The Post-Crash Deleveraging Process Is Over

Investment Thesis: The post-crash unresponsiveness of the economy to monetary and fiscal stimulus has been due to the deleveraging phase of the credit cycle. However, the data suggests that the post-crash deleveraging process is nearing completion. Going forward, this should make conventional monetary policies more effective, and lay the groundwork for an eventual pickup in nominal growth. This will provide the basis for higher corporate earnings and higher inflation. Stocks should benefit, while bond yields will rise.

Economists, such as Larry Summers, have been seeking an explanation for the weak recovery. The need for an explanation is pressing, since the economy has been surprisingly unresponsive to conventional monetary and fiscal stimulus.

Here is Summers on the subject: “We are now 10%  below where we thought the economy would be now in 2007. There's been close to no progress in regaining potential measured relative to the judgments made at the time in 2007.”

Many explanations have been offered to explain the weak recovery, of both a structural and cyclical nature. Economists generally rule out structural factors because they are unmeasurable: if a factor cannot be measured, then it can’t explain anything. “Obama’s anti-business policies” and “Republican obstructionism” are both unmeasurable, and thus useless as explanations.

The weakness of aggregate demand (AD) is generally considered a cyclical phenomenon, not a structural one, and AD should be responsive to macro policy. Keynesians say that the weakness of AD is a consequence of  inadequate fiscal stimulus, while monetarists point to inadequate monetary stimulus. Paul Krugman, on a lucid day, mentions both. But the economy has had massive inputs of both fiscal and monetary stimulus, and yet has remained far below potential for the past five years. The Keynesians need to explain why massive deficits didn’t do what they said they would, and the monetarists need to explain why massive bond purchases didn’t work either.

I have argued that, despite QE1, QE2 and QE3,  monetary stimulus has not been “massive”, as evidenced by sluggish M2 growth since the crash, which provides support for to the monetarist viewpoint. But I contend that the sluggishness of money growth is a symptom of a deeper phenomenon which explains the failure of the Fed’s efforts.

That deeper phenomenon is the credit cycle. Credit cycle theory was first proposed by Irving Fisher in 1933 and elaborated by Hyman Minsky in the 1970s. Modern proponents include Richard Koo of Nomura, and Steve Keen of the University of Western Sydney. According to credit cycle theory, inflection points in the credit cycle (i.e., Minsky Moments) force economic actors (including banks) to deleverage, and as long as the deleveraging process continues, the credit aggregates shrink and money growth is retarded. The bigger the debt overshoot, the longer the required repair period.

The US credit cycle experienced a Minsky Moment in the 2008-9 crash. Before the Minsky Moment, high financial leverage (especially in households, housing finance, banking and the securities industry) was acceptable. After the Moment, high leverage became diabolic as did all associated debt structures and obligors. The credit market shut down, forcing indebted actors to rapidly deleverage. 

The credit market had a major shock when Lehman defaulted, and has suffered from PTSD ever since. The deleveraging process took three years, from the end of 2007 to the end of 2010. Total credit did not begin to grow again until late 2010, and a number of sectors took much longer to complete the debt reduction process. Only now has the process finally ended, although the PTSD remains.

The debt market’s standards for acceptable leverage changed overnight after Lehman, instantly rendering uncreditworthy huge swaths of the economy including households, securities firms, finance companies, and banks. In order to regain market access, these actors had to unwind their pre-Crash debt accumulation in order to conform to new leverage standards, which has taken them a long time to accomplish. It took 15 years for the cycle to build up to the Minsky Moment, and it has taken five years to dig out from it. The credit cycle is at its root an artifact of psychology, and the recovery from a major shock does not happen quickly.

Market monetarists such as Scott Sumner discount credit cycle theory, on the argument that it is a derivative of monetary policy and can be overcome by competent monetary policy. I agree (I have to, since I believe the quantity theory), but I would argue that the credit cycle explains why the Fed’s “massive” stimulus policies have failed: the down-leg of the credit cycle creates huge headwinds for conventional policy. Only truly radical policies (e.g., helicopters) can combat the credit cycle, and they haven’t been tried.

How can we measure the credit cycle? The Fed’s “Flow of Funds” report provides data on credit stocks and flows for:

• Households
• Nonfinancial businesses
• Financial businesses
• State & local governments
• The federal government

Here’s a quick summary of  the 21st century credit cycle (all numbers are sectoral  liabilities):

Household Credit: $13T

Rapid (12%) growth before the crash, negative growth during the crash, now very low growth at 1%. No recovery yet: banks are not making mortgages.

Nonfinancial Business Credit: $9T

Rapid (13%) growth before the crash, mild contraction during the crash, now fully recovered to almost 10% growth. Business credit has had the strongest recovery. (The business credit cycle inflected in 2001.)

Financial Business Credit: $14T

Rapid growth (12%) before the crash, severe contraction during the crash (-13%), now flat at 0%. No recovery yet; the bleeding has just stopped. The PTSD remains strong, and regulation hasn’t helped.

State & Local Credit: $3T

Modest (6%) growth precrash, low growth during crash, negative growth since the crash. No prospects for recovery.

Federal Government Credit: $12T

Moderate growth precrash (5-10%), extremely rapid growth during the crash (35%), and now moderate growth again at 6%. Despite running big deficits during the crash, federal borrowing was insufficient to fully offset credit contraction by the private sector. (This supports the Keynesian argument that fiscal stimulus was too small.) The outlook for federal credit growth is not good; the declining deficit means that the pace of government borrowing will decline further, which will dampen overall credit growth.

Total Credit: $58T

This is the single most important data series in explaining the credit cycle. Total credit was growing at 10% before the crash, contracted modestly during the crash (despite big federal deficits), and has since “recovered” to an anemic 3% growth rate. Three percent growth is nowhere near full recovery; 8% growth would signal full recovery. The credit market is still a bit traumatized.

A crucial credit sector with respect to economic behavior is the financial sector, which is a provider of both credit and money, since money is a liability of the financial sector. The cyclical volatility of financial credit has been pronounced. Financial credit grew at an unsustainable 13% before the crash, contracted very severely, and has not yet recovered (zero growth). Total financial credit remains 18% below its 2008 peak. This explains a large part of what has happened since the crash. Hospitalized banks don’t lend freely.

The current 3% total credit growth and 0% financial credit growth explain the inability of conventional monetary policy to stimulate money growth, inflation and NGDP growth.  The Fed has the ability to control the money supply, inflation and nominal growth, no less than do the central banks of Venezuela, India, Egypt, Iran and Argentina (which have all succeeded in creating inflation). 

The failure of the Fed to get control of the money supply is explained by the headwinds resulting from the credit cycle, particularly the financial sector, as well as its unwillingness to adopt sufficiently radical policies despite lip-service to the contrary. The Fed has missed its statutory employment and inflation targets for the past five years. The Fed allowed the credit cycle to overwhelm its stimulus efforts (as it did in 1930-33).

The crash had nothing to do with the corporate sector, which had already suffered its own inflection in 2001. Business credit growth rebounded quickly, which has been a major bright spot for the economy. The business sector today is very healthy, despite low nominal growth.

Money growth depends in part on the demand for credit, and the cyclical decline in credit demand has resulted in the buildup of excess reserves at the Fed (instead of bank loans). The reasons are: (1) a lack of credit demand because borrowers are repairing their balance sheets; (2) a lack of credit supply because credit providers are repairing their own balance sheets, and (3) credit providers have have raised their lending standards. 

Credit has not been flowing to the economy at a pace anywhere near the pre-crash rate. In fact, it’s even worse than that: credit growth today is lower today than at any point between WW2 and the Crash. Currently growing at 3%, it had never before dipped below 4% even during the worst postwar recessions. This is a huge drag on both AD and money growth.

(Yes, credit growth data is nominal, but I think that nominal data is more explanatory today than real data. Low nominal growth is the problem in the current circumstance, and it should not be disguised by the use of adjusted data.)

As I said above, the Fed has full control over the money supply, inflation and nominal growth, if it chooses to exercise it. The Fed has the power to overcome the credit cycle, as as did the Bank of England in 1931, FDR in 1933, and the Bank of Japan most recently. But, by refusing to adopt radical expansionary policies, the Fed has allowed the credit cycle to negate its efforts. Ultimately, the fault lies with the Fed, and Bernanke knows it.

The Outlook for the Credit Cycle

There’s good news and bad news in the outlook for credit growth. The dominant sectors are households (mortgages) and the federal government (deficits). Each sector has about $13T of debt outstanding. The good news is that households have stopped deleveraging and have (almost) begun to borrow again. Over time, household debt should grow as lending standards are relaxed, but that will take more time.

The bad news is that the pace of federal borrowing has declined sharply and will decline further given the current budget outlook. Taxes have been raised and the Budget Control Act remains largely in place. The period of federal pump-priming is over, and the private sector is now on its own. (This annoys Krugman and worries Summers.)

As I observed earlier, the all-important financial sector has stopped shrinking, and may be poised to start to grow, although there are many forces at play. The financial sector remains badly shell-shocked, and the revival of animal spirits will take time.

There is a better-than-even chance that private sector credit growth will more than compensate for the withdrawal of big deficits, and there is very little chance that credit growth will turn negative, since all of the confidence indicators are positive. Going forward, the Fed will no longer have to contend with fighting a credit contraction, and may get some wind at its back.

Summers has expressed the concern that the US economy is only able to grow during credit bubbles. I would restate that as: the US economy is only able to grow during periods of credit growth--and this is only true in the absence of competent monetary policy. The credit cycle can be fought.

The post-crash deleveraging process has ended, and credit has started to grow again. Much will depend upon the re-opening of the mortgage market and the pace of fiscal contraction. Nonetheless, the economy is now in a position to better respond to conventional monetary policy tools, which should give the Fed a greater ability to stimulate money growth. It is now up to the FOMC to do its job.

Investment Conclusion: Stronger nominal growth will increase earnings and support higher equity valuations, while exerting downward pressure on bond prices. The up-leg of the credit cycle will accelerate, and could last quite a few years: the last one lasted 15 years. This is good news for both investment and employment.

December Jobs Report: What Recovery?

Investment thesis: The markets will continue to reflect economic stagnation until the Fed takes effective steps to meet its mandates. Bond prices should be supported, while earnings growth will moderate further. However, strong corporate buybacks support current equity valuations.

Readers may recall that last month the third quarter real growth number was raised to 4.1%, which is quite high. Market economists and pundits believed this number, and said that it signaled an accelerating recovery.  You may also recall that I said at the time that the revised third quarter number was a meaningless blip, and that the outlook for growth and employment remained bleak.

Well, the December employment data support my negative view (not that one month of data is in any way conclusive). Nonfarm payrolls rose by only 74,000 in December, the smallest increase in three years and far short of the growth that economists had predicted: the median forecast of 90 economists called for an increase of 197,000. The labor force participation rate fell to 62.8%, its lowest level since the Carter administration. The broader U-6 unemployment rate remained unchanged at 13.1%, about double what it should be at this stage of a recovery, and much higher than the peak level of prior recessions. We are looking at a weak, stagnant economy.

The lead steers in the market and the media just don’t spend enough time looking at the data. They seem to be overly headline-sensitive, and to lack a coherent model of the economy. Once the lemmings pick up the mantra of a “stronger recovery”, they won’t let the data stand in their way:

"If there ever there was a curveball, this was it," said Marcus Bullus, trading director at MB Capital in London. "These limp numbers are as puzzling as they are surprising."
Not to readers of this blog.

The pundits recommend that we ignore the December data, either because it was cold in December*, or because, as CNBC says: “Anyone reading the Labor Department report can see that the focus is on the trend, and according to the Labor Department and other general economic observations, the trend is still favorable”. Convinced? 

I hope it didn’t come as too big of a shock to the economists at DoL that it was cold in December. Are they aware that it could be cold in January and February too? They can improve their forecasts by consulting the Farmer’s Almanac.

It has been said that the best prediction of a future datapoint is that number today, and that you need a coherent rationale to predict otherwise: the future will resemble the past, ceteris paribus. When I look at the macro dashboard, what I see is stagnation at a low level, with a flat or downward trendline. Money growth is declining, as is velocity; inflation is declining; nominal and real growth are flat at low levels; the overall employment picture is recessionary; fiscal policy is contracting.

I scratch my head when I read that “the trend is still favorable”.  To what data are they referring? My data just aren’t going that way.

What does this mean for the new Fed chairman, Ms. Yellen? It means that the burden will fall heavily on her to spur the Fed to adopt more effective policies. I can’t imagine that her to-do list says “Continue current ineffective policies in order to miss both statutory mandates and further erode the Fed's credibility".

It may be a bit impolite to unearth a “discredited” and “outdated” economic theory, but the old Phillips Curve still explains a lot of the current economic phenomena: there is a trade-off between inflation and unemployment. The Fed has elected to choose “low inflation and high unemployment”. The unemployed are standing guard to ensure that we don’t experience 2% hyperinflation. The Fed needs to select “higher inflation and lower unemployment”, just as it was forced to do in 1933 and 2008-09.

Investment Conclusion

My 2014 forecasts** assumed that the newly-energized Yellen Fed would meet its mandates this year. But nothing has been done on that score yet; it’s a prediction not an observation. For now, the outlook is for continued stagnation and stable bond and stock prices (until Yellen can change policy). 

If you don’t buy my “Yellen wins” scenario, then you should expect falling bond yields and some negative earnings surprises. With NGDP growing at around 3%, the outlook for topline growth is modest, and post-recession productivity gains are almost exhausted. Supporting stock prices is strong free cashflow funding continued buybacks--instead of wealth-destroying M&A. Animal spirits in the boardroom are always bad for stockholders--even in Omaha.

That is why I am still moderately bullish.

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*”The Labor Department data included signs that the hiring slowdown was at least partly due to colder-than-usual weather last month, a factor that suggests the December reading isn't necessarily the beginning of new downward trend.” (WSJ)

**  “My 2014 Predictions: Still Bullish”, Seeking Alpha, 3 Jan. 2014.

It's Time For The Fed To End QE

Remarks by Bill Dudley of the NY Fed and the most recent Fed minutes reveal what I have been saying for almost a year: No one has any idea what the purpose of QE really is or how it works.

Here is what Dudley said:

“We don’t understand fully how large-scale asset-purchase programs work to ease financial market conditions—is it the effect of the purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?”

Here is what last month’s FOMC minutes say about QE:

“Most participants viewed the program as continuing to support accommodative financial conditions, with a number of them pointing to the importance of purchases in serving to enhance the credibility of the Committee's forward guidance about the target federal funds rate.”

Is that clear? The Fed doesn’t know why it is buying bonds, but figures that QE signals an accommodative “stance” and enhances the “credibility of its forward guidance”. No one mentions the fact that the Fed’s credibility has been badly wounded by the failure to achieve either of its mandates over the past few years.

Did the committee have a thought-provoking discussion concerning the steady decline in money growth over the past two years, and what to do about it? No, it was not discussed. It was noted without remark that "M2 contracted in November." But this rather inconvenient fact did not dampen the committee’s self-congratulation, noting that “The projected improvement in economic activity was expected to be supported by highly accommodative monetary policy.” Negative money growth is highly accommodative, if you turn the chart upside down, or stand on your head.

So we have a situation in which money growth is low, unemployment remains high, inflation is far below target, and QE is being withdrawn--although no one is quite sure what QE does.

The Fed should cease this farce and end QE now, immediately. Since QE has no measurable effect on anything, and no logical rationale, let’s get it out of the way. It is an excuse that allows the committee to advertise that it is providing a “highly accommodative monetary policy” while doing nothing of the kind. It's a place-holder for real policy.

I would recommend that the Fed unearth the old Bernanke textbook, and implement price-level targeting (PLT), such that the more the Fed undershoots on the inflation rate, the more it will need to correct. The committee should target the price level that would have been achieved had the Fed been fulfilling its 2% target. Yes, nominal output targeting would be even better, but price-level targeting is radical enough: sufficient unto the day is the unconventional policy thereof.

If the Fed were to implement PLT, it would have quite a bit of catching up to do, requiring a few years of above-target inflation. The announcement of PLT would raise inflation expectations, lower the real funds rate, and stimulate demand. The measure of success would be widening TIPS spreads and rising bond yields (which should be at least 4% at this stage of the recovery).

All of this is old hat for the committee. Inflation and/or price-level targeting has been on the table for at least 15 years. As Bernanke told the Japanese in 1999:

“A target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the price-level gap created by eight years of zero or negative inflation.”

It may be that Bernanke was wrong, and that there is some fatal flaw in a PLT policy. Fine--let the FOMC debate it. It’s frustrating that the Fed minutes read like those of the Titanic’s health and safety committee: much discussion of the irrelevant, and no discussion of what matters. What matters right now is inflation.

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.

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*“2013: The Year Of Printing Money”, Dec. 16, 2012

Third Quarter Growth: Please Ignore The Blip

Investment Thesis: Bonds are oversold, and stocks remain attractive.

Bond prices are falling while stock prices are rising. This reflects the market’s bullish interpretation of the 4.1% annualized third quarter growth revision. The market has taken that single data point and extrapolated it into a faster recovery. Faster recovery would mean higher corporate earnings growth, and higher inflation. Hence, stocks up, bonds down.

The market is wrong on both counts. The third quarter growth number was a blip in a long series of blips in both directions. The signal to noise ratio is low and anomalous. Most other signals point in the opposite direction: low money growth, declining money velocity, low nominal and real growth, low inflation.

Money supply growth has been falling for the past two years (from 10.5% to 5.5%, YoY), while velocity has continued its long downward march. Inflation remains dangerously low and nominal growth is stalled at a scarey 3.4%. Metals are capitulating, not an inflation signal. There is nothing on the dashboard to signal faster growth, besides the revised 3Q number.

Quarter-on-quarter growth has been very volatile, and continually reverses direction. It means nothing unless sustained, which I don’t expect. While it’s hard to get excited about 3% bond yields, there is nothing to suggest that yields will go higher; they are more likely to decline once the bleak reality asserts itself.

The stock market would seem to lack a compelling inner logic. It is forecasting both low inflation and strong earnings growth, which is an unlikely combination. I am expecting low inflation and modest earnings growth. The topline will remain under pressure from low nominal growth, while the productivity gains from the recovery are diminishing in scale.

My bull call on the Dow is not driven by earnings growth, but rather by the fact that one is still being paid more to own stocks--even at these prices--than to own cash or bonds. The forward earnings yield on the S&P is now 6.1%, which is twice the yield on the ten-year. Hence I see the S&P as still being fairly priced; not a screaming buy as in 2009, but still your safest bet.

I expect negative earnings surprises going forward, for the reasons given above. So, for example, if S&P earnings were to have a flat or negative quarter, prices would decline. That is the risk at this price-level. But I see nothing that would cause a sell-off, and there is still upside.

Ignore 3Q Noise: Growth Outlook Still Bleak

Executive Summary

The growth outlook remains bleak, despite the third-quarter revision. However, stocks are still attractive.

I have been bearish on the growth outlook for quite awhile. On Friday, third quarter growth was revised upward to 4.1%, which is billed as “the strongest advance in nearly two years”.  Supposedly this is a signal for strong growth going forward.

My reaction? That’s nice, but I’m still bearish on the growth outlook. The revised growth number is the annualized rate of growth in the third quarter, i.e., the growth rate between June and September. Annualized quarter-to-quarter growth is highly volatile and often reverses direction. I don’t think it can tell us very much.

I look at the year-on-year growth numbers which give us the growth rate over twelve months, and provide a better sense of the economy’s longer-term trajectory. That data tells a very different story. On a year-on-year basis, third quarter real growth was 2% and nominal growth was 3.4%. I’ve been saying that you can’t have 4% real growth with 3-4% nominal growth, and I still say it: the economy needs 6-7% nominal growth, which requires 3-4% inflation, which isn’t happening under this Fed.

Five years after the Crash,  the economy remains in “low”: low money growth, low inflation, low nominal growth, low real growth, low employment growth. I would observe that YoY growth in M2 has recently fallen below 6%, its lowest rate of growth since mid-2011, and that PCE inflation is now 0.7%, its lowest level since the Crash (and 35% of the target rate). Employment growth has been stuck below 2% for the past two years. There are few bullish signals buried in the data. The one ray of sunshine is household deleveraging, which has finally ended. The Minsky cycle may be turning.

Investment conclusion

Stocks remain in value territory relative to bonds, but underlying earnings growth will slow, given 3% nominal growth. Negative earnings surprises are likely to begin to exceed positive surprises. Nonetheless, it would be prudent to remain highly exposed to US equities. The outlook for metals is bleak. The value of a hedge declines as the probability of the adverse event declines. The risk of an inflation surprise is low.

The Taper: Monetary Nonfeasance

The Fed’s long-awaited taper has finally begun.

Having added $1 trillion to its assets in 2013, and having failed to achieve either of its statutory mandates, the Fed has decided to reduce purchases while predicting eventual victory: “The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate.” Not tomorrow, but someday.

And what about deflation risk, Bernanke’s  personal bete noir?  “The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.”  “Monitoring” will prevent deflation; that’s a new policy tool. Bernanke said today that “inflation can’t be picked up and moved where you want it.” This from the man who said that a central bank could always create inflation using the printing press.

It is noteworthy that, unlike Draghi who talks through all of the data including money growth, Bernanke does not. This saves him from having to explain why he has no control over money growth. Instead he repeats the line that the Fed is providing a “highly accommodative stance of monetary policy”. Which is actually not true, when we are looking at 6%  money growth, 1% inflation and 3% nominal growth. That is not a highly accommodative stance.

In point of fact, the Fed has been tightening for the past two years, with M2 growth falling from 10.5% to 6.0%, inflation falling from 2.0% to 1.1%, and nominal growth from 5% to 3% (YoY). QE3 has had no impact on money growth. At present, using its current policy instruments, the Fed has no control over the independent variables in the Quantity Theory: the money supply and velocity. This is why nominal GDP has been sliding sideways.

Where is Chairman-to-be Janet Yellen in all this? We don’t know. Bernanke says that she is on board with tapering, although I doubt it. I think that she is keeping a low profile until she takes the helm. Then we will find out what she really thinks.

I hope that Obama nominates Stanley Fischer* as vice chair, which would add a lot of heft to a weak team, and might add some firepower to the doves. He’s a monetarist, not an Austrian.  At MIT, he was the thesis adviser for Ben Bernanke, Mario Draghi, and Greg Mankiw. You can’t beat that!

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*Who would be the first African native to sit on the FOMC.