We think U.S. and global growth prospects are deteriorating under the weight of bad monetary policy, making equities vulnerable until policies improve.
- Today’s PPI declined 0.2% month-over-month for October. Yesterday’s CPI data showed month-over-month inflation at -0.1% for October and year-over-year inflation slowing to 1%. Industrial production fell 0.1% in October (a measure of real growth).
- Overall retail sales were moderate at 0.4% month-over-month in October and 3.9% year-over-year in nominal terms, but their growth is partly due to a shift in mix toward more expensive autos. One of our complaints with the current monetary policy is that it is favoring upper incomes at the expense of median incomes, allowing big companies and expensive cars to do better than more job-creating sectors of the economy.
- Excluding autos, retail sales gained only 0.2% in October and are up only 2.4% year-over-year in nominal terms, not enough to maintain even the slow “new normal”, in part due to the Fed’s huge borrowing from banks.
- Real GDP growth over the last four quarters was 1.6%, a rate that has only occurred during recessions. Similarly, nominal growth at 3.1% year-over-year, has, since the 1950s, occurred only during recessions.
- Even with the Federal Reserve subsidizing big companies and big debtors, corporate earnings will have trouble growing with slow GDP growth. Broad-based corporate earnings (based on the NIPA accounts used in the GDP) have been stagnant at $900-$960 billion per quarter in nominal terms for eight quarters.
Given regulatory restraint on bank leverage, our view is that the super-low interest rate policies in the U.S., Europe and Japan are contractionary. They rechannel credit away from job creators. If so, promises of super-low future interest rates through the “forward guidance” policy is adding to the damage, not alleviating it. Small and new businesses face the threat of the Fed guiding new credit toward the government and big businesses for years to come.
- In answer to a direct November 13 question about the negative impact of the Fed’s trickle down policy, Vice Chairman Yellen practically acknowledged the failure of the five year old policy: “Wage growth has been weak or nonexistent in real terms over the last several years. As the economy recovers, my hope and expectation is that that would change and, if we can generate a more robust recovery in the context of price stability, that all Americans will see more meaningful increases in their well-being.”
- The FOMC minutes from the October 29-30 meeting showed continued discussion of tapering. In more current policy statements, however, Chairman Bernanke on Tuesday raised the possibility of the Fed waiting for a 6% unemployment rate before raising the Fed funds rate. And In her November 13 confirmation hearing, Fed Vice-Chairman Janet Yellen acknowledged economic weakness and emphasized continuity of policy: “We have further to go to regain the ground lost in the crisis and the recession.”
We expect the Fed to continue borrowing $85 billion per month from the private sector in order to fund its bond purchases. This will push the Fed’s liabilities to roughly $4 trillion at year-end, up from $800 billion pre-crisis. There’s no indication the balance sheet expansion has helped the economy – the Fed is causing banks to reduce their short-term lending (e.g. to small businesses) in order to make ever-increasing loans to the Fed.
- Banks have increased their cash (including loans to the Fed and interbank loans) to $2.7 trillion or 19.4% of total assets (used to run 7%).
- At roughly $2.5 trillion, the Fed now holds 92% of the cash of the banking system as bank reserves. And bank reserves have reached fully 25% of bank deposits, a higher reserve ratio than China’s.
- The high level of bank reserves held at the Fed is consistent with the slow velocity of money, the weak expansion in private sector credit and the dismal economic performance during the Fed’s “stimulus” efforts.
Fed Remains Contractionary
The Fed’s response to slow growth and high unemployment – bond-buying and near-zero rates – is itself contractionary and disinflationary, especially when combined with tight regulatory constraints. The Fed hasn’t been printing. Credit is rationed through regulation, leaving credit increasingly misallocated toward government and big companies.
- Part of our constructive view of the outlook for the economy and equities earlier in 2013 was that the Fed would taper, reinforcing the economic acceleration underway in the first half of 2013. That was happening in July, with equities moving to new highs despite the Fed’s discussion of tapering and the May reset in bond yields. The Fed’s flip-flop left the economy with higher interest rates and heightened uncertainty about the taper, the pain without the gain.
- A taper would have encouraged banks to make short-term loans to the private sector. Under current policy, much of the banking system’s short-term lending goes to the Fed, which dead-ends it into government bonds. We think a taper would facilitate an increase in job-rich working capital loans for small and new businesses. Commercial and industrial loan growth has slowed to 7.1% year-over-year.
- A taper would strengthen the dollar, encouraging investment in the U.S. to capture dollar appreciation as in the 1990s. We viewed the 2012 and first-half 2013 decline in gold prices toward the ten-year average as favorable for equities and think it would have resumed if the Fed had tapered.
- A taper would also reduce the uncertainty about when the Fed will taper and whether it will hurt the economy. This uncertainty is discouraging investment.
The Fed’s policy of near-zero rates is contractionary, regardless of forward guidance. By underpricing credit relative to inflation, growth and investment returns, the Fed forces credit to be rationed – through bank examiners, leverage ratios and risk-based capitalization standards. The near-zero rate harms interbank markets and causes a transfer of wealth from savers to debtors.
- Bond-buying is also contractionary. By buying only long-duration high-grade credit, the Fed subsidizes those assets at the expense of more job-rich credit like working capital loans. This helped corporate earnings growth, but the data shows very slow overall U.S. growth, weak investment and very weak job growth. One cause: a massive shift of private sector credit toward the government and corporations.
Fed Has No Cash, Can’t Create Money
The Fed doesn’t have cash and can’t “create money.” Since 2007, it has shifted its assets from large holdings of Treasury bills (saleable for cash) to near-zero holdings of cash or near-cash in 2013.
- If asked for cash, the Fed has to raise it from the private sector. Here’s one illustration of this Fed shuffle: Say Bank A wants to withdraw money from its reserves at the Fed and doesn’t want currency. The Fed has to get Bank B to fund Bank A. The Fed could buy T-bills from Bank B, paying with a Fed IOU (excess reserves). The Fed still has no cash yet, but it could sell the T-bills to Bank C, receive a wire transfer and pass the requested cash to Bank A. The result is that Bank A has more cash and a smaller deposit at the Fed. Bank B has a deposit at the Fed but less T-bills. Bank C has more T-bills, less cash.
- The Fed is unchanged after completing the shuffle. There’s no cash created in the private sector. In effect, the Fed borrowed money from one group and gave it to another, so it’s a wash in terms of the amount of spendable money in the private sector. Private sector credit is up only 3.3% yoy, showing no indication of money printing. The bad news is that the Fed is hurting the economy by shuffling money toward the government. The good news is that a non-traumatic exit is still possible because private sector credit hasn’t bubbled yet and the private sector has lengthened the duration of its debt, cushioning it from rate hikes.
- The Fed would face the same problem if it wanted to monetize the fiscal deficit. It doesn’t do this, but let’s say it bought debt directly from Treasury with the goal of wiring it money to pay the bills. Since it doesn’t have any cash to wire, it would have to raise cash from the private sector. As in the example above, it would buy Tbills from Bank B in exchange for excess reserves, then sell the Tbills to Bank C for cash to wire to Treasury to monetize the debt. The problem is that this doesn’t create any cash, it just moves cash from Bank C to Treasury.
The Fed borrows short-term to buy long-term debt. Its policy is more like a Structured Investment Vehicle, a sovereign wealth fund or a high reserve requirement.
- The Fed’s QE purchase of bonds doesn’t change anything except the effective maturity of the national debt -- the private sector ends up with a floating rate Fed IOU rather than a fixed rate 10-year Treasury bond. Looking at the combined Fed and Treasury balance sheets, the effect is to shorten the effective maturity of the government’s debt.
- In sum, the Fed only monetizes debt if it uses paper currency to pay. Otherwise, the Fed is a matched set of assets and liabilities. Rather than “printing money”, the Fed “regulates money” in the private sector through the reserve requirement and the injection of reserves (now defunct) and the regulation of bank leverage (now a very active constraint).
David Malpass is the President of Encima Global and a contributor to e21.
