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How Central Banking Has Evolved Markets Through Monetary Policy
Nicholas Bucheleres www.NJBDeflator.blogspot.com
“It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is most adaptable to change.” -‐-‐Charles Darwin Over the past two decades, the United States has seen prosperous levels of income and asset price growth. With real GDP climbing steadily and the Dow Jones having more than tripled since the mid-‐ 90s, most would say that the US merely hit a road bump in 2007. And that road bump just happened to be an extremely over-‐leveraged financial sector that was so desperate to reap profits that they traded peoples’ lives on the sketchy asset-‐backed security (ABS) derivatives market. But you can’t blame a dog for chewing through the sofa, blame the person who let the dog inside the house: the US Federal Reserve. I do not think that the Federal Reserve is a malicious entity within the US financial system, in fact, the Fed has been integral the this country’s economic success and has saved us from ruin many times since its inception in 1913. I don’t even necessarily blame the Fed for the loose monetary policy over the past two decades that arguably brought us into the current conundrum in the first place, but market participants must note the Fed’s increasing presence in financial markets. In the past decade, the Fed has stood not as a safeguard against ruin, but rather it has been controlling the world economy through coordinated and uncoordinated monetary policy. This is not a trend that began over since the 2008 crash, rather, this is a trend that has been slowly building over the last half-‐ century-‐-‐ a trend that has entered into a vicious cycle. This cycle has created a strong feedback loop that intensifies with further debt monetization by central banks around the world.
The Beginning of Boom-‐And-‐Bust Finance Equity prices (blue), national income (red), and public debt (green) had been rising healthily up until the stock market crash of 1987. The Fed’s response to the crash was one of monetary accommodation that included cutting the federal funds rate (and thus broader interest rates) and injecting liquidity into the market to help support prices. These accommodative policies carried over into the 90s, where we saw the most rapidly appreciating stock market in relevant American history: the dotcom-‐ bubble of the 90s. The Federal Reserve’s response to the ‘87 stock market crash has proven to be a turning point in the evolution of markets not only in federal policy, but also in market participants’ response to the Fed’s actions: a testament to human financial greed is the parabolic development in US equity prices that began in the early 90s and continued to a head in the early 2000s. The fact that market speculators were able to drive equity prices so high, so quickly, before crashing is evidence of how unprecedented such behavior was in modern United States finance. The Fed’s response to the dotcom crash? Lower rates and more liquidity. This time we see public debt begin to ascend more rapidly, but money supply does not increase by as much. The post-‐dotcom Fed slashed rates more heavily than it injected liquidity, partly because Americans were instructed (at the behest of US leaders) to own homes in the beginning of the 21st century. The Fed kept rates low and encouraged home purchases (and mortgages) in order to convalesce the economy from the 2000 crash, and investment bankers were glad to facilitate this process by bundling mortgages and selling-‐ off the risk. In 2005 equity prices began to turn parabolic again, but this time they were fueled by the expansion of credit introduced by the avant-‐garde asset-‐backed securities that allowed higher leverage (and effectively provided an expansion of credit). The underlying vulnerabilities of this boom caused US equities to sell off in 2007—a crash of over 40%, compared to the 30% sell-‐off of the dotcom crash— bringing US equity indices down to the trough of the 2000 dotcom crash. Fed Led Evolution The Fed’s responses to recent market calamities have empirically proven to catalyzed future crashes through an induced, never-‐ending boom-‐and-‐bust cycle of liquidity provision, which has rendered markets and asset prices catatonic without monetary easing by the Fed. That easy money, though, causes participants to become greedy and creates bubbles in broad-‐economy asset prices. Is the cure worse than the disease? Maybe not, but price engineering by the Fed is a reality. Although we might be seeing housing prices and employment bottom out, we are still facing serious risks that lie not only in Europe, but also importantly in China. Until we have a strong recovery in the real
economy, not just price appreciation, and until confidence and expectations rebound, equity (and to a lesser degree commodity) prices will be directly tied to quantitative easing by the Fed and international central banks.
The monetary base (blue) and the Dow Jones (red) aptly display the Fed’s monetary policy effects on equity prices: the first round of quantitative easing was from March 2009 through April 2010, and you can see the sharp increase in money supply in 2008 after the Fed agreed to buyback mortgage-‐backed securities (TARP). Immediately following QE1, markets sold-‐off and were desperate for another hit of liquidity. They got that hit in the summer of 2010 when Bernanke announced QE2 at Jackson Hole, and markets rallied through the summer of 2011 until the buzz wore off. Then we had the announcement of “QE2.5” dubbed “Operation Twist” that buoyed equities through Q1 2012. And there you have it: the previous four year “bull cycle” described through three bouts of monetary easing. As we can see, each round of quantitative easing has less of an effect than the round before it—diminishing returns to scale. In order for monetary policy— solely quantitative easing at this point because rates are already at zero—to be effective, the Fed will have to increase the magnitude of purchases and actions. This means that the next round of easing will most likely be even more “untraditional,” whatever that will mean. One thing is certain: it is going to be big. As I have noted in previous articles, though, why have equities so rapidly outpaced leading economic indicator performance such as housing and unemployment?
The velocity of money (blue) against the S&P500 (red) shows one reason for the divergence of equities from broad economic conditions. The Fed prints money, but each dollar that they print has a lesser-‐and-‐lesser effect (diminishing returns to scale). With a velocity of money as low as it currently is, the money that the Fed prints is sitting in digital bank vaults funding the deleveraging of the shadow banking system with very little demand for its use in the real economy. While the dollars that the Fed prints don’t necessarily find their way into the real economy and benefit consumers and borrowers, the printing does show up in the form of asset inflation in capital markets. Prices of stocks are bid higher as the US dollar-‐denominated stock prices need to adjust to a weaker dollar, accordingly wealth is spread throughout capital holders (Wall St.) but never finds its way to Main St. Further evidence of the Federal Reserve’s unintended, yet palpable malfeasant effects on the economy is the juxtaposition of M1 Money Multiplier (blue, below) and M2 Money Stock (red, below). A low money multiplier is indicative of a disruption in the monetary transmission mechanism that the Fed depends upon. As the Fed further suppresses the money multiplier through further balance sheet expansion and increases in the money supply, it is actually decreasing its ability to effect markets through those policies. Coincidentally, the money multiplier (below) topped out in 1987, the year of the stock market crash whose trough began the Fed’s monetary policy largesse: a perfect example of the Fed’s unintended malicious effects upon economic indicators and real growth. This is the reflexivity that forces the Fed to focus on price engineering rather than stimulating real growth— monetary policy simply cannot spur sustainable real growth.
Monetary Transmission Mechanisms Looking at the recovery through the rise in equity prices is obviously not a fair assessment of the real economy. Unemployment was rising and housing prices falling throughout much of the post-‐2008-‐ crash recovery. That is because the Fed’s quantitative easing programs did not effect “real recovery assets” at all. While I am very grateful that the Federal Reserve prevented the US from falling into a deflationary spiral that would have surely ended in all out depression, we must address what the quantitative easing actually did and where the money went.
Wages as a portion of GDP (blue) and after-‐tax corporate earnings as a proportion of GDP (red) have undulated between correlation and anti-‐correlation over the past half century, but a significant trend emerged in 1987: wages began to fall steadily while after-‐tax corporate earnings experienced large increases. The wage-‐to-‐GDP ratio is currently at its lowest in (at least) recent history and after-‐tax corporate earnings-‐to-‐GDP at their highest. These trends were exacerbated in 2000 and 2008 during those years’ respective crashes and ensuing expansionary monetary policies. This is essentially the Occupy Wall Street movement in one chart, put much more succulently than the protestors could mumble it: the encumbered economy is forcing corporations to cut back on expenses, including wages, while their profits remain in tact. The “Wall Street bankers” are less to blame than the protesters think; it is an unfortunate situation, but it has been three decades in the making. Also at work here are the supply-‐side economics (dubbed Reaganomics) of the 80s and the severe cost-‐ cutting that corporations engage in during financial crises, but regardless of the supply-‐side, monetary policy has done very little to revitalize the lower and middle-‐class consumers over the past half century, especially during times of financial crisis. These trends are self-‐reinforcing with more monetary accommodation: the upper-‐class that owns the factors of production see increases in income and wealth with inflation, while the middle and lower-‐ classes see their wealth erode with inflation as their cost of living increases and their (non-‐existent) wages are slower, if at all, to increase. Both of these trends reiterate why the middle-‐class of the United States is evaporating, which can be good in the short run for the few titans of industry that own the factors of production, but which is bad for everyone in the long run. This principle is perfectly demonstrated through the faux-‐recovery since 2008: asset prices, most notably equity prices, increased rapidly over the past four years while employment and home-‐sales have continued to fall. Why? Because those who work blue-‐collar jobs do not have access to the wealth gains that the rising equity prices bring to capital markets. This is not to say that this recovery was a bad alternative; it is to say that there must be an overhaul of the structural economy before we can say that we have officially exited the recession. Increasing wealth for the rich is fine in the short run, but in the long run, as the middle class disappears, so does a major constituent of United States GDP. Tax burdens on the wealthy increase in to finance entitlement programs and unemployment benefits for the soon-‐to-‐be lower-‐class, and we will find that the economy is actually worse off than if we made an all-‐inclusive effort to bring everyone out of the recession together, not just “distribute” the wealth from the top down. This is not possible through monetary policy alone, as we can see, and the trickle-‐ down effect is a bona fide myth at this point.
The University of Michigan Consumer Sentiment Survey (red), unemployment (green), and the Dow Jones (blue) paint the picture I described above: at the peak of the dotcom bubble in 2000 consumer sentiment topped out at 112; it is currently at 58. I reiterate—consumer confidence has never recovered from the 2000 stock market crash. In fact, consumer confidence has barley recovered from the ’87 crash. Also yet to recover from the 2000 crash is unemployment. Unemployment bottomed out at the height of the dotcom bubble and has never been as low since then. All the while, equity prices ratchet up all-‐time highs. This chart perfectly illustrates my antagonized belief that we have not recovered from the dotcom crash over 12 years ago. We have not taken time to structurally evolve our economy; all we have done is inflate asset prices and concentrated wealth among the already endowed, while having to tax them more in order to pay for the dislocated, unemployed middle and lower classes. The situation is unfair for everyone, but it’s better to have a highly taxed income than no income at all.
Structural Issues Also Present In Credit Markets
Above we have M2 money supply (blue, left-‐hand side) and commercial & industrial loans at commercial banks (red, right-‐hand side) since 1981. As a student of historical market crashes and inefficiencies, I always try to quantify such instances as "irrational exuberance" and "unsustainable expansion of credit," and the chart above highlights an interesting relationship between credit expansion and money supply. The relationship between money supply and business loans, rather the indexed spread between them, encapsulates the idea of "exuberant, irresponsible credit expansion." The amount of loans available within the economy is should be dictated by the supply of money. Loans rising too far above the money supply during booms is the uninformed speculator at the bottom of the information food chain greedily borrowing money to get a piece "the action," which is the definition of a market top or bubble. In a situation like this, one can find debtors taking out loans in order to finance principal and/or interest payments on previous loans; hence the inorganic and unsustainable rise in the amount loans outstanding. Notice that business loans put in an interim peak every time a recession hits (grey area); that is causation, not simply correlation...It goes to show how dangerous and catalytic irresponsible credit expansion can be for markets—irrational credit expansions that are normally led by lax monetary policy that gives the illusion of an endless supply of “cheap money.”
The real proof of this relation is in the differential between money supply and business loans, i.e., "The amount of loans available within the economy should be dictated by the supply of money."
Above is business loans minus M2 money supply (blue) indexed on the left-‐hand side and the Dow Jones Industrial Average (red) indexed on the right-‐hand side. As the chart clearly shows, each top in the equity market is shortly followed by a top in business loans relative to the supply of money; and each market bottom is followed by a rebound in business loans relative to money supply. It is important to note that the blue line is business loans relative to money supply, which does a great job at "grading" accommodative monetary policy's effect on the economy, rather than just on the stock market. As we can see, business loans rebounded somewhat robustly following the first three recessions of the last three decades, but we have yet to have a rebound in business loan activity from the 2008 lows, contrary to equity performance. Beyond that, business loan activity relative to money supply has been steadily making lower highs and lower lows since the dotcom bubble of the 90s. This means that while aggressive Federal Reserve easing has helped buoy equity markets after economic turmoil over the past two decades, it has done little to heal the underlying economy. Furthermore, there has not been a recovery in business loan activity from the recent recession, and business loans relative to money supply are still at their 2008-‐bottom levels. The Fed's quantitative easing programs are simply not the comprehensive solution to our economic foibles. The above chart is a perfect example of why our middle class is disappearing, and how it is affecting our economy. We added 15% of our GDP ($2.3trillion) to the economy through QE1 and QE2,
and look where that has brought us. The middle class is not "doing fine," and it is no fault of their own, but it is to the malaise of the entire economy. The Fed's quantitative easing programs don't have much more steam, but this economy is desperate for more: a paradigm shift is on the horizon. Japanification We have clarified that extreme dependence on monetary policy and central banking can effect asset prices, but has little tooth to boost the real economy. Monetary policy’s neglect for the real economy confuses growth with asset price bubbles and induces economies into range-‐bound asset price growth cycles that do not efficiently distribute wealth within a society.
The S&P500 (red) and the US 10-‐year Treasury yield/S&P500 differential [10-‐year yield minus S&P level, indexed] over the past 20 years perfectly display how “mean reverting” price engineering truly is. Each bout of price inflation requires, you guessed it, more debt monetization and yields the economy increasingly dependent on said easing. Interest rates plummet as equity and commodity prices soar until the Treasury/S&P differential reaches the indexed spread of ~400. Once reality rears its ugly head, markets whiplash down, forcing asset prices back to their “mean” and closing the Treasury/asset differential, until the next round of easing. The further we go down the rabbit-‐hole of debt monetization, the closer we are to the “Japanification” of the United States. As we put more faith dependence in central banking and increase our debt-‐to-‐
GDP ratio under the hope that “this time it will actually work,” we are knowingly embarking on a well-‐ studied path that that is the “recovery” of Japan after their financial crisis of the 80s.
During the late 80s Japan and South Eastern Asian suffered asset price bubbles fueled by ultra-‐ accommodative central banks and sovereigns. The economic laxness caught up with the Japanese, as it always does, and that is when their debt-‐to-‐GDP ratio really began to soar. A decade after the onset of their crisis the debt-‐to-‐GDP ratio hit 103%-‐-‐the current ratio of the United States. What happens over the next 17 years in Japan is more of the same as the initial response to the financial crisis, and now Japan’s debt-‐to-‐GDP ratio is over 200% and rising; what is supposed to prevent the US from falling into the same printing trap as Japan? What’s Next? Five years into this recession, and not only do we lack a clear-‐cut solution for our growth, but every week it seems there is a new international headwind. Europe may be on the brink of a full continental collapse sparked by their highly integrated failure of a banking system; China’s manufacturing is slowing and their property bubble is reaching a peak; if/when China falls, then we will see Australia and the rest of Asia fall. These are not predictions, they are contingent facts, and central bankers know this, so we can expect more of the same in terms of accommodative monetary policy in the near future. The next round of internationally coordinated monetary
accommodation in the form debt monetization or direct asset purchase will be the largest number that most international citizens have ever heard in their lives. We are talking about a number close to 10% of the world GDP (world GDP=$59trillion). Due to the aforementioned diminishing returns to scale of monetary policy, I project the next round of liquidity to be at least $3trillion , and I would not be surprised if we reached $6trillion by the end of it. The next round will come after international equity markets fall further, there are more bankruptcies, and leading economic indicators deteriorate even more [September Update: the ECB has pledged unlimited bond purchases to lower European yields]. This is not because the Fed is behind the ball (although it usually is); it is because the costs of further easing currently outweigh the benefits. Remember, the quantitative easing programs are meant to prevent economic ruin, not to inflate asset prices and achieve new highs in asset markets. The outcome of the next round of monetary policy will be similar to those in recent history mentioned in this paper, but this time, it should it might actually kick-‐start the nominal economy as perceived inflation will go through the roof. We’re talking about near 0% interest rates around the developed world [near-‐term rates in Germany hit 0% in the auction at the end of May and are expected to go negative]. Oh yeah, and massive inflation. I think gold will have no trouble hitting $3,000/oz in the medium-‐term and I see copper tripling over the next decade. This is, of course, until we hit the next bubble sometime around 2018 and start over again. The trend remains: since the stock market crash of 1987, through the dotcom bubble, and into the real-‐estate & stock market bubbles of 2007, each euphoric high and ensuing crash have been more extreme than the last. These extremes are fueled by the easing that is meant to cure us. The policy that we are facing within the coming months/years will, as the trend dictates, trump them all, and so inevitably will its hangover. We will continue to set range-‐bound highs in equity markets for years to come, but asset prices and the nominal economy will continue to outpace the real economy until we see structural reforms addressed over liquidity provision. It does not appear that will be the case for a while, though. Consumer confidence is so low around the world that unless further easing is pursued, the bottom very well could fall out of the global economy. Until then, there is no ceiling to money printing and central bank financial engineering. Welcome to the 21st century. Questions, comments, suggestions, or to request chart pack, email me: email@example.com
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