Roach Motel Monetary Policy
John P. Hussman, Ph.D.
All rights reserved and actively enforced.
Reprint Policy
While we continue to observe some noise and
dispersion in various month-to-month economic reports, the growth
courses of production, consumption, sales, income and new order
activity remain relatively indistinguishable from what we observed at
the start of the past two recessions. The chart below presents the
Chicago Fed National Activity Index (3 month average), the CFNAI
Diffusion Index (the percentage of respondents reporting improvement in
conditions, less those reporting deterioration, plus half of those
reporting unchanged conditions), and the year-over-year growth rates of
new orders for capital goods excluding aircraft, real personal
consumption, real retail and food service sales, and real personal
income. All values are scaled in order to compare them on a single
axis.
Strong leading indicators such as the
CFNAI and the Philly Fed Index have been weak for many months, and the
deterioration in new orders has moved from a slowing of growth to
outright contraction in recent months. In the order of events, a slowing
in real sales, personal income, and personal consumption expenditure
typically follows – these are called coincident indicators.
These growth rates generally only weaken materially once a recession is
in progress, and reach their highest correlation with recession about
6-months into the downturn. That’s what we’ve begun to observe over the
past few months, adding to our impression that the U.S. joined a global
(developed economy) recession during the third quarter of this year.
The most lagging set of economic indicators includes
employment measures, where I’ve frequently noted that the
year-over-year growth rate of payroll employment lags the year-over-year
growth rate of real consumption with a lag of about 5 months. As a
result, the year-over-year growth rate in payroll employment reaches
its highest correlation with recession nearly a year after a recession
has started – another way of saying that it is among the last
indicators to examine for confirmation of an economic downturn.
All of that said, our concern about recession
emphatically is not what drives our concern about the stock market
here. In early March, our measures of prospective return/risk moved to
the lowest 1% of historical data based on a broad ensemble of
indicators and consistent evidence of market weakness following similar
conditions in numerous subsets of historical data. Those conditions
remain largely in place today.
There’s no question that massive fiscal and
monetary interventions have played havoc with the time-lag between
unfavorable conditions and unfavorable outcomes in recent years, which
prompted us back in April to introduce various restrictions to our
hedging criteria (see below). Still, present conditions remain strongly
negative on our estimates. Meanwhile, the stock market is not “running
away” – at best, these interventions have allowed the market to churn
at elevated levels. Only a month ago, the S&P 500 Index was below
its level of March 2012, when our estimates shifted to the most negative
1% of the data, and was within about 11% of its April 2010 levels,
which is the last time that our present ensemble approach would have
encouraged a significant exposure to market risk. Notably, as of last
week, an upward spike in long-term Treasury yields took market
conditions to an overvalued, overbought, overbullish, rising yields
syndrome – which has tended to be anathema to the stock market, even
prior to the more limited downward bouts of recent years.
Beyond that, a natural question is – if recession
concerns don’t factor into our present defensiveness in the first
place, why should we be concerned about recession at all, and devote so
much analysis to this issue in the weekly comments? The first answer
is that the foundation of this particular cyclical bull market has
rested on the continuation of massive fiscal and monetary
interventions, and a new recession would stretch those interventions to
untenable limits (and to some extent already have), which should be of
concern regardless of one’s stock market views. The second answer is
that much of Wall Street’s overbullish sentiment, as well as its
“valuation” case for stocks, rests on the continuation of record high
profit margins that are largely an artifact of extreme government
deficits and depressed personal savings (see Too Little To Lock In).
A contraction in sales, coupled with a contraction in profit margins –
which is what we presently expect – is likely to devastate the
“forward operating earnings” case for stocks, and I continue to expect
Wall Street to be blindsided by this fairly predictable outcome (as it
was in 2001-2002, as it was in 2008-2009).
The distortions we presently observe in the
economy will have significant long-term costs, but it is entirely naïve
to believe that these costs should be evident precisely at the point
where the wildest distortions are taking place. Federal deficits
presently support about 10% of economic activity, and the primary
driver of improvement in the unemployment rate has not been job
creation but a plunge in labor participation, as millions of workers
drop out of the labor force. In a post-credit crisis environment, and
particularly with Europe’s sovereign debt in question, it should be no
surprise that the world has been willing to accumulate U.S. currency and
Treasury debt at near-zero interest rates. That makes debt seem benign
and money creation seem without consequence. But it is absurd to point
at that happy short-term outcome and dance under the illusion that
escalating debt won’t matter in the longer term, or that massive money
creation will be easily reversed, or that strong inflation will be
avoided if it is not reversed.
We have already accumulated enough government debt
to place a broad range of current and future government services under
a cloud. Given that most of the publicly held U.S. government debt is
of short maturity, there is no way of inflating away its real value
over time, because interest rates would adjust at each rollover of that
debt. In the event that the sheer size of the U.S. debt results in a
loss of confidence (which is a 5-10 year proposition, though not yet a
present one), there is no reason that we could not expect the same
short-term funding strains that many European countries are facing in
fits and starts today.
Meanwhile, last week, Ben Bernanke announced that
the current “Twist” program (where the Fed buys long-term Treasuries
and sells an equal amount of shorter-dated Treasuries) will be replaced
with outright “unsterilized” bond purchases. In doing so, Ben Bernanke
has put the economy on course to choke down 27 cents of
monetary base for every dollar of nominal GDP by the end of next year –
in an economy where even the slightest normalization to interest rates
of just 2% would require the monetary base to be cut to just 9 cents
per dollar of GDP to avoid inflationary outcomes. The chart below is a
reminder of where we are already.
Understand that Fed policy now requires
interest rates to remain near zero indefinitely, because competition
from non-zero interest rates would reduce the willingness to hold
zero-interest currency, provoking inflationary outcomes unless the
monetary base was quickly reduced. Given an economy perpetually at the
edge of recession, so far, so good. But as interest rates essentially
measure the value that an economy places on time, Ben Bernanke's message to the U.S. economy is clear: time is worthless.
Monetary policy has become a roach motel – easy
enough to get into, but impossible to exit. Bernanke seems pleased to
note that inflation presently remains low, but why shouldn’t it? In a
structurally weak economy, velocity drops in exact proportion to new
monetary base, with zero effect on real output or inflation.
The problem is that Bernanke seems incapable of running thought
experiments. Suppose the economy eventually strengthens at some point
past 2013. At that point, the Fed would have to sell nearly $3 trillion
of U.S. debt into public hands in order to reabsorb the money creation
he claims “is only a temporary matter.” These sales would add to the
stock of U.S. debt already held by the public, very likely while a
significant government deficit is still in place. Such a sale would be,
by two orders of magnitude, the largest monetary tightening in U.S.
history. Is that possible to achieve without disruption? I doubt it.
So instead, the Fed must rely on the economy
remaining weak indefinitely, so it will never be forced to materially
contract its balance sheet. To normalize the Fed’s balance sheet
without contraction and get from 27 cents back to 9 cents of base money
per dollar of GDP without rapid inflation, we would require over 22 years
of suppressed interest rates below 2%, assuming GDP growth at a 5%
nominal rate. Indeed, Japan is on course for precisely that outcome,
having tied its fate 13 years ago to Bernanke’s experimental prescription
(stumbling along at real GDP growth of less than 1% annually since
then). Bernanke now sees fit to inject the same bad medicine into the
veins of the U.S. economy. Of course, a tripling in the consumer price
index would also do the job of bringing the monetary base back from 27
cents to 9 cents per dollar of nominal GDP. One wonders which of these
options Bernanke anticipates. Psychotic.
Big picture – my perspective remains unchanged:
the long-term viability of the global economy is being increasingly
wrecked by short-sighted policies focused on avoiding short-term
economic adjustments, and at bottom, on avoiding the restructuring of
unserviceable sovereign, mortgage and financial debt. Yet only that
restructuring is capable of unchaining the economy from reckless past
misallocations; only that restructuring is capable of unleashing robust
new demand that would form the basis for sustainable economic activity
and job creation. You either pull the bad tooth, or you provide every
kind of pain killer and symptom reliever, and let the problem rot
indefinitely.
From an investment perspective, we know that the
impact of quantitative easing both in the U.S. and abroad has generally
been limited to a rally in stocks toward the highs of the prior
6-month period, in some cases moving as high as the monthly Bollinger
band (2 standard deviations above the 20-month average). Given that the
S&P 500 is within a few percent of its highs, and that conditions
have already established an overvalued, overbought, overbullish,
rising-yields conformation, much of the “benefit” of QE on stocks
appears already priced in, as it has been since October when Bernanke
effectively announced the present policy. The downside risk overwhelms
the upside potential, in my view, but we can’t confidently rule out
some amount of upside potential – which would still seem dependent on
the avoidance of negative economic surprises.
