Tuesday, June 25, 2013

Real Interest Rates, Fremont, and the Land of Oz

Happy summer solstice.  I recently attended the Fremont Solstice parade and for those of you who know anything about that Seattle event, I can tell you that there is nothing I could write about in this blog that could ever be as exciting and fun as that parade.  But those visual images cannot compare to the parade going on in our financial markets!

About a year ago in June I posted an article about negative real interest rates. It turns out that it has been the most popular by far of all my postings.  http://larrydavidsonspoutsoff.blogspot.com/2012/06/negative-real-interest-rates-cannot.html

The main point of that article was to underscore how low real interest rates were last summer.  I am not sure why that post hit the mark but in any case I think it is time to update the results to summer 2013. My conclusion is that real rates are on the rise, the Fed is not soon going to change its policies, and every time the Fed tries to do the right thing the financial markets will get hysterical like they did last week.

After the Fed’s announcement that they might begin to taper the famous quantitative easing programs as early as later this year, market rates have started to rise. Expectations can be a powerful factor in credit markets, so the mere notion that rates “might” rise in the future can send them surging today. The benchmark 10 year government treasury rate increased half a point in the last month and almost 90 basis points since last summer.  So for sure – market rates are rising.

What happens to real interest rates, however, depends also on another fragile psychology factor – inflationary expectations. Most measures of expectations of future inflation rates have moved slightly downward since last year – meaning markets and surveys currently do not soon expect markedly higher inflation.  Economic problems among our main trading partners suggest continuing slack in our export sales and possibly even lower inflation in the near future.

With market interest rates rising and expected to keep rising and with inflation expected to remain stable or fall, we have to conclude that real interest rates are headed upward in the very near term. What about after that? Since market interest rates are well below their norms, it is not easy to see a reversal. But the inflation factor offers more room for story-telling and rising uncertainty. In two recent postings I made the point that just like interest rates, inflation today is well below normal values. It is only a matter of time before the effects of monetary policy, a stronger domestic economy, and a declining value of the dollar begin to push inflation back closer to 3%.

So while real interest rates are rising right now, there is still some question as to their continued future course. What happens to real interest rates will be the outcome of a race between market rates and inflationary expectations. The more inflationary expectations rise relative to market rates, the less increase there will be in real interest rates. But that outcome misses the well-known effect of changes in expected future inflation on market interest rates. The higher is expected future inflation the higher are market interest rates. In sum – this is what the medium terms holds for the real interest rate:
·        Stuff causes market rates to rise and the real interest rate to rise
·        Inflation expectations rising causes real interest  rates to fall
·        Inflation expectations rising causes market rates to rise and real interest rates to rise.
·        Result – real interest rates will begin rising with or without a rise in inflationary expectations.

And, of course, that matters because it is the real interest rates that measure the payoff to saving and investing. Significantly rising real interest rates favors savers over investors.  Rising real interest rates also cause slower economic growth so in today’s uncertain economic environment rising real interest rates are not welcome. This puts pressure on the Fed to continue its quantitative easing as markets seemed to be shouting last week.

Could the markets' lamentations be correct? What is true is that most of us do not react well to change. A change in Fed policy now is simply that – a big fat change in your face.  So the market cries out. But when the surgeon begins to wean you off the pain medicine and you cry out, at some level you understand that your future is one with zero pain  medicine. You are glad that the doctor is reducing your dose because you know it is the right thing to do.

It is the same with real interest rates. They are rising and they are going to keep rising. But Dr. Bernanke and his gang of associates are not ready to reduce the pain medicine. Investors are not convinced that the patient is healed. So the big question is when will the patient be ready. When will the Fed announce that the patient is healed and when will the patient believe it? Okay Doc I am ready to reduce the medicine because I know I don’t need it anymore.

I can’t see this happening for a while. Sure, there are numerous signs that the US economy is on the mend. But then again there are just as many worrisome signs both at home and abroad. How long will Europe’s economy struggle? Will it get worse before it gets better? China is also facing rising interest rates? Can China rein in excessive credit growth and inflation without causing an even bigger economic slowdown? Will Japan’s three-part program work after decades of stagnation? If all these places slow how will Brazil and other emerging nations manage to recover?  The world’s post-crisis economy is not back on track and this does not help confidence in the US economy.

Those are global worries – but there are plenty of domestic ones to boot. Will our dysfunctional government grow even more dysfunctional this year? Will we postpone once again legislation that address our financial and economic problems? Is the recent housing boom just a bubble? Will labor market trends swamp any reductions in the unemployment rate that might be part of moderate growth. Is higher inflation going to erode already marginal income gains?

The upshot is that the Fed is in a pickle. Everyone knows the Fed must reverse its policy. Everyone knows that rising real interest rates are coming. Yet global and domestic worries prevent the Fed from making any changes to its current policy. Every time it even imagines a change in policy the financial markets are going to be hysterical. 

We could learn some lessons from Oz. The scarecrow always had a brain and the cowardly lion was always brave.  We didn’t need three rounds of quantitative easing and we didn’t need endless stimulus from the government. From the beginning of the economic recovery we have needed good policies that aim at real problems: housing, banking, finance, immigration, healthcare costs, etc. Without apparent progress on these real problems, the Fed is stuck in a no-win position, Some people want more drugs and despite the rationality of tapering any deviation from the current stimulus will be met with chaos that will whiplash our precious portfolios. 

Tuesday, June 18, 2013

The Perils of Tampering and Tapering by Guest Blogger Robert Klemkosky

Since May 22, volatility in most markets (stocks, bonds and currencies) has increased, not only in the U.S. and Europe, but also in Asia and especially in emerging markets. That happened to be the date that Fed Chairman Ben Bernanke testified before a congressional joint economic committee. In answer to a question about slowing the Fed’s monetary stimulus, he replied “If we see continued (economic) improvement and we have confidence that it is going to be sustained, then we could – in the next few meetings – take a step down in our pace of (bond) purchases.” He also warned that “premature tightening would carry a substantial risk of slowing or ending the economic recovery.”

The above response was in reference to the Fed’s most recent qualitative easing (QE) program called QE3 or QE Infinity. The two prior QE programs had definite purchase amount targets and schedules. QE 1 involved the purchase of $1 trillion of mortgage-backed and U.S. Treasury bonds in 2008 and 2009. QE2 involved another $600 billion of bond purchases from November 2010 to June 2011. QE3 was more open ended in that the Fed announced in August 2012 that it would purchase $85 billion of bonds each month until, later announced, the U.S. unemployment rate falls below 6.5 percent.

$85 billion monthly may not sound like much, but do the math, and it comes to more than $1 trillion annually. The QE programs have bloated the Fed balance sheet from $800 million before the financial crisis of 2008-2009 to $3.3 trillion today – four times larger in five years.

The purpose of the QE programs was to reduce long-term interest rates and increase asset prices, stocks, bonds and housing. By increasing asset prices, which has happened, less in housing than stocks and bonds, the Fed counted on the wealth effect and lower interest rates to increase confidence and stimulate consumer spending and corporate investment. The Fed also was concerned about deflation and has targeted 2 percent as the desirable inflation rate.

Bernanke’s response was certainly measured and cautions, and some have referred to it as “splitting hairs,” but it has created turmoil in the markets. Since then, bad has become good, and good has become bad in terms of economic news and market reaction. When the economic news is too good, long-term interest rates rise and bond and stock prices fall. If the news is bad, the opposite effect takes place. Investors prefer Goldilocks economic news, not too good or too bad.

As mentioned earlier, the QE programs have been successful in keeping long-term interest rates low, thus supporting higher bond prices; lower mortgage rates have helped increase house prices by 13 percent in the last year after a drop of 33 percent from peak prices in 2006; and the stock market as measured by the S&P 500 is up 140 percent from the low of March 2009. How about its effect on the U.S. economy? Who knows what the U.S. economy would have been like without the QE programs, but their impact has not been as dramatic as the Fed had hoped them to be.

June 2013 marks the fourth anniversary of the present economic recovery. Economic growth has averaged around 2 percent during the four-year economic recovery period – one of the slowest recoveries in the post-WWII era. Even though economic growth was 2.4 percent in the first quarter of 2013, the 15 quarters of growth have been very uneven, from highs of 4 percent in the fourth quarters of 2009 and 2011 to lows of less than .5 percent in the first quarter of 2011 and the fourth quarter of 2012. Plenty of hopes and disappointments for U.S. economic growth.

Employment and job creation has been one of the biggest problems in the recovery. There are still 2.5 million fewer people employed today than in 2007, and the unemployment rate remains high at 7.6 percent. For many, it has been a jobless recovery. The private sector of the economy has done a better job of creating employment than the government sector, which has shed more than 1 million jobs at the state, local and federal levels.

But the operative word now is tapering; when will the Fed begin to gradually reduce its $85 billion monthly purchases of bonds, and when will it stop completely? It seems the market has become, if not addicted, fixated on the supposed benefit of the QE monetary stimulus, and thus the bad news is good news scenario. But no matter when the start of the tapering or the end of QE3, the Fed cannot keep purchasing $1 trillion of bonds each year. While inflation and inflationary expectations don’t appear to be a problem in the short term and even out to five years, continued monetary stimulus could result in inflation in the longer term – especially given the fiscal and monetary stimulus undertaken recently by Japan and the Bank of Japan as well as the Eurozone and the European Central Bank.

Eventually normalcy for the economy hopefully will prevail, and real interest rates will then become more positive, which means that nominal interest rates will rise. The 10-year U.S. Treasury bond yield has already recently increased from 1.6 percent to 2.4 percent, but even 2.4 percent is a historically low rate. The question is when will rates rise further? Given all of the uncertainty, it is not obvious to investors. But a return to more normal economic growth without fiscal or monetary stimulus may be a welcome and positive event for investors. It has been six long years since the Fed got so entangled in the economy. Less entanglement should be a huge positive, but it will create uncertainty and risk, especially for the bond markets. But tapering will be better than tampering. It will mean a return to normalcy. The Fed only needs to signal its exit plan with clarity and less opacity so investors are not left guessing as now.


Tuesday, June 11, 2013

Fiscal Discipline Now Rather Than Later

Cartoon by Jim Gibson

Great news! The US government budget deficit is smaller than we expected. Now we don’t have to worry about that pesky thing. According to the Congressional Budget Office (CBO) we can expect the US budget deficit for 2013 to weigh in at only $642 billion. That amounts to 4% of the nation’s GDP. That is $200 billion less than expected just a few months ago. Get out the Swisher Sweets and Bud Light – it is time to celebrate.

That really is good news. What is not so good news is that more and more we are hearing that this improvement means we can forget about working on our government debt problems. Before this news was known various economists were reluctant to deal with the national debt problem because such a policy might weaken our economy and prevent a full recovery. Now that the major scare seems to be over, these people are emboldened and louder than ever. But they have it backwards. The recent budgetary progress means it will be even easier to solve our economic problems because we are that much closer to removing the negative impacts of the government on the economy.

Joe, the 5 foot 3 inch 400 pound 14 year old exclaims to his mom – I only gained 20 pounds this year. That’s great honey let’s celebrate by eating a fried potato farm.  That’s pretty much what these people are saying about the debt. A $642 billion deficit in one year means we ADD another $642 billion to our huge government debt. Adding $642 billion instead of $842 billion is definitely a good thing – but it does nothing to reduce the swollen debt. It simply makes it bigger at a slightly slower pace.  But notice that when you are at $642 billion it makes it easier to get to $442 billion…and then to $222 billion. This is the time to keep plugging away at the problem. It is not the time to smoke a cigar and hope good things keep happening.

The CBO’s figures show that the net federal debt which was at a bloated 66.8% of GDP in 2012 will rise to 68.8% this year and then to 69.9% in 2014. More typically this debt was about 35% of the economy before the crisis hit. So let’s say the debt load doubled in about five years. Even with very optimistic assumptions, the CBO sees the debt load at about 66% in 10 years (2023). It is like admitting that after averaging a svelte 200 pounds for much of your life, you have now ballooned to 400 pounds. You now have a 10-year plan to get back down to 375! What a joke. How stupid do they think we are? Don’t answer that.

Can I really make comparisons with overweight people and the government debt? Of course I can. While it is not easy or trivial to decide an optimal country debt load it is very difficult to deny that a country that usually runs debt loads of 35% is not in some way harmed by debt loads of twice that amount. Some experts say that the debt explosion was caused by a weak economy. But notice that the CBO has the debt load at 66% in 2023. They do not believe the economy will be weak for 10 years. It is not the economy that is causing the debt. It is government’s inability to govern that is causing this drag on the economy. Call this drag crowding out or simply call it risk aversion. Either way, too much debt is slowing us down and hurting the average citizen.

One more point that supports a more aggressive approach gets to the idea of jeopardy. Our President moans on camera about our inability to help flood victims one day; tornado victims another day; and Boston bombing victims yet another day. We should all be frustrated about the fact that there are important unmet needs that turn up every day. Your kid needs new braces for her teeth. Sorry honey, we just bought a car we can’t afford and the monthly payments mean we have to wait to get your teeth straightened. Obama cannot complain he doesn’t have enough money to help tornado victims at the same time he supports programs that keep our debt at no less than 66% of GDP for the next 10 years. If you want to be able to help in an emergency then you need an emergency fund. There is no emergency fund because we will spend this year $642 billion more than the government collects.

All of this is made worst by the fact that we know that interest rates are going to rise from their very low levels. This is important for many reasons but a primary consideration is that as interest rates rise we will pay more interest expense on the national debt. With the value of the debt rising AND interest rates rising – interest expense will be a larger and larger component of government spending. Interest expense cannot be cut. It must be paid. This makes cutting the annual deficit and the total debt even harder. It makes helping tornado victims harder.

The worry warts tell us that any attempts to reduce the deficit through policy will be more than the economy can handle. They compare a possible US plan to balance the budget to draconian efforts in Europe that have been blamed on much slower growth in that part of the world.   But we don’t have to do anything extreme with taxes and spending that would send us careening into another recession. We have seen numerous proposals floated that have teeth but which only gradually bring back fiscal discipline. But it is difficult to talk rationally about a national debt management plan when even the smallest unexpected reduction in the deficits leads to demands for more government stimulus. We now have a window of opportunity to restore competitiveness to our US economy. Having a larger national debt is not the route to that competitiveness.

Tuesday, June 4, 2013

Krugman versus Reinhart & Rogoff

Cartoon by Jim Gibson

Imagine the bar fight when Danny accused Mike of not being a scientist. You aren’t a scientist – nah nah nah. Yea, but your mom wears combat boots. It sounds pretty stupid – and sounds even stupider when Economist Krugman dukes it out with colleagues Reinhart and Rogoff.  I am guessing they are not having lunch together at the faculty table. Is Macroeconomics a science? Are these guys scientists? And why does it matter? In brief I would say yes, yes, and because we think it matters even if it doesn’t.

Wikipedia says a science is “a systematic enterprise that builds and organizes knowledge in the form of testable hypotheses and predictions about the universe…refers to a body of knowledge itself, of the type that can be rationally explained and reliably applied.”

For those of you not sufficiently trained in globbygook, just about anything fits this definition of a science if it is trying to “figure-out” something. Your two-year old puts your best carving knife into the light socket and you explain to him that there is something called ‘lectricity and note that the knife will take the ‘lectricity out of the wall and into your body and it will hurt.  You might not know it but you are acting as a physicist and you are using a body of knowledge called physics. Physics explains why the electricity will go into your body and harm you. Hundreds of other kids have already tested the hypothesis and laid a solid empirical foundation to support the theory. Pretty cool – physics is obviously a real science.

But so is macroeconomics. I can’t tell you how many hours I spent theorizing about econ stuff and how many more hours I spent running little experiments that end up either supporting or not supporting hypotheses.  For my doctoral dissertation I had a theory that said that Nixon’s Wage and Price Controls of the early 1970s would reduce inflation only if they reduced inflationary expectations. I spent about a year drinking JD and formulating a model, gathering data, and then running a bunch of statistical tests that might reject or not reject my theory.  To be scientific you need to start with a problem that you want to explain, have an explanation, and then try to put your explanation to the test. If your explanation fails the test, then you move on to sales or painting. If your explanation does not fail the test, then you hold on to it for a while – a least until someone has a better explanation than yours. It is like being a sheriff in the cowboy days of the Old West. You were sheriff until someone came along who was faster at the draw. Truth, like sheriffs, evolves. 

If you are still awake, you might retort that while economists pretend to do all that stuff, they are not REAL scientists like physicists and geneticists and sexologists. And for that opinion, you would be wrong. Why? Because Wikipedia cannot be wrong.  Look again at the definition of a science and you will see that the only real criterion is that you are trying to test your hypotheses. There is no single criterion that says whether your test is strong enough.  There is no single test of a theory being “good enough.”  You are the sheriff until someone beats you to the draw.

You might be surprised but if you think about it, it isn’t so strange. Take meteorology.  There are some things these weather people know and get right every single time. If a cloud reaches a saturation point then it is very likely to rain soon. But if you ever lived in Florida during hurricane season you know that there are some things that meteorologists almost never get right. Where exactly will the full force of a hurricane hit Sanibel Island? When will it arrive? How long will it stay there? These are very critical and important questions. Meteorology has a lot of good theories and they have put these theories to the test many times – but they still don’t succeed much when it comes to the most important questions.  Geneticists know a cell deformity or marker when they see one. But they still do not know when or if YOU will get pancreatic cancer. Other medical sciences can treat the symptoms of your cold but they cannot stop millions of people catching colds every year. 

Every science is the same. There are no REAL sciences. You either use the scientific method to advance knowledge or don't. Every science has things it can easily explain and other things it cannot. Let’s face it we have contrasting theories with respect to every aspect of our life. Should we floss or gargle? Take vitamins? Use synthetic oil in your car? Should I have my prostate checked every year? Who was better the Beatles or the Stones?

I am not belittling science. There is much we know. I am just making the point that there is much we don’t know. The low-hanging fruit is gone and every science is in the process of discovering new and important things. In that discovery process there are always competing models, competing scientists, and competing opinions. This is true in macroeconomics and it is true in physics.

So what’s the rub with respect to macro? The answer is that there is room for difference of opinion in some very important areas. Think of what we are trying to accomplish with policy. It looks easy on a power point slide – but how do we REALLY get the US economy to grow faster? Note that whatever policy we deliver, it will involve the actions and reactions of firms and households, spenders and savers, investors, domestic citizens and foreigners, and so on. Psychology and expectations will always be at work. The ages of the population this year and next will impact how policies create changes in behavior. It is a wonder that we ever get this question right. What size ark should we build when the floods come? I am guessing we could get some very different answers to that question too.

What galls me is not that economists get things wrong and not that they disagree about policy. What galls me is when they do not even try to act like scientists. Not checking data that supports a very strong policy position is poor science. Shooting from the hip without any real attempt to utilize a large body of information and data is likewise unforgivable. Arguing in voices that sound more like competitors in divorce court does nothing but reduce the confidence that people have in macro science. Economists need to put on their big-boy pants and quit acting like children. There will always be politics and ideology. The best economists will try their hardest to be above that fray.