The Magic Is Back

Misplaced Angst About Fed Asset Purchases

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

The Magic Is Back

The Feds Congressional (Public) Responsibilities

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The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

Growth is a means, not an end

Real GDP (annualized percent change)

The Magic Is Back

8 7 6 5 4
4.3 2.9 2.0
3.1
Forecast

8 7 6
3.0 2.4 1.9
3.5

3.8

3.8

5
3.5 3.5

3
2 1 0 -1 -2 -3

2.8 2.0 2.0

2.7

3.0

3
2 1 0 -1 -2

0.2

-0.2

-2.8
% change from the previous quarter
% change from four quarters earlier

-3

-4
-5 -6 -7

-4
-5 -6 -7

% change over the four quarters of the year

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

Source: US Department of Commerce. Updated through 2013 Q3.

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

Maximum employment is not just about this

Unemployment rate (percent)

The Magic Is Back

12 11 10 9
Proved to be premature and the Fed backed down
Horizontal bars denote the Fed's view (forecast range) about the near-term and sustainable unemployment rate (often referred to as the Nairu, or nonincreasing inflationary rate of unemployment)

12 11 10 9

8
7 6 5 4

8
7 6 5 4

3
2 1 0
Note: The red boxes identify the first step in each Fed tightening sequence.

3
2 1 0

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

Sources: Vertical bars denote recessions and are designated by the NBER; US Department of Labor. Updated through December 2013.
The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

Recent dropouts were not all retirees

Selected employment reference points (thousands)
90 55

The Magic Is Back

85 16 to 24 year olds (right scale)

50

80 35 to 44 year olds (left scale)

45 to 54 year olds (left scale)

45

75
25 to 34 year olds (left scale)

40

Over 55 years of age (right scale) 70 2007 2008 2009 2010 2011 2012 2013 2014 35

Source: US Department of Labor. Updated through December 2013.

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

A comprehensive view of true unemployment

Selected employment reference points (thousands)
0.50 0.50

The Magic Is Back

0.45

All over 16 years of age or older who are not classified as employed

0.45

0.40

0.40

0.35

0.35

.............. 0.30

16- to 54-year olds who are not classified as employed 0.30

0.25

0.25

0.20 1947

0.20 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012

Source: US Department of Labor. Updated through December 2013.

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

What about inflation says the Fed is off base?

Core PCE chain price index (percent change from 12 months earlier)

The Magic Is Back

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10 9 The FOMC's forecast for PCE chain price inflation and longrun goal

11
10 9

8
7 6

8
7 6

5
4 3

5
4 3

2
1 0 1960

2
1 0

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

Range of FOMC forecasts for PCE inflation. Sources: Vertical bars denote recessions and are designated by the NBER; US Department of Commerce. Updated through November 2013 (inflation) and December 18, 2013 (FOMC forecast).
The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

The Magic Is Back

Three Monetary Weapons ... (1) Short-term interest rates (federal funds rate); (2) Communications (the future path of the funds rate); (3) Asset purchases (long-term interest rates)

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The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

The zero-floor on rates forced the Fed to look to LSAPs

Federal funds rate and nominal 10-year Treasury yield (percent)

The Magic Is Back

20

20

16 10-year Treasury yield

16

12

12

Federal funds rate

60

65

70

75

80

85

90

95

00

05

10

Sources: Vertical bars denote recessions and are designated by the NBER; Federal Reserve Board. Updated through January 10, 2014.
The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

Asset purchases helped the Fed to ...

Nominal and inflation-adjusted 5-year Treasury yield 5 years in the future (percent)
4,750 All factors supplying Federal Reserve reserves 4,500 4,250 4,000 3,750 3,500 3,250 3,000 2,750 2,500 2,250 2,000 1,750 1,500 1,250 1,000 750 500 250 0 Aug 2007 Aug 2008 Aug 2009 Aug 2010 Aug 2011 Aug 2012 Aug 2013 Aug 2014
Forecast

The Magic Is Back

4,750 4,500 4,250 4,000 3,750 3,500 3,250 3,000 2,750 2,500 2,250 2,000 1,750 1,500 1,250 1,000 750 500 250 0

Other Fed credit

TALF (Dec 31, 2009) Credit extended to AIG, Inc.

Central bank liquidity swaps (Feb 1, 2010) Discount Window Term auction credit
RPs MBS

GSE debt Securities in reverse RPd with foreign official and international accounts Securities committed to reverse repurchase agreements with dealers Securities loaned to dealers through the TSLF term facility (Feb 1, 2010) Securities loaned to dealers through the overnight facility Unencumbered Treasuries and agencies

Source: Federal Reserve Board. Updated through January 8, 2014.

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

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... hold long-term rates down, when needed

Nominal and inflation-adjusted 5-year Treasury yield 5 years in the future (percent)

The Magic Is Back

7
6 5 4 3
Five-year forward inflation expectations plus inflation risk premium (5 x 5 breakeven) Five-year forward Treasury yield (5 x 5)

7
6 5 4 3
Five-year forward real Treasury yield (5 x 5 TIPS)

2
1 0

2
1 0 -1

-1 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: Federal Reserve Board. Updated through January 10, 2014.

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

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The Magic Is Back

Fed asset purchases have nothing to do with money, QE, liquidity, flooding the world with cheap money, the Weimar Republic, inflation, printing presses, monetization of debt ...

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The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

Claims that this is about printing money are off base ...
Wilshire 5000 (Dec 31, 1970 = 830.27)

The Magic Is Back

20,100 18,090
16,080 14,070 12,060 10,050 8,040 6,030 4,020 2,010 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

20,100 18,090
16,080 14,070 12,060 10,050 8,040 6,030 4,020 2,010 0

Source: Dow Jones. Updated through January 10, 2014.

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

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... and ignore the earnings that guide equity markets

Wilshire 5000 (Dec 31, 1970 = 830.27)

The Magic Is Back

After-tax GDP profits (billions of dollars)

22,500 20,250
18,000 15,750 13,500 11,250 9,000 6,750 4,500 2,250 Shaded area represents after-tax GDP profits (right scale) Line represents the Wilshire 5000 index (left scale)

Forecast

2,100
1,800 1,500 1,200 900 600

300

0 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020
Note: the Wilshire 5000 P/E has averaged 10.6 since 1947, excluding the unprecedented multiples during1997 - 2001.

Note: scales aligned to the historical 10.6 times price-earnings average (for these measures) ex. the 1990s. Sources: US Department of Commerce; Dow Jones. Updated through 2013 Q3 (profits) and Dec. 6, 2013.
The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

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Why the Feds critics got off on the wrong foot

Monetary base (billions of dollars)

The Magic Is Back

4,000 3,800 3,600 3,400 3,200 3,000 2,800 2,600 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 1970

4,000 3,800 3,600 3,400 3,200 3,000 2,800 2,600 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0

1975

1980

1985

1990

1995

2000

2005

2010

2015

Source: Federal Reserve Board. Updated through December 2013.

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

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Fed asset purchases create no money, because ...

Monetary base (billions of dollars) M2 (billions of dollars)

The Magic Is Back

4,000 3,800 3,600 3,400 3,200 3,000 2,800 2,600 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 1970

Monetary base (left scale)

The money supply, M2 (right scale)

40,000 38,000 36,000 34,000 32,000 30,000 28,000 26,000 24,000 22,000 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0

1975

1980

1985

1990

1995

2000

2005

2010

2015

Source: Federal Reserve Board. Updated through December 2013.

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

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... the reserves created by LSAPs are excess (in quarantine)

The Magic Is Back

Selected components of the monetary base (billions of dollars)

4,000 3,800 3,600 3,400 3,200 3,000 2,800 2,600 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 1970

The monetary base = currency in circulation + required reserves + excess reserves (left)

M2 (right scale)

40,000 38,000 36,000 34,000 32,000 30,000 28,000 26,000 24,000 22,000 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0
1995 2000 2005 2010 2015

1975

1980

1985

1990

Source: Federal Reserve Board. Updated through December 2013.

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

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The Magic Is Back

Markets have largely discounted the end of LSAPs

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The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

How markets see it ... inflation views are steady ...

Nominal and inflation-adjusted 5-year Treasury yield 5 years in the future (percent)

The Magic Is Back

7
Five-year forward Treasury yield (5 x 5)

7
6 5
Five-year forward inflation expectations plus inflation risk premium (5 x 5 breakeven)

6 5 4 3

4 3

2
1 0 -1 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Five-year forward real Treasury yield (5 x 5 TIPS)

2
1 0 -1

Source: Federal Reserve Board. Updated through January 10, 2014.

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

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... and if you look beyond the ZIRP window ...

Nominal and inflation-adjusted 5-year Treasury yield 5 years in the future (percent)

The Magic Is Back

7 6
5 4 3 2 1
Five-year forward real Treasury yield (5 x 5 TIPS) Five-year forward inflation expectations plus inflation risk premium (5 x 5 breakeven) Five-year forward Treasury yield (5 x 5)

7 6
5 4 3 2 1

0 -1
-2 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

0 -1
-2

Source: Federal Reserve Board. Updated through January 10, 2014.

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

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... the forward (5 x 5) real rate is not far from steady state
Nominal and inflation-adjusted 5-year Treasury yield 5 years in the future (percent)

The Magic Is Back

7
6 5 4 3
Five-year forward inflation expectations plus inflation risk premium (5 x 5 breakeven) Five-year forward Treasury yield (5 x 5)

7
6 5 4 3
Five-year forward real Treasury yield (5 x 5 TIPS)

2
1 0

2
1 0 -1

-1 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: Federal Reserve Board. Updated through January 10, 2014.

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.

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The Magic Is Back

The Mechanics of Finance, The Milken Institute and the National Press Foundation, Washington DC, January 14, 2014.