Last week's deluge of economic data yielded some better-than-expected headline numbers, however if you look under the hood, the evidence suggests economic performance continues to be subpar. Sequential Q3 "real" GDP rose a better-than-expected 2.8% annualized, however the number that matters, year-over-year nominal GDP, printed 3.1% -- the exact growth rate of Q2 and Q1 remaining at the lowest trajectory of the recovery.
Friday's October non-farm payroll data showed a robust 204,000 jobs created, blowing away the consensus estimate of 120,000. Wage growth, however, continued to stagnate, growing 2.2% year-over-year with September's 2.1% growth rate being revised lower to 2.0%.
The September growth rate for personal consumption, the largest component of GDP, grew at just 2.7% year-over-year -- a sharp deceleration from the previous month’s 3.2% growth rate and the 3.3% trailing 12-month average pace. The trend toward the convergence of wage growth and consumption growth continues, implying that future GDP growth is becoming more a function of wage growth.
Average Hourly Earnings Vs. Personal Consumption
While the better-than-expected economic data is welcomed, the Fed surely understands that wage growth and consumption growth are required for GDP growth that is needed to close the output gap. This week two papers from Fed staffers received a lot of attention from Wall Street Fed watchers for the implications of what is deemed “optimal control” monetary policy. Gavyn Davies of the Financial Times
explains in What Fed Economists Are Telling the FOMC
Both papers conduct optimal control exercises of the [Janet] Yellen-type. These involve using macro-economic models to derive the path for forward short rates that optimize the behavior of inflation and unemployment in coming years. The message is familiar: The Fed should pre-commit today to keep short rates at zero for a much longer period than would be implied by normal Taylor Rules, even though inflation would temporarily exceed 2%, and unemployment would drop below the structural rate. This induces the economy to recover more quickly now, since real expected short rates are reduced.
The Fed is looking for aggregate demand to increase, and it has thrown everything in the monetary toolkit at the economy with questionable results. It makes you wonder if there is anything more it can do. “Optimal control” policy? Give me a break. It begs the question as to whether monetary policy even works at all.
Last week former SocGen macro strategist Dylan Grice of Edelweiss Holdings opined on this subject, and his comments could not have been timelier. The following is from his November edition of the Edelweiss Journal
This new interventionist idea was brought into the realm of economics through the Trojan horse of macroeconomic theory and, in particular, its defining metaphor that the economy is basically an engine. Originally, this metaphor gave economists an excuse to use the same mathematics physicists had used with such great success in the 19th century. The hope was that such tools would afford them similar acclaim. But by the time of the Great Depression Keynes was explaining the slump as being somewhat akin to failure in a car’s electrical system.
Today, the metaphor gives another kind of comfort. One that allows economists to pretend that like an engine, the economy is something that a well-trained expert, perhaps with a PhD from Princeton, should be in control of, and “do things to.” They can optimize it, fine-tune it, or manipulate it in some other way so as to achieve the outcomes most beneficial to “society.” Such experts think they know how to “drive” the economy the way a well-talented astronaut might say a space shuttle. You’ve probably heard them talk about the economy reaching “escape velocity” or being stuck at “stall speed.” Now you know where they get it from.
They see their job as to constantly monitor the economic engine, check its gauges and dials, ensure its satisfactory performance while all the time standing ready to intervene should anything untoward happen. Thus, writing in January 2012 Larry Summers claimed that “government has no higher responsibility than ensuring economies have an adequate level of demand,” as though doing so were no more complicated than pouring out the correct measure of fuel into a tank. Should the economy ever become too hot and aggregate demand too high, the engineers are supposed to be able to spot this and put the brakes on before anything bad happens.
Grice exposes monetary policy’s dirty little secret. It’s a fraud. It's a fallacy.
This is how the Federal Reserve defines monetary policy
and its role:
The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals.
Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.
There's just one problem: This is wrong. This is backwards. I would argue that a range of economic variables including employment, output, and prices of goods and services affect the amount of money and credit affecting long-term interest rates, FX, and short-term interest rates which triggers Fed policy. Monetary policy doesn't lead the cycle, it lags. Monetary policy isn't revolutionary, it's reactionary.
The Fed is operating under a false premise that it controls levers that run the economy. The Fed is operating under the premise that it can calibrate aggregate demand by adjusting these levers. Can you name a time in modern monetary history where the FOMC's decision to move the Fed funds rate triggered a chain of events that affected short-term rates? The market doesn't just wait around for the Fed to tell it what to do. The market moves first and it moves because of changes in the supply and demand for capital.
Fed Funds Rate Vs. 5-Year Yield Over 5-Year/10-Year Spread
The vast majority of market participants believe the 10-year Treasury yield is at this 2.50% level because of quantitative easing. But think about the economic benchmarks for growth. The growth rate of nominal GDP is around 3%. The growth rate for consumption is around 3%. The growth rate for inflation is around 1.8%. The growth rate in wages is 2.2%. The growth rate for S&P 500
(INDEXSP:.INX) revenues is 2.9%. With the exception of recessions, these growth rates are among the lowest in the last 50 years.
On the flip side, equity market gains are among the best in the last 50 years. As the stock market approaches year-end, the S&P 500 is due to log one of the best five-year average annual performances since 1950. If the market closes near recent highs, the five-year average annual growth rate of 14.8% ranks in the top 10 with only four periods in the late '90s and two in the '50s besting the performance. However when measuring against the same five-year average annual economic growth rate of 2.4% the performance of the market is number one over the time frame.
If the Fed is correct in that monetary policy controls the levers of the economy by calibrating aggregate demand, then why has this unprecedented stimulus campaign yielded record high market gains but record low economic gains? Let's revisit Dylan Grice:
On a related note, we’ve recently come to the conclusion that there seems to be a widespread misunderstanding of what “capital” is.
Capital is not money. One is scarce, the other is infinite.
As stock markets blink green on more QE supposedly making us all more wealthy, the developed world is saving less than it has at any time since WWII... Capital comes from savings, and the policy of cheap credit with its inflation of time preference has encouraged spending, not saving. Scarce capital is growing ever scarcer. One day, the price of capital will reflect its underlying scarcity, because one day it must.
Brilliant! I have never really thought of it that way, but this is exactly the reason monetary policy is having a bifurcated impact on markets and the economy.
The reason QE is benefiting markets but not Main Street is because money is not capital. Securities transactions only require money to grow, but Main Street requires capital to grow. Money is a medium of exchange -- like, say, taking proceeds from the sale of a fixed income asset to buy an equity asset. Capital is a medium of savings that is used for investment, like taking income after expenses (profits) to invest in plants and equipment to generate and more importantly compound returns on invested capital in excess of the cost of that capital. The Fed is not increasing capital available to Main Street, but rather only money available to Wall Street.
Capital Vs. Money
The Fed is creating money to encourage spending, but this is at the expense of savings, thus we see a lot of financial transactions but not a lot of investment. In the 1990s, base money and savings were virtually the same number, but today, base money has grown to over 5x savings. The economy doesn't need money to grow, it needs capital. Since the Fed introduced easy money as a remedy for cyclical deceleration in order to stimulate consumption, it discouraged savings. This worked in the short run but it cannibalized future economic growth by starving the system of necessary capital that was needed to finance this growth.
This is the essence of Dugger's structural trap
that I have written about in previous articles. Precious capital that should be used for productive investment has been funneled into unproductive financial engineering, and we are now witnessing the consequences. Fed policy doesn't need to keep interest rates lower for longer. That does nothing.
The Fed needs to allow the bond market to correctly price money where the supply and demand for capital finds equilibrium. We don't need more activist monetary policy based on ridiculous forward guidance; we need laissez-faire
monetary policy that allows the markets to work. Once the cost of capital is priced relative to its return, savings will grow and investment will increase, providing the seeds for sustainable future economic growth. The longer the Fed prolongs this process, the longer the economy will be mired in stagnant growth below its potential.