Surging Interest Rates

Last week I wrote about the hysteria about rising inflation. This week I want to focus on interest rates. The story line goes something like this. The Fed has recently been raising interest rates and the Fed now plans to raise them several times next year. This increase in interest rates will pummel the economy and therefore the stock market will take a dive more powerful than a flock of pelicans in a feeding frenzy.

The below chart is useful for thinking about interest rates and recessions. Both lines are annual averages for each year. The chart goes from 1953 to 2017. The blue line is the interest rate set by the Fed. It is called the Federal Funds Rate but we can call him FFR. The red line is the rate on 10 year Treasury Bonds. Let's call that one 10TB. 10TB is usually on top of FFR but please no sexual jokes. The FFR is below most interest rates since it is known to be a measure of the cost of funds for banks and other financial institutions. These institutions lend money at a rate above FFR so as to make profits. Being a floor rate -- when the Fed raises the FFR we expect most other rates to rise too. A rising tide lifts all boats or something like that.

As the chart below shows the Fed has raised the FFR, depending on how you count them, about 12 times over those 65 years. You can also see there are 9 vertical grey bars in the chart indicating recession years.In the case of every one of those recessions you can see that they were preceded by a rise in the FFR. But notice too that this FFR/Recession relationship is less like Fred and Ethel and more like Ricky and Lucy. That is, the relationship is highly unstable.

          It took a huge increase in the FFR from 1976 to 1980 (and then to 1982) to cause two recessions. The FFR went from 5% to more than 15% -- a tripling -- to create those two recessions.

          The 1990 recession was preceded by a rise in the FFR from 6.7% to 9.2% from 1987 to 1989. Strangely the FFR was already starting to fall before the recession hit.

          The next recession didn't start until 2001 and while the FFR doubled from about 3% to 6.2%, it took from 1993 to 2000 to increase that much. Like the recession in 1990, this one didn't last very long.

          The big recession of 2008/2009 looks peculiar. The FFR rose from 1.4% in 2004 to 5% in 2007 but then fell to 1.9% right before the recession. So we have four years of FFR action before that recession. But how much the FFR had to do with that recession depends on whether you use the 5% rate in 2007 or the 1.9% rate in 2008. And, of course, that recession had a lot to do with bad housing loans and less to do with FFR policy.

Some people seem to have a lot of clarity on their favorite bourbon as well as the impact of the FFR on the economy. I don't see it myself. While I love JD I also realize there are a lot of very interesting bourbons out there. And when it comes to the Fed lifting rates in 2018, I am not highly confident that such policy actions will lead to the economy or the stock market crashing.

A note on interest rates. This graph is very interesting. Notice the strong upward trend in interest rates before 1981 and the following 37 year downward trend. Much of that has to do with inflation. It makes sense that interest rates should be impacted by inflation. If you expect a rise in the inflation rate, investors demand a higher market interest rate -- because they know that inflation reduces the buying power of the future interest and principle payments they will receive. Just as coal miners wanted a 39% pay increase in 1979 (for a three-year contract) to shield them from high expected future inflation, financial market investors want higher returns.

Thus inflation and inflation expectations distort the graph. But for my purposes today, working with market rates creates no real distortions. The FFR is always quoted in nominal terms and the question here concerns whether policies that raise the FFR have a reliable relationship with dire changes in the overall economy. My answer is no.

One caveat. Caveat is a foreign word for cover my butt. Should the Fed raise the FFR a lot  more and should they sustain that policy for a couple of years, then I'd start selling my bitcoins and Apple stock.
   

Inflation is Roaring Back

A picture is worth a thousand words. Right?

I guess you can answer that question. At the heart of current discussions about the US economy is whether or not the inflation monster has awakened from its long nap and is about to devour us. Since the future is all about the future and only the Great Tuna knows the future, the rest of us can only make silly statements and forecasts about it. So in that spirit I thought I would ask Fred to draw a picture that we could gaze upon.

But before we gaze, let me try to summarize the issues. The US economy is stronger as evidenced by a low unemployment rate, tighter labor markets, rising wages,  higher inflationary expectations, and higher actual inflation. While most of that sounds lovely and juicy like a large steak au poivre, apparently people who own things like stocks and bonds were scared out of their bejeezers by this story. When hearing this information from Charlie Sheen, they sold their stocks like a new shipment of socks in Venezuela.

Another way of saying this is that we are in a new epoch in which good news is bad news. A strong economy apparently means a weak economy. A strong economy with promises of better profits and higher incomes means something horrible is going to happen. Are we supposed to hope for bad news so that will mean better future outcomes? To be less sarcastic, the false news being spread is that a strong economy and tight labor markets mean that wages and prices will grow too fast -- with the buying power of the wages being eroded as productivity peaks and falls. In the meantime, the Fed will react by raising interest rates and somehow moving interest rates up a few notches will cripple the strong economy. And then the rise in government deficits will pile on the parade by causing even more inflation.

Don't you just love macro? You don't have to answer that.

So there we are as we gaze at the chart below. I graphed two series -- the red line is the CPI. The blue is earnings of workers in the private sector. Each is monthly data from 1970 to the end of 2017. I graphed the growth rates of both series -- each represents the percentage change in that month relative to the value in that month a year before. Thus the data points are monthly but they are smoother than taking the percentage change from one month before. Some of the month-to-month craziness or variance gets removed and lets our eyes focus on more persistent or durable changes.

The reason for graphing these two series over a long period is to gain some perspective on the more recent changes. For example, look at the red line (inflation) since 2015. It is clearly rising indicating a rising inflation rate. Notice that the blue line (workforce earnings) shows no such increase. In fact, the wage line has been generally falling and flattening since about 1997. Thus, the very clear uptick in inflation does not seem to be caused by anything happening to wages. Perhaps inflation is being impacted by oil prices or the price of Donald Trump's hair cuts. Or maybe inflation got tired of being so low. The rise seems large only in relation to the very low rates after the last recession.

One clear thing in the chart is that inflation and wage gains often accelerate before a recession. The grey bars indicate recession years. Before most of the recessions wages and prices did accelerate and that was mostly because the economy was growing at unsustainable rates. Notice too that it often takes several years of rising inflation and wages before bad things start to happen.

Also notice from the chart that we do not know when the next recession will start and clearly we know that the economy has not been rising at unsustainable rates. Much of the writing in the last years laments that the economy is growing too slowly. But these things can change and we are right to wonder if the economy will grow faster, wages and prices will careen upward, and a recession will follow. It is right to wonder. But it seems crazy that such a possibility makes us crazy. Crazy enough to cause a stock market collapse.

Graphs are food for thought. I pointed out a few things from the graph. What about you? What does this graph whisper to you? Is inflation on its way to scary levels?

Americas on First. Whats on Second.

Abbot and Costello made a very funny skit about baseball – the most famous lines were: who's on first; what's on second; I dunno is on third. It is one of the funniest bits ever. Try it at youtube: https://www.youtube.com/watch?v=kTcRRaXV-fg

The point of that bit is that language can be confusing. Abbott and Costello talk past each other in a very revealing way. It reminds me of what we have today with the phrase "America First". In the destructive political environment we live in today, even such innocuous words can cause extreme, emotional, even violent reactions from the poles of the political spectrum. So I thought I would have a little fun with that today.

In grade school, I was usually first in line for recess and lunch. Being first was not anything to envy. America is not first in a lot of things and for good reason. I doubt we could ever place first in a rugby or a badminton match. And of course, China and India have us beat on population, and we are even pretty far down the list when it comes to income per person. You can’t be first at everything.

Which brings up lots of things America is good at. We are best in the world at American football. No one makes bourbon or JD like Americans. It’s not easy to beat America at swimming or average wealth per person. Then there is Kentucky Fried Chicken and McDonalds.

So what is the big deal when it comes to America First? President Trump says he wants to make America great again and he wants to do it by putting America first. That sounds pretty intuitive but maybe not. Think about most relationships. Percy Sledge’s second verse in his song When a Man Loves a Woman goes like this:

When a man loves a woman
Spend his very last dime
Trying to hold on to what he needs
He'd give up all his comforts
And sleep out in the rain
If she said that's the way
It ought to be

Sleeping out in the rain is not my idea of a good time but Percy had it right – the best way to have a great relationship is to put your friend in first place. There is no competition here. A rising tide lifts all boats. Not putting yourself in first place is sometimes the best way to be tied for first place.

Got you humming the song, right? What a great song. Anyway, the point is that this works for America too. I am trying to not imagine a ménage à trois with President Trump, Theresa May, and Angela Merkel but it is true that the US has great relationships with many countries. Thumbing your nose at them or somehow threatening them is not always the best way to do what’s good for the USA. Again, America First might mean America selfishly making nice with our friends abroad. (Notice I said with our friends.)

So is there any sense in which America First is a positive slogan? I think so. When you won the spelling bee in fifth grade you were proud of yourself. When you played on the state championship athletic team you were equally proud. When the US Olympic team came in first you might have raised your fist into the air with pride. Moving to first chair in the orchestra made your parents beam with pride. Being first can be the sign of things that are very good for us.

You practiced every day. You set goals and tried to achieve them. You learned the value daily of learning from your mistakes. A competition can sometimes make you even better than you were. This learning doesn’t just make you the kid that got the trophy. It turned you into a person who takes great pride in solving problems, learning new things, and being a great example for people around you.

Trying to make America first in terms of job opportunities, corporate competitiveness, and governance is valuable. It is not so much that we come in first. What matters is that we try to come in first. Being first isn’t great for everything. Being first despite everyone else is clearly not often the best path. Being first to make yourself better, however, is hard to argue with.

But what about America first with the underscore on America? We have 300+ million here some of whom were not born in America. My mother came to the USA in 1929. Apparently, her father was not good at picking years. But they came from Budapest and made the USA their home. My mother became a citizen and I never once heard her say Hungary first. She taught me about Hungarian culture and she made stuffed cabbage Hungarian style that was to die for. But like many of us, she rooted for America. Her husband (my father) fought in World War II and like most people in America he wanted America to win the war.

Does that mean that we all have to approve of everything done by the American government or its people? Of course not. This is a free country and we have the rights to disagree, to speak out, to protest, and so on. But the question of America First in this context is how you come down on the great majority of things. If it turns out that you resist everything done by Americans, then I would question why you even want to live here. America First means to me that you have taken America to be your home and that when it comes to the full system, warts and all, America comes first and the rest of those places are at least a step behind.

Depreciating the Dollar

Secretary Mnuchin was asked if he ever spanked his child. He said he had heard that a spanking might be an effective parental tool at times for some children. The next day, he was arrested for advocating spanking to world leaders.

No not really. He did not say that. But Mnuchin did say he had heard that a depreciated currency might lead to more exports from that country. Immediately he was piled on by everyone from Tiny Tim to Tom Brady. Despite Mnuchin repeating a mantra found in almost every book on international trade, the world decided that Mnuchin had cleverly advocated a US policy to reduce the value of the dollar. Shout it from the housetops -- the new US policy is to depreciate the dollar so exports will rise and Americans will be protected from the world's vandals. No, not really. Could the press get any lamer?

But this is not about beating up the press. It is about ideas and facts. The first fact is that the dollar, despite limping a bit lately, is pretty darn strong. Second, most of us haven't a clue what it means to have a policy to depreciate the dollar. So let's work on that today. First, do 10 burpees.

The lovely chart below I graciously got from our good friend FRED at the St. Louis Fed. https://fred.stlouisfed.org/ It shows the exchange value of the euro versus the dollar. The euro is just one of many currencies I could have used, but this one is fine for our purposes. The chart shows that before 2000, one euro was able to command about 1.15 dollars. By 2008, the euro greatly appreciated (the dollar depreciated) to where one measly little euro could buy almost 1.6 dollars. At that time, the dollar was really weak. At the close of the business day on Friday, January 26, 2018, the quote was 1.24 dollars to a euro. Since 2008, the euro is much weaker and the dollar is much stronger.

• Since way back before 2000, the dollar weakened considerably through about 2008.
• Since 2008 the dollar is much stronger
• Since 2009, 2010, and so on the dollar is stronger
• There is a weakening of the dollar since sometime in 2017.

As far as the euro data show, the dollar is pretty strong. Things have turned of late but clearly not enough to change the general impression of a strong dollar.

So my first point is that there is no evidence of any real weakening of the dollar. But what if this short-term turn means the dollar is going to continue to fall. So what? And would our government want that outcome enough to actually promote it?

Even small birds know that a depreciated currency is good for exports, right? Sorry Charlie, but not really. Often a depreciated currency simply means a country's goods have become less competitive in global markets. If foreigners prefer France's goods over US goods, they don't need as many dollars and thus the value of dollar falls. Thus the depreciated dollar may simply be the sign that a country's goods have lost favor in the world. A falling dollar does nothing to heal the thing that produced the decline in competitiveness.

But that is not the whole story. Not by a long shot. A depreciated dollar means that US households who want to import Cognac from France or sausages from Germany will find all that stuff costs more. If they really prefer these imported goods over US goods and continue buying them, then they have to pay more. Ouch. I am not sure our US government wants to be responsible for that ouch.

And that's not even the whole story. We love it when foreigners invest in the USA. If they buy stocks, they drive the stock market up and we get richer. If they buy bonds, they drive interest rates lower and we can borrower cheaper. If they invest in new businesses, employment and wage opportunities improve. In short, we love it when foreigners invest in the USA. If foreigners believe the dollar will fall, then this weakens any returns they would expect to gain in the USA. That's because to bring their earnings home to their countries, they will have to use a depreciated currency. Would Mr. Mnuchin really want to be responsible for telling those foreigners not to invest in the USA?

It is true that some countries -- especially developing countries that rely greatly on foreign exports for growth and development -- take measures to depreciate their currencies. It is unfair and it hurts the US when these countries do so but that does not mean that it makes sense for rich, industrial countries like the US to copy them. Often when these countries behave like that they are breaking international trade rules, and there are ways to address those issues without following bad policy with more bad policy.

Furthermore, playing exchange rate bingo with the rest of the world is not a winning strategy. We can hope to expand our exports by depreciating the dollar but then export-dependent countries will simply retaliate. They have much more to lose than we do. It is hard to see us winning that game and in the meantime we all suffer.

Mnuchin denied it was the policy of the USA to depreciate the dollar. Let's all hope he really means that.