Tag Archives: M2

Why “Not-QE” is QE: Deciphering Gibberish

I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”  – Alan Greenspan

Imagine if Federal Reserve (Fed) Chairman Jerome Powell told the American people they must pay more for the goods and services they consume.

How long would it take for mobs with pitchforks to surround the Mariner Eccles building?  However, Jerome Powell and every other member of the Fed routinely and consistently convey pro-inflationary ideals, and there is nary a protest, which seems odd. The reason for the American public’s complacency is that the Fed is not that direct and relies on carefully crafted language and euphemisms to describe the desire for higher inflation.

To wit, the following statements from past and present Fed officials make it all but clear they want more inflation:  

  • That is why it is essential that we at the Fed use our tools to make sure that we do not permit an unhealthy downward drift in inflation expectations and inflation,” – Jerome Powell November 2019
  • In order to move rates up, I would want to see inflation that’s persistent and that’s significant,” -Jerome Powell December 2019
  • Been very challenging to get inflation back to 2% target” -Jerome Powell December 2019
  • Ms. Yellen also said that continuing low inflation, regarded as a boon by many, could be “dangerous” – FT – November 2017
  • One way to increase the scope for monetary policy is to retain the Fed’s current focus on hitting a targeted value of inflation, but to raise the target to, say, 3 or 4 percent.” –Ben Bernanke October 2017
  • Further weakness in inflation could prompt the U.S. Federal Reserve to cut interest rates, even if economic growth maintains its momentum”  -James Bullard, President of the Federal Reserve Bank of St. Louis  May 2019
  • Fed Evans Says Low Inflation Readings Elevating His Concerns” -Bloomberg May 2019
  • “I believe an aggressive policy action such as this is required to re-anchor inflation expectations at our target.”  Neel Kashkari, President Minneapolis Fed June 2019

As an aside, it cannot be overemphasized the policies touted in the quotes above actually result in deflation, an outcome the Fed desperately fears.

The Fed, and all central banks for that matter, have a long history of using confusing economic terminology. Economics is not as complicated as the Fed makes it seem. What does make economics hard to grasp is the technical language and numerous contradictions the Fed uses to explain economics and justify unorthodox monetary policy. It is made even more difficult when the Fed’s supporting cast – the media, Wall Street and other Fed apologists – regurgitate the Fed’s gibberish.   

The Fed’s fourth installment of quantitative easing (“QE4”, also known as “Not-QE QE”) is vehemently denied as QE by the Fed and Fed apologists. These denials, specifically a recent article in the Financial Times (FT), provide us yet another opportunity to show how the Fed and its minions so blatantly deceive the public.

What is QE?

QE is a transaction in which the Fed purchases assets, mainly U.S. Treasury securities and mortgage-backed-securities, via their network of primary dealers. In exchange for the assets, the Fed credits the participating dealers’ reserve account at the Fed, which is a fancy word for a place for dormant money. In this transaction, each dealer receives payment for the assets sold to the Fed in an account that is essentially the equivalent of a depository account with the Fed. Via QE, the Fed has created reserves that sit in accounts maintained by it.

Reserves are the amount of funds required by the Fed to be held by banks (which we are using interchangeably with “primary dealer” for the remainder of this discussion) in their Fed account or in vault cash to back up a percentage of specified deposit liabilities. While QE is not directly money printing, it enables banks to create loans at a multiple of approximately ten times the reserves available, if they so choose.

Notice that “Quantitative Easing” is the preferred terminology for the operations that create additional reserves, not something easier to understand and more direct like money/reserve printing, Fed bond buying program, or liquidity injections. Consider the two words used to describe this policy – Quantitative and Easing. Easing is an accurate descriptor of the Fed’s actions as it refers to an action that makes financial conditions easier, e.g., lower interest rates and more money/liquidity. However, what does quantitative mean? From the Oxford Dictionary, “quantitative” is “relating to, measuring, or measured by the quantity of something rather than its quality.”   

So, QE is a measure of the amount of easing in the economy. Does that make sense to you? Would the public be so complacent if QE were called BBMPO (bond buying and money printing operations)? Of course not. The public’s acceptance of QE without much thought is a victory for the Fed marketing and public relations departments.

Is “Not-QE” QE?

The Fed and media are vehemently defending the latest round of repurchase market (“repo”) operations and T-bill purchases as “not QE.” Before the Fed even implemented these new measures, Jerome Powell was quick to qualify their actions accordingly: “My colleagues and I will soon announce measures to add to the supply of reserves over time,” “This is not QE.”

This new round of easing is QE, QE4, to be specific. We dissect a recent article from the FT to debunk the nonsense commonly used to differentiate these recent actions from QE.  

On February 5th, 2020, Dominic White, an economist with a research firm in London, wrote an article published by the FT entitled The Fed is not doing QE. Here’s why that matters.

The article presents three factors that must be present for an action to qualify as QE, and then it rationalizes why recent Fed operations are something else. Here are the requirements, per the article:

  1. “increasing the volume of reserves in the banking system”
  2. “altering the mix of assets held by investors”
  3. “influence investors’ expectations about monetary policy”

Simply:

  1.  providing banks the ability to make more money
  2.  forcing investors to take more risk and thereby push asset prices higher
  3.  steer expectations about future Fed policy. 

Point 1

In the article, White argues “that the US banking system has not multiplied up the Fed’s injection of reserves.”

That is an objectively false statement. Since September 2019, when repo and Treasury bill purchase operations started, the assets on the Fed’s balance sheet have increased by approximately $397 billion. Since they didn’t pay for those assets with cash, wampum, bitcoin, or physical currency, we know that $397 billion in additional reserves have been created. We also know that excess reserves, those reserves held above the minimum and therefore not required to backstop specified deposit liabilities, have increased by only $124 billion since September 2019. That means $273 billion (397-124) in reserves were employed (“multiplied up”) by banks to support loan growth.

Regardless of whether these reserves were used to back loans to individuals, corporations, hedge funds, or the U.S. government, banks increased the amount of debt outstanding and therefore the supply of money. In the first half of 2019, the M2 money supply rose at a 4.0% to 4.5% annualized rate. Since September, M2 has grown at a 7% annualized rate.  

Point 2

White’s second argument against the recent Fed action’s qualifying as QE is that, because the Fed is buying Treasury Bills and offering short term repo for this round of operations, they are not removing riskier assets like longer term Treasury notes and mortgage-backed securities from the market. As such, they are not causing investors to replace safe investments with riskier ones.  Ergo, not QE.

This too is false. Although by purchasing T-bills and offering repo the Fed has focused on the part of the bond market with little to no price risk, the Fed has removed a vast amount of assets in a short period. Out of necessity, investors need to replace those assets with other assets. There are now fewer non-risky assets available due to the Fed’s actions, thus replacement assets in aggregate must be riskier than those they replace.

Additionally, the Fed is offering repo funding to the market.  Repo is largely used by banks, hedge funds, and other investors to deploy leverage when buying financial assets. By cheapening the cost of this funding source and making it more readily available, institutional investors are incented to expand their use of leverage. As we know, this alters the pricing of all assets, be they stocks, bonds, or commodities.

By way of example, we know that two large mortgage REITs, AGNC and NLY, have dramatically increased the leverage they utilize to acquire mortgage related assets over the last few months. They fund and lever their portfolios in part with repo.

Point 3

White’s third point states, “the Fed is not using its balance sheet to guide expectations for interest rates.”

Again, patently false. One would have to be dangerously naïve to subscribe to White’s logic. As described below, recent measures by the Fed are gargantuan relative to steps they had taken over the prior 50 years. Are we to believe that more money, more leverage, and fewer assets in the fixed income universe is anything other than a signal that the Fed wants lower interest rates? Is the Fed taking these steps for more altruistic reasons?

Bad Advice

After pulling the wool over his reader’s eyes, the author of the FT article ends with a little advice to investors: Rather than obsessing about fluctuations in the size of the Fed’s balance sheet, then, investors might be better off focusing on those things that have changed more fundamentally in recent months.”

After a riddled and generally incoherent explanation about why QE is not QE, White has the chutzpah to follow up with advice to disregard the actions of the world’s largest central bank and the crisis-type operations they are conducting. QE 4 and repo operations were a sudden and major reversal of policy. On a relative basis using a 6-month rate of change, it was the third largest liquidity injection to the U.S. financial system, exceeded only by actions taken following the 9/11 terror attacks and the 2008 financial crisis. As shown below, using a 12-month rate of change, recent Fed actions constitute the single biggest liquidity injection in 50 years of data.

Are we to believe that the latest round of Fed policy is not worth following? In what is the biggest “tell” that White is not qualified on this topic, every investment manager knows that money moves the markets and changes in liquidity, especially those driven by the central banks, are critically important to follow.

The graph below compares prior balance sheet actions to the latest round.

Data Courtesy St. Louis Federal Reserve

This next graph is a not so subtle reminder that the current use of repo is simply unprecedented.

Data Courtesy St. Louis Federal Reserve

Summary

This is a rebuttal to the FT article and comments from the Fed, others on Wall Street and those employed by the financial media. The wrong-headed views in the FT article largely parrot those of Ben Bernanke. This past January he stated the following:

“Quantitative easing works through two principal channels: by reducing the net supply of longer-term assets, which increases their prices and lower their yields; and by signaling policymakers’ intention to keep short rates low for an extended period. Both channels helped ease financial conditions in the post-crisis era.”   -LINK

Bourbon, tequila, and beer offer drinkers’ very different flavors of alcohol, but they all have the same effect. This round of QE may be a slightly different cocktail of policy action, but it is just as potent as QE 1, 2, and 3 and will equally intoxicate the market as much, if not more.

Keep in mind that QE 1, 2, and 3 were described as emergency policy actions designed to foster recovery from an economic crisis. Might that fact be the rationale for claiming this round of liquidity is far different from prior ones? Altering words to describe clear emergency policy actions is a calculated effort to normalize those actions. Normalizing them gives the Fed greater latitude to use them at will, which appears to be the true objective. Pathetic though it may be, it is the only rationale that helps us understand their obfuscation.

Jerome Powell & The Fed’s Great Betrayal

“Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

John Maynard Keynes – The Economic Consequences of Peace 1920

“And when we see that we’ve reached that level we’ll begin to gradually reduce our asset purchases to the level of the underlying trend growth of demand for our liabilities.” –Jerome Powell January 29, 2020.

With that one seemingly innocuous statement, Chairman Powell revealed an alarming admission about the supply of money and your wealth. The current state of monetary policy explains why so many people are falling behind and why wealth inequality is at levels last seen almost 100 years ago. 

REALity

 “Real” is a very important concept in the field of economics. Real generally refers to an amount of something adjusted for the effects of inflation. This allows economists to measure true organic growth or decline.

Real is equally important for the rest of us. The size of our paycheck or bank account balance is meaningless without an understanding of what money can buy. For instance, an annual income of $25,000 in 1920 was about eight times the national average. Today that puts a family of four below the Federal Poverty Guideline. As your grandfather used to say, a dollar doesn’t go as far as it used to.

Real wealth and real wage growth are important for assessing your economic standing and that of the nation.

Here are two facts:

  • Wealth is largely a function of the wages we earn
  • The wages we earn are predominately a function of the growth rate of the economy

These facts establish that the prosperity and wealth of all citizens in aggregate is meaningfully tied to economic growth or the output of a nation. It makes perfect sense.

Now, let us consider inflation and the role it plays in determining our real wages and real wealth.

If the rate of inflation is less than the rate of wage growth over time, then our real wages are rising and our wealth is increasing. Conversely, if inflation rises at a pace faster than wages, wealth declines despite a larger paycheck and more money in the bank.

With that understanding of “real,” let’s discuss inflation.

What is Inflation?

Borrowing from an upcoming article, we describe inflation in the following way:

“One of the most pernicious of these issues in our “modern and sophisticated” intellectual age is that of inflation. Most people, when asked to define inflation, would say “rising prices” with no appreciation for the fact that price movements are an effect, not a cause. They are a symptom of monetary circumstances. Inflation defined is, in fact, a disequilibrium between the amount of currency entering an economic system relative to the productive output of that same system.”

The price of cars, cheeseburgers, movie tickets, and all the other goods and services we consume are chiefly based on supply and demand. Demand is a function of both our need and desire to own a good and, equally importantly, how much money we have. The amount of money we have in aggregate, known as money supply, is governed by the Federal Reserve. Therefore, the supply of money is a key component of demand and therefore a significant factor affecting prices.

With the linkage between the supply of money and inflation defined, let us revisit Powell’s recent revelation.

“And when we see that we’ve reached that level we’ll begin to gradually reduce our asset purchases to the level of the underlying trend growth of demand for our liabilities.”

In plain English, Powell states that the supply of money is based on the demand for money and not the economic growth rate.  To clarify, one of the Fed’s largest liabilities currently are bank reserves. Banks are required to hold reserves for every loan they make. Therefore, they need reserves to create money to lend. Ergo, “demand for our liabilities,” as Powell states, actually means bank demand for the seed funding to create money and make loans.

The relationship between money supply and the demand for money may, in fact, be aligned with economic growth. If so, then the supply of money should rise with the economy. This occurs when debt is predominately employed to facilitate productive investments.

The problem occurs when money is demanded for consumption or speculation. For example:

  • When hedge funds demand billions to leverage their trading activity
  • When Apple, which has over $200 billion in cash, borrows money to buy back their stock  
  • When you borrow money to buy a car, the size of the economy increases but not permanently as you are not likely to buy another car tomorrow and the next day

Now ask, should the supply of money increase because of those instances?

The relationship between the demand for money and economic activity boils down to what percentage of the debt taken on is productive and helps the economy and the populace grow versus what percentage is for speculation and consumption.

While there is no way to quantify how debt is used, we do know that speculative and consumptive debt has risen sharply and takes up a much larger percentage of all debt than in prior eras.  The glaring evidence is the sharp rise of debt to GDP.

Data Courtesy St. Louis Federal Reserve

If most of the debt were used productively, then the level of debt would drop relative to GDP. In other words, the debt would not only produce more economic growth but would also pay for itself.  The exact opposite is occurring as growth languishes despite record levels of debt accumulation.

The speculative markets provide further evidence. Without presenting the long list of asset valuations that stand at or near record levels, consider that since the last time the S&P 500 was fairly valued in 2009, it has grown 375%. Meanwhile, total U.S. Treasury debt outstanding is up by 105% from $11 trillion to $22.5 trillion and corporate debt is up 55% from $6.5 trillion to $10.1 trillion. Over that same period, nominal GDP has only grown 46% and Average Hourly Earnings by 29%.

When the money supply is increased for consumptive and speculative purposes, the Fed creates dissonance between our wages, wealth, and the rate of inflation. In other words, they generate excessive inflation and reduce our real wealth.  

If this is the case, why is the stated rate of inflation less than economic growth and wage growth?

The Wealth Scheme

This scheme works like all schemes by keeping the majority of people blind to what is truly occurring. To perpetuate such a scheme, the public must be convinced that inflation is low and their wealth is increasing.

In 2000, a brand new Ford Taurus SE sedan had an original MSRP of $18,935. The 2019 Ford Taurus SE has a starting price of $27,800.  Over the last 19 years, the base price of the Ford Taurus has risen by 2.05% a year or a total of 47%. According to the Bureau of Labor Statics (BLS), since the year 2000, the consumer price index for new vehicles has only risen by 0.08% a year and a total of 1.68% over the same period.

For another instance of how inflation is grossly underreported, we highlighted flaws in the reporting of housing prices in MMT Sounds Great in Theory But…  To wit: 

“Since then, inflation measures have been tortured, mangled, and abused to the point where it scarcely equates to the inflation that consumers deal with in reality. For example, home prices were substituted for “homeowners equivalent rent,” which was falling at the time, and lowered inflationary pressures, despite rising house prices.

Since 1998, homeowners equivalent rent has risen 72% while house prices, as measured by the Shiller U.S. National Home Price Index has almost doubled the rate at 136%. Needless to say, house prices, which currently comprise almost 25% of CPI, have been grossly under-accounted for. In fact, since 1998 CPI has been under-reported by .40% a year on average. Considering that official CPI has run at a 2.20% annual rate since 1998, .40% is a big misrepresentation, especially for just one line item.”

Those two obscene examples highlight that the government reported inflation is not the same inflation experienced by consumers. It is important to note that we are not breaking new ground with the assertion that the government reporting of inflation is low. As we have previously discussed, numerous private assessments quantify that the real inflation rate could easily be well above the average reported 2% rate. For example, Shadow Stats quantifies that inflation is running at 10% when one uses the official BLS formula from 1980.

Despite what we may sense and a multitude of private studies confirming that inflation is running greater than 2%, there are a multitude of other government-sponsored studies that argue inflation is actually over-stated. So, the battle is in the trenches, and the devil is in the details.

As defined earlier, inflation is “a disequilibrium between the amount of currency entering an economic system relative to the productive output of that same system.”

The following graph shows that the supply of money, measured by M2, has grown far more than the rate of economic growth (GDP) over the last 20 years.

Data St. Louis Federal Reserve

Since 2000, M2 has grown 234% while GDP has grown at half of that rate, 117%. Over the same period, the CPI price index has only grown by 53%. M2 implies an annualized inflation rate over the last 20 years of 6.22% which is three times that of CPI. 

Dampening perceived inflation is only part of the cover-up. The scheme is also perpetuated with other help from the government. The government borrows to boost temporary economic growth and help citizens on the margin. This further limits people’s ability to detect a significant decline in their standard of living.

As shown below, when one strips out the change in government debt (the actual increase in U.S. Treasury debt outstanding) from the change in GDP growth, the organic economy has shrunk for the better part of the last 20 years. 

Data St. Louis Federal Reserve

It doesn’t take an economist to know that a 6.22% inflation rate (based on M2) and decade long recession would force changes to our monetary policy and send those responsible to the guillotines. If someone suffering severe headaches is diagnosed with a brain tumor, the problem does not go away because the doctor uses white-out to cover up the tumor on the x-ray film.

Despite crystal clear evidence, the mirages of economic growth and low inflation prevent us from seeing reality.

Summary

Those engaging in speculative ventures with the benefit of cheap borrowing costs are thriving. Those whose livelihood and wealth are dependent on a paycheck are falling behind. For this large percentage of the population, their paychecks may be growing in line with the stated government inflation rate but not the true inflation rate they pay at the counter. They fall further behind day by day as shown below.

While this may be hard to prove using government inflation data, it is the reality. If you think otherwise, you may want to ask why a political outsider like Donald Trump won the election four years ago and why socialism and populism are surging in popularity. We doubt that it is because everyone thinks their wealth is increasing. To quote Bill Clinton’s 1992 campaign manager James Carville, “It’s the economy, stupid.”

That brings us back to Jerome Powell and the Fed. The U.S. economy is driven by millions of individuals making decisions in their own best interests. Prices are best determined by those millions of people based on supply and demand – that includes the price of money or interest rates. Any governmental interference with that natural mechanism is a recipe for inefficiency and quite often failure.

If monetary policy is to be set by a small number of people in a conference room in the Eccles Building in Washington, D.C. who think they know what is best for us based on flawed data, then they should prepare themselves for even more radical social and political movements than we have already seen.

We’re Gonna Need A Bigger Boat

If 2018 rings in a bear market, it could look something like the Kennedy Slide of 1962.

That was my conclusion in “Riding the Slide,” published in early September, where I showed that the Kennedy Slide was unique among bear markets of the last eighty years. It was the only bear that wasn’t obviously provoked by rising inflation, tightening monetary policy, deteriorating credit markets or, less commonly, world war or depression.

Moreover, market conditions leading up to the Slide should be familiar—they’re not too far from market conditions since Donald Trump won the 2016 presidential election. In the first year after Kennedy’s election, as in the first year after Trump’s election, inflation seemed under control, interest rates were low, credit spreads were tight, and the economy was growing. And, in both cases, the stock market was booming.

Here’s an updated look at Trump’s stock rally versus the Kennedy rally and subsequent Slide:

As you can see, we’ve now reached the chart’s critical juncture—at this time of the calendar in 1962, the post-election rally was ending, and the Slide was about to begin. Our chart begs the question: Will the similarities continue and lead us into a Trump Slide in early 2018?

Or, with less drama, you might like to hear my Q1 stock market outlook.

While it’s certainly possible Trump’s rally has run its course, I’ll argue that it’s unlikely. And to make my case, I’ll rely largely on a single indicator, one that measures monetary policy. I use the indicator to help determine whether policy is behind the curve, ahead of the curve, or somewhere in between. In this article, I’ll call it VCURVE, for “versus the curve.”

Tracking VCURVE Through 16 Market Corrections

Before I explain how VCURVE is calculated, let’s look at the history. The following chart compares VCURVE to every instance since 1954 when the stock market corrected by more than 10% and for at least two months:

The upper panel shows an especially strong correlation with stock price cycles between 1954 and 1988. All ten of that period’s market corrections coincided with an upward spike in VCURVE. Despite a few instances of delay between the change in VCURVE and the market’s reaction, the indicator’s early track record was stellar—it predicted every correction with almost no head fakes. (I say “early track record” because fed funds data is only available from 1954. I’ll modify the indicator to gain a longer history at another time.)

But the historical performance didn’t persist after the 1980s at the same exceptional standard. The lower panel shows the correlation weakening, with jumps in VCURVE becoming a fifty–fifty proposition as to whether they signal a market correction.

The reason for the weaker correlation is open to debate, but I would say it’s explained mostly by the Fed’s practice of jumping to action at any hint of market turmoil. VCURVE probably hasn’t shown the same predictive power under the FOMCs chaired by Alan Greenspan, Ben Bernanke and Janet Yellen because of the respective Greenspan, Bernanke and Yellen “puts.” Whereas VCURVE before Greenspan was as reliable an indicator as you’ll find, more recently the Fed’s plunge-protection game often wins the day.

Calculating VCURVE

All that said, even the chart’s lower panel shows an excellent market indicator. The head fakes may be more frequent, but every correction still lines up with a degree of VCURVE turbulence. And just as importantly, it’s an easy indicator to calculate. Here are the two steps:

  1. From the current fed funds rate, subtract the lowest rate since the last market correction.
  2. Add the change in inflation over the past twelve months.

The first step tells us how far along the Fed is in a tightening cycle, and the second converts that figure to a measure of where the Fed stands versus “the curve.” Consider a few possible combinations:

  • If the current tightening cycle is far along but inflation is falling, VCURVE won’t be as high as it otherwise would be, because the Fed has taken enough action to dampen inflation risks. (Policy is ahead of the curve.)
  • If the current tightening cycle is young but inflation is rising, VCURVE will be higher than it otherwise would be, because the Fed may be forced to tighten more aggressively to contain inflation risks. (Policy is behind the curve.)

So VCURVE has three qualities that make it an effective indicator. It’s conceptually relevant, easy to calculate and historically proven.

And what does it tell us today?

At first glance, the latest reading is ambiguous. It’s higher than it was between 2012 and 2015, but only modestly so at 1.6%. To glean more information, we’ll take a closer look at the indicator’s history.

Testing VCURVE Against Subsequent Real Stock Returns

The next chart shows average inflation-adjusted stock returns over three-month periods following VCURVE readings in each of seven buckets:

From the pattern shown on the chart, we can make two observations:

  1. The strongest real returns tend to follow VCURVE readings of less than 2%.
  2. Real returns don’t normally fall below zero until VCURVE jumps above 3%.

We shouldn’t bet all our chips on the exact thresholds of 2% and 3%, history not always repeating and all that, but the pattern gives us a reasonable guide to early 2018. The latest reading of 1.6% falls within a range that’s followed by real quarterly stock returns averaging over 3%—hardly a bearish signal.

Conclusions

More broadly, two particular risks pose the greatest threats in early 2018. First, the market may have run too hot since Trump’s election, leaving investors overextended and unable to push prices higher. An overbought market appears to partially explain the Kennedy Slide of 1962, and a similarly overbought market today could spark a profit-taking correction.

Second, the Fed’s determination to tighten policy should continue to push VCURVE higher, even as it’s not especially high today. To be sure, rate hikes alone are unlikely to make a difference until later in 2018 at the FOMC’s projected pace of twenty-five basis points every four months, but further hikes coupled with an unexpectedly large jump in inflation would be a different story. In a rising inflation scenario that shows the Fed falling behind the curve, a correction of at least 10% would be likely and we’d probably see a full bear.

Of course, plenty of other risks could gain traction as the year gets underway. See, for example, these thirty risks discussed by Deutsche Bank and ZeroHedge or these fifteen from Doug Kass and Real Investment Advice. Also, market valuation points to meager long-term returns, as I discussed in “2 Key Indicators” and then showed somewhat differently in “Charts that Might Define the Jerome Powell Era.”

On a three-month horizon, though, most of the best indicators favor continued strength. Credit markets aren’t nearly as threatening as they were before recent bears—delinquencies, credit spreads and bank lending standards are all either neutral or just mildly bearish at worst. Moreover, the real and financial economies appear settled into a “virtuous” loop of mutually reinforcing strength, as I discussed here, while the GOP’s tax cuts should help sustain that loop for awhile longer.

And lastly, the Fed’s inch-worming monetary tightening pace hasn’t accumulated enough force as of yet to push VCURVE into a danger zone. As possibly the most effective of all fundamental indicators, I don’t recommend betting against VCURVE.

All things considered, I expect market valuation to become even more expensive before the next correction takes hold. Comparing the Trump and Kennedy rallies—as in the first chart above—I expect Trump’s market to build an even bigger slide.

A Strong Signal From The Economic Dashboard

We’ve been seeing more and more commentaries discussing bad stuff that can happen when the Fed tightens policy and, as a result, the yield curve flattens. (See, for example, this piece from Citi Research and ZeroHedge.) No doubt, the Fed’s rate hikes will lead to mishaps as they usually do—in both markets and the economy. But most forecasters expect the economy to expand through next year, believing that the Fed and the yield curve aren’t yet restrictive enough to trigger a recession.

We won’t make a full-year 2018 forecast here, but we’ll share one of our “dashboard” charts that supports the consensus view for at least the first half of the year. With one methodological change to a chart we published in August, we’ll look at the following indicators, which together have an excellent track record predicting the business cycle:

The idea is that the economy tends to turn over when investors lose money, borrowers find it hard to obtain financing, business earnings weaken, and banks struggle with a flat or inverted yield curve. Here’s a history of all four of those indicators in the quarter before and the quarter of the last nine business cycle peaks, although with less data for lending standards, which the Fed began surveying for the first time in mid-1990:

With that history as our background (in charcoal gray), our dashboard highlights the most recent data, along with our fourth quarter estimates for asset price gains and S&P 500 earnings growth:

In our view, the above chart is the best way to judge recession risks—with a strong reminder of how current conditions compare to the conditions that shaped past business cycles. That comparison looks favorable as of mid-December, just as it did in August. Here are our takeaways, moving from right to left along the chart:

  • Although the yield curve is likely to become more recessionary as the Fed continues to tighten, it’s not yet as flat or inverted as it normally is at business cycle peaks.
  • Business earnings aren’t yet recessionary, either, although gains over the last four quarters reflect depressed earnings in 2015 and 2016, which isn’t quite as bullish a signal as it would be if earnings had risen consistently over that period.
  • Outside of the commercial real estate sector, lending conditions aren’t constraining borrowing growth, and even CRE lending conditions aren’t restrictive when compared to the last three business cycle peaks.
  • Asset gains have been stellar over the past four quarters, far above the flat or declining performance that nearly always precedes business cycle peaks.

We think the last point is the most convincing. Of all the “rules” in economics, the rule that asset prices lead the business cycle is as reliable as any, and they’re a long way from recessionary as of this writing. In fact, if Q4’s gains match the average gains over the past four quarters, real asset gains for 2017 will reach 25% of personal income. That’s three months of personal income from asset gains alone—hardly an environment where households stop spending and the economy slips into recession.

But eventually, monetary tightening will have greater effects, and the outsized asset gains of recent years will become more burden than boon. That’s notwithstanding Janet Yellen’s FOMC press conference on Wednesday, where she downplayed risks posed by soaring asset prices. Yellen’s parting words are certainly welcoming of debate, and we recommend the responses here, as well as this recent report from the Office for Financial Research. But for this article, we’ll just couple our bullish economic view for H1 2018 with a chart we first shared last week:

Although the chart includes only seven business cycles to keep it readable, the full history shows asset gains, adjusted for inflation, jumping above those of any other cycle since the Fed began recording gains in 1947. It paints a bigger picture behind the “virtuous” loop that’s currently fueling the economy and thus far impervious to the Fed’s snail-pace tightening. And we think it describes the greatest challenge Yellen’s successor will face, although not an immediate challenge. In our view, the tightening we’ve seen to date is still too new and too tepid to threaten the usual damage, especially with the dashboard readings above and with fiscal policy set to loosen. But further out, we suggest trusting the history of how long-running virtuous loops normally unwind.

2-Charts That Will Define The Fed’s “Jerome Powell” Era

In September, we proposed a theory of the Fed and suggested that the FOMC will soon worry mostly about financial imbalances without much concern for recession risks. We reached that conclusion by simply weighing the reputational pitfalls faced by the economists on the committee, but now we’ll add more meat to our argument, using financial flows data released last week. We’ve created two charts, beginning with a look at cumulative, inflation-adjusted asset gains during the last seven business cycles:

According to the way that the Fed defines its policy approach, our first chart stamps a giant “Mission Accomplished” on the unconventional policies of recent years. Recall that policy makers explained their actions with reference to the portfolio balance channel, meaning they were deliberately enticing investors to buy riskier assets than they would otherwise hold. Policy makers hoped to push asset prices higher, and they seem to have succeeded, notwithstanding the usual debates about how much of the price gains should be attributed to central bankers. (See one of our contributions here and a couple of other papers here.) But whatever the impetus for assets to rise, it’s obvious that they responded. In fact, judging by the data shown in the chart, policy makers could have checked the higher-asset-prices box long ago, and with a King Size Sharpie.

Consider the measure on the vertical axis, percent of personal income. From the risky asset trough in Q1 2009 through Q3 2017, households accumulated asset gains, in real terms, equivalent to 139% of personal income. (Nominal gains were much greater, but we used the CPI to deduct the amount of purchasing power that households lost on their asset holdings. Also, we defined asset holdings as the four biggest categories that the Fed computes gains for—equities, mutual funds, real estate, and pensions.)

In other words, households are enjoying an investment windfall that amounts to nearly sixteen months of personal income, which is larger than the windfalls accrued in any other business cycle since the Fed began tracking asset gains in 1947. Not only that but the gap continues to widen—as of this writing, we’re likely approaching 145% of personal income and well clear of the previous peak of 128% from the 1991–2001 expansion.

Getting back to policy priorities, the chart seems to tell us that asset prices no longer need boosting. The Fed’s pooh-bahs proved they could boss the investment markets, and they’ve almost certainly moved on to new endeavors.

Bull, bear, or donkey?

But record asset gains are just one of the reasons the Fed’s priorities are likely to be changing. To describe another reason, we’ll first show that policy makers may wield a King Size Sharpie but that it’s not a Permanent Marker:

As you can see, our second chart looks like the first, except that we pinned the tails on the asset price donkeys. We tacked on the down halves of each cycle, showing that the portfolio balance channel has a reverse mode.

So what should we make of the result that asset price cycles, adjusted for inflation, have ended with busts that reverse a large portion and often the entirety of the prior booms?

According to our beliefs about how investment markets work, the up and down phases of asset cycles are closely connected. Also, monetary stimulus influences both phases at the same time. It helped fuel the giant gains of recent expansions, but it also helped create the imbalances that led to giant losses. And after the accelerated advances of 2016-17, it’s fair to wonder if today’s imbalances are approaching the extremes of 2000 and 2007. Even some FOMC members are gently acknowledging that risk.

But we think the committee members are even more concerned than you would know by just reading their meeting minutes. We expect financial imbalances to become their biggest worry, bigger than the risk of recession, which should matter less and less to the central bankers’ reputations as the business cycle expansion continues to lengthen. In fact, a garden variety recession would barely affect their legacies at all by mid-2019, when the expansion, if still intact, would become the longest ever. By that time, the FOMC’s greatest reputational threat would be another financial market debacle, which would suggest that manipulating asset prices maybe wasn’t such a good idea, after all. In other words, the committee’s reputational calculus will change significantly during Jerome Powell’s first few years as chairperson.

All that said, Powell probably wants a recession-free economy in, say, his first year or two in the position. Moreover, he’ll certainly stress continuity with his predecessors’ policies. But once he becomes comfortable in the job, the Fed’s priorities will look nothing like they did under Janet Yellen and Ben Bernanke. Instead of fueling asset gains, Powell’s biggest challenge will be containing imbalances connected to prior gains. He and his peers will aim to avoid pinning another oversized tail on the donkey—or at least to manage the fallout from said tail—and that’s a challenge that could very well define his regime.

Learning From The 1980’s

Forget about big hair, Ray-Bans, and Donkey Kong. Don’t even think about Live-Aid, Thriller, and E.T. Above all else, the 1980s were the gravy days of the money supply aggregates.

Beginning in late 1979, the Fed built its policy approach around the aggregates—primarily M1 but occasionally M2, and policy makers also monitored M3 while experimenting with M1B and, later, MZM. But those were just the “official” figures. Economists and pundits debated the Fed’s preferred measures while concocting their own home-brewed variations.

Notably, the Fed allowed interest rates to fluctuate as much as necessary to achieve its money growth targets. Fluctuate they did—rates soared and dipped wildly as a direct result of the Fed’s policy. The world, meanwhile, watched the action as attentively as a Yorkie watches breakfast, studying every wiggle in every M. Missing one wiggle could have meant the difference between exploiting the volatility that the Fed unleashed or being sunk by that same volatility.

And to make sense of it all, the world looked to the most famous economist of his day, Milton Friedman. By converting a large swath of his profession to his strict brand of Monetarism, Friedman more than anyone else had triggered the monetary frenzy.

But then, almost as quickly as the frenzy blew in, it blew right back out. With none of the Ms living up to their billings as economic indicators, the Monetarists drifted from view. Not in five minutes but in five years, give or take a couple, their period of fame was over. Friedman’s reputation as an economics savant fell particularly hard—his highly publicized forecasts proved inaccurate in each year from 1983 to 1986. And the Fed once again redesigned its approach, first deemphasizing and eventually dropping its money growth targets.

But maybe the Monetarists came closer to explaining the economy than their critics allowed?

Maybe the best indicator—I’ll call it “MDuh”—was somehow hidden in plain sight?

Those are the arguments I’ll make in this article, and I’ll back each one with up-to-date data. I’ll propose a way of thinking that’s considered common sense in some circles even as it’s blasphemous within the mainstream core of the economics profession. And I’ll explain why MDuh was the true lesson of Friedman’s research.

Before we get to MDuh, though, there are two things you should know about Friedman and his co-researcher Anna Schwartz (if you didn’t already know them). First, they relied on data, not theory, when they shaped their version of Monetarism. They found a strong historical correlation between money growth and economic activity, and they also found that money growth predicts activity. They published those results in a groundbreaking 1963 book, A Monetary History of the United States, 1867–1960.

Second, to their credit they never claimed to understand the monetary “transmission mechanism,” meaning the reasons the historical correlations were as strong as they were. But they offered their best guess, which lined up with prevailing Monetarist thinking. They believed that “there is a fairly definite real quantity of money that people wish to hold” and that our continual efforts to adjust money holdings to those fairly definite levels are the business cycle’s driving force.  (See here for source.)

The Glaring but Rarely Acknowledged Problem with M1 and M2

The second point above explains why Monetarists defined the aggregates as they did. They defined each aggregate according to the characteristics that might influence the “fairly definite real quantity of money that people wish to hold.” But the characteristics they believed important, such as liquidity, stability, and value as a medium of exchange, led to unreliable indicators, as shown in the chart below:

The chart compares the most popular Monetarist measures, M1 and M2, to two measures that I created, MDuh and NBL. I’ll define MDuh and NBL in just a moment. I’ll first offer an explanation for why M1 and M2 lost their pre-1980s mojo as GDP correlates. And to do that, I’ll need to review a fallacy that underpins not only Monetarism but all of mainstream macro.

Mainstream theory relies on the false premise that bank loans are no different to other loan types. It ignores the reality that bank loans are unique, because banks are the only institutions that create deposits (money) while delivering loan proceeds. Bank borrowers receive money that banks create from thin air, and that brand new money has powerful effects. It boosts spending without requiring prior saving, meaning it’s mostly additive to economic activity. That is, it doesn’t have a large “crowding out” effect on other spending—bank-created money flows directly into nominal GDP. It might affect prices, real growth, or a combination of prices and real growth, depending on how the new money is spent. But it’s important to remember that the new money connects to a bank loan. The money–GDP correlation is merely a byproduct of a lending–GDP correlation. Bank lending, not money, is the driving force.

Back to M1 and M2: Why did those highly touted measures lose their strong correlations to GDP, whereas MDuh didn’t?

I would say it’s because they lost their connections to bank lending. The economists who created them made both additions to and subtractions from bank-created money, whereas I made no such adjustments when I calculated MDuh. I didn’t bother with the differences between checking, savings, and time deposits, and I didn’t bother with money that’s not created by banks, such as money market funds. In other words, I didn’t bother with the characteristics of money that absorb the attention of mainstream economists—liquidity, stability, and value as a medium of exchange. For what it’s worth, I doubt that people maintain definite money holdings, as the Monetarists claimed.

MDuh depends on a single question: Is a potential MDuh component initiated by a private entity with the legal authority to create money, meaning either a commercial bank or a similar deposit-taking institution? If the answer is yes, I include the component in MDuh. Otherwise, I don’t. By using only that criterion, I’m estimating the amount of new money that banks pump into the economy when they make loans and buy securities. Not surprisingly, MDuh correlates almost perfectly with net bank lending—the correlation between 1959 and 2016 was 0.97. And net bank lending, as you might have guessed, is “NBL” in the chart above.

To say it again, banking realities tell us that bank lending, not money, is the business cycle’s driving force, as shown by the data in my chart.

Why Friedman and Schwartz Were Almost “On The Money”

Now for the irony.

Over the 94-year period covered in Friedman and Schwartz’s Monetary History, data only existed for a few types of money. The authors couldn’t separate different types of bank accounts as finely as statisticians do today. They couldn’t measure any non-currency, non-bank-created money that may have existed over the period of study. In other words, they couldn’t add and subtract the various components of the Ms that disconnect them from bank lending.

So MDuh is far from an original measure. It consists of currency in circulation plus bank deposits less bank reserves, which is equivalent to the measure Friedman and Schwartz used in their book for the period until the Fed’s inception in 1913 (there were no central bank–held reserves) and almost equivalent thereafter. Their monetary history could have just as accurately been called “The History of MDuh.” In effect, their study of MDuh triggered the 1980s monetary frenzy in the first place.

(The only discrepancy between MDuh and Friedman–Schwartz is my adjustment for bank reserves, which isolates private sector–supplied credit by excluding deposits that arise though the Fed’s open market operations. Without the adjustment for bank reserves, MDuh would mix apples with oranges. It would combine private sector lending, which is pro-cyclical, with the Fed’s lending, which is intended to be counter-cyclical. Private sector lending is more strongly correlated to GDP, as you would expect.)

In an ideal world, Friedman and Schwartz’s followers would have recognized that MDuh mostly demonstrates the connections between business cycles, inflation, and bank credit cycles. But that’s not what happened. They stuck to their training, which told them that bank loans are identical to other types of lending. And then they obsessed over how to define money supply, as if economic insight comes down to whether to include, say, overnight repos in your favorite M. By so doing, they moved further and further from MDuh.

Next Steps for Those Who See Things as I Do

As mentioned above, my conclusions probably sound like common sense to many of you, even as they conflict with mainstream macro. You might wonder if you can exploit that discrepancy, and I explain how in my book Economics for Independent Thinkers (website here, Amazon link here).

For now, though, I’d say the next time your favorite analyst breaks down M1 or M2, comment politely that those indicators emerged from long-standing fallacies about money and banking. Suggest that maybe people don’t fine-tune their money holdings to a “fairly definite” level as Monetarist theory requires. Or, even if they do, the desired money holdings wouldn’t propel the economy in the same way bank loans do. And then ask her to look at MDuh instead. Or, better yet, ask her to look at net bank lending and be done with it. Money, while occasionally interesting, mostly sows confusion among those who study it.

Author’s note: I plan to post a follow-up or two with more detailed statistics, including correlations with real growth, and I’ll also consider the economics profession’s response to critiques such as mine. The follow-ups are unlikely to be widely published— but they WILL BE published here at Real Investment Advice so check back frequently. Also, for more on the realities of banking and how they differ from textbook theory, see this Bank of England report.