocity is not the answer, because velocity continued to decline.

Here is a stab at an explanation for what happened in 2013:
1. The Dow rose, not because of an acceleration in growth, but rather due to a decline in fear: the risk premium fell. There were no major black swans in 2013, and confidence is returning.
2. Nominal growth remains low despite the third quarter data, as I have explained in earlier posts.
3. Bond prices fell because the market has been spooked by false signals, namely the taper and the 3Q growth blip. 

Given the above hypotheses, we need to ask how much the equity risk premium can decline further. If the only thing holding stock prices up is confidence, what’s the outlook for confidence? I think it’s reasonably good. All of the financial stress indices remain low. Bank stocks are way up, which is a clear sign of confidence. So now to 2014.

My Predictions for 2014 (YoY):
My macro outlook has two scenarios: (1) Janet Yellen succeeds where Ben Bernanke failed; or (2) Yellen also fails. It all hinges on Yellen’s ability to create a consensus on the FOMC that the Fed must do more to meet its mandates. This is a political question, not an economic one. It is about group psychology, and leadership. 

Yellen and Bernanke are very close ideologically, but different in personality. Bernanke is a low-key academic who placed a high priority on consensus and institutional credibility. He wanted to cure the recession while preserving the authority of the institution. The price of this decision has been subpar growth and high unemployment. Bernanke was not going to go to war with the hawks, and allowed them to stymie his efforts.

Yellen, by contrast, is an outspoken dove who might be more willing to jeopardize consensus to achieve a more muscular policy. In other words, she might sacrifice institutional credibility in order to achieve the Fed’s statutory mandates. (Only in central banking can you weaken your credibility by achieving your goals.)

I am going to put my chips on scenario #1, in which Yellen succeeds in pushing the committee in a more dovish and unconventional direction. I’m not talking about the pace of the taper which is only symbolic. I am talking about moving the needle on money growth and inflation by doing something more radical. By more radical I mean things like reducing interest on reserves, new asset purchase categories, or price-level targeting. All the kind of things that Bernanke used to advocate before he became chairman.

Based on this "Yellen Succeeds" scenario, here are my predictions for the key indices one year from now:

1. Fed policy:
Last year the Fed’s balance sheet grew by $1 trillion under “full” QE3. This year I would expect a slow taper, given prior guidance. The Fed’s balance sheet should grow by another $500 billion to $4.5 trillion.

2. Money growth:
Yellen can’t be happy with 5.5% money growth and 1% inflation. I expect her to find ways to accelerate M2 growth to a range in the vicinity of 7-8%.

3. Nominal growth:
If Yellen can get M2 growth up to 7-8%, nominal growth should rise from the current 3.4% to a more comfortable 5%, which would be a major achievement. The Holy Grail would be 6% nominal growth.

4. Real growth:
Real growth on a year-on-year basis is now running at 2%, about half of what it should be. By this time next year, I would look for 3.0-3.5% real growth; better than now but still inadequate.

5. Inflation:
I expect that Yellen will be able to achieve the 2% target by year-end.

6. Bond market: The 10-year is now at 3%. Assuming Yellen can move the needle on money growth and inflation, the year-end yield should be between 3.5 and 4%, but not soon. Bearish for bonds.

7. Stock market:
If the foregoing growth and inflation scenario proves correct, the Dow will be supported by continued earnings growth, offset by higher bond yields. I predict that the Dow will close the year somewhat above where it is now: around 18,000. If there is risk, it is on the upside. Cash and bonds remain unattractive.

Just as was the case last year, everything hinges on the Fed's policy effectiveness. I am giving Yellen the benefit of the doubt, on the idea that the committee will grant her some initial deference as the new chairman. The $64 question is how hard she is prepared to pound the table.
*“2013: The Year Of Printing Money”, Dec. 16, 2012

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