One thing overlooked in Friday’s weak Q2 GDP report was that YOY nominal GDP grew at 3.9% which is in line with the post-recession recovery average. It’s not going to cut it from the standpoint of what we need to close the output gap, but it’s a far cry from the debilitating contraction in nominal growth we experienced during 2009.
Nevertheless with data continuing to reflect a sluggish economy, or more importantly, continued weakness in the employment picture, all signs point to further accommodative measures out of the Federal Reserve. The chatter out of the press and various Wall Street dealers suggests that a new round of QE is on the offing.
The question for investors is not whether QE III will happen, but rather what it will look like. By all accounts a simple extension of bond market purchases would have a muted impact with yields already so low. Other suggestions include reducing the interest paid on excess reserves (IOER) banks hold at the Fed, but it would seem that at the current 25bps, if a bank had a better place for that money it would be putting it there.
Last week I read a Bloomberg story citing a report out of BAML’s Ethan Harris and Priya Misra that suggested that the Fed’s “nuclear options” included things that I think are going to get a lot more consideration, like imposing a ceiling on yields, weakening the US dollar via FX intervention, a money financed fiscal expansion and raising the inflation target.
When then Governor Ben Bernanke gave his infamous “helicopter speech” titled Deflation: Making Sure “It” Doesn’t Happen Here
, he outlined what he viewed was the central bank’s “ammunition” for fighting deflation risk when the funds rate has been forced to zero, and you might say that Fed policy post-financial crisis has been an exercise in crossing these options off the list.
Now that interest rates are at the zero bound the next “tools in the toolkit” range from buying foreign government debt to dollar devaluation. I believe that due to our reliance on foreign financing of US Treasury debt (50% of outstanding) that an outright dollar devaluation is not in the cards for fear of alienating our lenders and disrupting global capital markets. Plus he states as much in his speech. Bernanke’s next options on the list are a money financed tax cut and/or direct purchases of private assets.
Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.
Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.
We are dealing with a desperate Fed and it could call for desperate measures. You know he’s not going to get any help from fiscal authorities so he may have to take Sen. Schumers’ suggestion and just go at it alone. Something like the purchasing of private assets indeed could be Bernanke’s nuclear option, and it’s quite possible he bypasses the banking system to inject the liquidity.
I think we will start to hear more about a program along the lines of a nominal GDP (NGDP) target that is used to justify direct purchases of private assets. What is a Nominal GDP Target?
The idea of targeting NGDP would be to place an extrapolated dollar amount on the output gap based on a specified growth rate and the Fed would commit to tightening or easing based on where nominal growth deviated from that trajectory going forward.
Until recently the idea of an explicit NGDP target was a policy advocated by who would probably be considered fringe economists calling themselves Market Monetarists
The market monetarism school of macroeconomics advocates that central banks target the level of nominal income instead of inflation, unemployment, or other measures of economic activity... Market monetarists prefer a nominal income target due to their twin beliefs that rational expectations are crucial to policy, and that markets react instantly to changes in their expectations about future policy, without the "long and variable lags" highlighted by Milton Friedman.
But last October, one of the most respected Wall Street economists, Goldman’s Jan Hatzius published a report, titled "The Case for a Nominal GDP Level Target"
that I think put the policy option on the table. Hatzius’ predecessor is current NYFRB President Bill Dudley who is one of Bernanke’s so-called dovish lieutenants.
We believe that the best way for the Federal Open Market Committee (FOMC) to deliver significant additional easing would be to target a nominal GDP path such as the one shown in Exhibit 1, indicating that it will use additional asset purchases—and all other available policy instruments—to ensure that actual nominal GDP reverts to trend over the medium term.
I don’t dispute the idea of a NGDP target. I think it does make a lot of sense over the long run; however, the key is not about whether we should aim for a level of NGDP in the future but rather how do you get to the optimal level from here and from what level do you extrapolate the growth rate.
More from Hatzius:
The specific path in Exhibit 1 is calculated as the level of nominal GDP in 2007 extrapolated forward at a rate of 4½% per year. We can think of this number as the sum of real potential GDP growth of 2½% and inflation as measured by the GDP deflator of about 2%.
That sounds good and great but as you can see on his chart that puts the current output gap 10% higher just over $17t vs. today’s NGDP of 15.595t. Running regression analysis on various starting points yields very different output gaps. For example, if you start in 1945 you are looking at $23t but if you start in 2002 the number drops to a much more manageable $16.4t. It doesn’t seem reasonable to start in 2007 considering that NGDP number was reflecting nominal spending coming from a massive credit bubble economy.
Regardless you are still talking about creating a few trillion in nominal growth (i.e. inflation) out of thin air over the next couple of years. How do you do that when consumers won’t borrow? It goes back to the “helicopter drop” Bernanke cites in his speech or purchasing private assets. It sounds crazy but what if they in effect just mail everyone $10,000 or offer to buy used computers, flatscreen TVs, upside down SUVs and condos in Florida at 2x the value. It’s no crazier than a money financed tax cut.
If the Fed did go nuts and drop money from the skies they would be naïve if they thought it would not elicit a severe market response. The inflationary tail risk would likely manifest itself in an immediate collapse in the US dollar and a corresponding rise in long term interest rates. The prudent thing to do would be to raise short term interest rates a bit to help protect the dollar and anchor the curve, but we aren’t dealing with a prudent Fed Chairman. We are dealing with Dr. Strangelove.
In the April FOMC
press conference Bernanke specifically commented as to whether the Fed would accept some higher inflation in order to bring down the unemployment more quickly.
I guess the question is, does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased reduction – a slightly increased pace of reduction in the unemployment rate? The view of the committee is that would be very reckless.
If they launch QE III whether they employ an explicit NGDP target or not the objective is the same. In order to bring down unemployment the output gap must be closed, and the options for doing so without accepting higher inflation are dwindling. When Operation Twist ends they are effectively out of bullets, and to continue buying they will have to print. Despite what he said in April, if he continues to follow the path he outlined in 2002, the nuclear option could be a very real possibility.
I think it’s quite possible the equity market is discounting this nuclear option. The market knows where the output gap is and knows the Fed won’t stop until we close it. When I wrote about how to navigate this market in Trading The Wrong Playbook Bubble
back on June 12 it was not meant to be facetious; it was meant to suggest the market isn’t discounting traditional fundamental metrics.
With Ben Bernanke having turned all assets into commodities, market price is not driven by valuation and growth based on models and forecasts, it’s driven by positioning and sentiment based on speculation and fear.
In case you hadn’t noticed, market price has been ignoring all valuation and growth metrics based on models and forecasts. This past week was a perfect example. As suggested in US Monetary Policy: On a Magic Carpet Ride
, the positioning and fear continue to point toward a deflationary collapse based on deteriorating fundamentals, but price action continues to fade this reality and may be telling a different story.
Are stocks discounting a rising inflationary environment, and will a rally to new highs finally prick the bond market bubble and unleash this flood of liquidity into the system? It’s difficult to handicap and the situation is very fluid. But equities made a bold statement last week and we do not want to fade a market that continues to make critical multi-year pivots support while poised to challenge the previous pre-crisis highs of 2007.
On June 2,
the weekend following the May Non-Farm payroll number, I posted a chart of the S&P 500
(^GSPC) on my firm’s blog with three main pivots 1160, 1265 and 1340 pointing to “potential positive divergence” in the relative strength index (RSI). Recall that payroll number was a stinker sending the 10YR to 1.50% and the S&P down 30 handles to 1278.
Despite the weakening fundamentals I was looking for support. I said 1278 was a level we have been watching for some time as it represents a 10% corrective measured move against the 10% Nov 2011 correction
The following Monday the market traded off another 12 points to an intraday low of 1266.74 right on top of the 1265 pivot and reversed to close unchanged. After the market rallied from this historically significant level I commented on June 21
As we showed the weekend in The Definition of Insanity
after the misery known as May NFP, the 1265 level is important and the reversal after testing the following Monday is important. Just as the rally to 1340 and 1360 where the market is trying to consolidate and bring down the indicators to generate the energy for what we believe is healthy price action. If we hold and embark on another leg higher it could be a spectacular melt up rally.
Then this past Wednesday
Well for a month we’ve been consolidating 1340 and 1360… We are still thinking a 1310 flush test is in order but make no mistake bears DO NOT want to see this area made support after making the critical 1265
level support. If so we could be heading higher and fast...
Obviously the following two-day 3.5% rally from the 1340 area would be considered higher and fast. Of course the point is to toot our horn a bit but also demonstrate that while most are focused on what the market should be
doing based on fundamentals (the wrong playbook) our analysis is focused on what the market is
doing in recognizing important price pivots, flushing short positioning and fading extremely bearish sentiment.
I’m not saying fundamentals won’t matter at some point, they just don’t matter now. The market is on a mission and it’s going where it wants to go. While crash callers continue to point to earnings, data and Europe market price is focused on other matters and if we are going up from a structural perspective it’s doing what it’s supposed to be doing. Perhaps the only thing crashing is the wrong playbook bubble.
This week’s CFTC
commitment of traders report showed large speculators (aka hedge funds) remain net short for the 50th consecutive week. In fact the last week they were net long was the first week of August when we crashed. I remarked to a friend that I didn’t think the market would stop rallying until “they” get flat to long. I said they are following the 2011 analog but I was thinking more like 2006 when we saw summer weakness but the market wasn’t finished rallying and after Labor Day we embarked on the final leg into the 2007 top.
Last year the speculative community was still long the QE II reflation correlation trade thinking they were going to get an extension and when they didn’t it was Katy bar the door. This year they are short. If we don’t crash soon when the boys come back from the beach they may be piling in to get long before year end. It could be melt up city.