Wednesday, April 16, 2014

The Fed & Inflation
Janet Yellen, “The Fairy Godmother of the Bull Market,” may soon have to deal with an age-old adage: “Beware of what you wish for, because you just might get it.” She might have to explain why the Fed’s goal is to inflate the inflation rate back to 2%. She obviously wants to avoid deflation. Consider the following:

(1) CPI inflation rate upticking. March data released yesterday showed an increase in the CPI inflation rate to 1.5% y/y from 1.1% the month before. It was led by food prices and rents. The former rose 0.4% m/m, and 1.7% y/y.

(2) Rent inflation rising.The CPI rent of shelter component rose 0.3% m/m, and 2.7% y/y, the highest reading since March 2008. This is a very odd measure indeed. It accounts for 32% of the total CPI. It has two major subcomponents, namely tenant rent and owners’ equivalent rent (OER). The former, which reflects actual rent paid by actual renters and accounts for 7% of the CPI, rose 2.9%, and has been hovering around this rate for the past 10 months. The latter, accounting for 24% of the CPI, has increased from 2.2% six months ago to 2.6% during March.

OER is an imputed measure of the rent homeowners would have to be charged to rent the homes they own. I kid you not, though I’m sure you knew that already. Presumably, it is based on actual tenant rent. Nevertheless, the recent leap in the OER inflation rate obviously can’t be explained by a similar jump in tenant rent inflation.

This oddity is one reason why the Fed prefers to use the personal consumption expenditures deflator (PCED) as a better measure of consumer price inflation. Both rent components are in the PCED too. However, the overall weight of rent of shelter is only 15% of the PCED, with tenant rent at 4% and OER at 11%.

(3) Inflation mandate needs explaining.It’s not obvious to me why the Fed’s commitment to boost inflation is a good thing, especially if inflation is led by higher food prices and rents. We doubt that will stimulate economic activity by causing consumers to buy food and rent apartments before their prices go higher. On the contrary, the rising costs of these essentials reduce the purchasing power of consumers.

Inflation-adjusted average hourly earnings in private industry (using the overall CPI to deflate this measure of wages) fell 0.2% m/m during March. It is still up 0.5% y/y. Tenant rent inflation has been outpacing wage gains since September 2011.

Despite March’s uptick in the CPI inflation rate, we believe that there are powerful deflationary forces offsetting all the monetary stimulus provided by the major central banks of the world. Since the start of 2009, the assets on their balance sheets have increased 78% by $6.2 trillion--at the Fed ($2.3 trillion), ECB ($0.4 trillion), BOE ($0.3 trillion), BOJ ($0.9 trillion), and PBOC ($2.3 trillion).

If anyone had predicted five years ago that this would happen and that the major central banks would be worrying about the possibility of deflation rather than hyperinflation, few would have believed such a ludicrous prediction. Yet here we are, with all the models used by macroeconomists at the central banks to predict inflation clearly not working.

Microeconomic models seem to be more useful in explaining why this is happening. Globalization has made markets more competitive and reduced the pricing power of firms. Technological innovations are inherently deflationary as they boost the productivity of both labor and capital. Instead of "hypering" inflation, ultra-easy monetary policy has funded the development and implementation of deflationary technologies. Easy money has also funded the fiscal excesses of governments that often expanded capacity to provide jobs even if the demand fundamentals didn’t justify such expansion.
(Based on an excerpt from YRI Morning Briefing)
The ECB & Deflation
Over in the Eurozone, ECB President Mario Draghi has been the Fairy Godfather of the bull market, not only in stocks but even more impressively in bonds, especially in the region’s peripheral countries. This past Saturday, at an IMF conference, he sought to reassure investors in these markets that the ECB will do whatever it takes to avert deflation.

Of course, he first made that pledge in the context of defending the euro in a speech on July 26, 2012. Now he is worried that the euro is too strong: “The strengthening of the exchange rate would require further monetary policy accommodation. If you want policy to remain as accommodative as now, a further strengthening of the exchange rate would require further stimulus."

On a year-over-year basis, the euro is up by 8% against the dollar and by 9% against the yen. In recent weeks, it has reached levels against the dollar not seen since late 2011. The strong euro is contributing to deflationary pressures by depressing import prices, which boosts the CPI, and by raising export prices, which could slow the Eurozone’s export engine.

"I have always said that the exchange rate is not a policy target, but it is important for price stability and growth," Draghi said. "What has happened over the last few months is that it has become more and more important for price stability."

On Sunday, at the same IMF conference, ECB executive board member Benoît Cœuré, in prepared remarks, reiterated that the bank’s Governing Council “is unanimous in its commitment to use also unconventional instruments within its mandate,” including asset purchases if additional easing is required to avert deflation.

Some observers claim that this is easier said than done since the ECB's charter forbids it from financing governments. However, buying government bonds in the secondary market isn’t explicitly prohibited. Since assuming the ECB presidency in November 2011, Draghi introduced two major unconventional policies to ease funding pressure in the Eurozone's banking sector:

(1) More than €1 trillion was pumped into the bloc's financial system between December 2011 and February 2012 through the provision of cheap three-year loans to banks. The banks used the funds to buy government bonds. Some observers called it "backdoor Quantitative Easing."

(2) In September 2011, Draghi launched his Outright Monetary Transactions (OMT) program to buy bonds in the secondary market. This ship never left port because of opposition from the Bundesbank. In addition, Germany's constitutional court in a preliminary ruling in February claimed, "there are important reasons to assume [OMT] exceeds the [ECB's] mandate.” However, final judgment was deferred pending a ruling by the European Court of Justice.

In any event, Draghi’s pledge to do whatever it takes to defend the euro worked like magic to ease financial conditions in the Eurozone. It’s not obvious how actually implementing a QE program now will work much better to boost inflation given that government bond yields are already so low. It would have to channel more of the monetary stimulus to the private sector through purchases of asset-backed securities, which are in short supply currently.

A QE program would have to dramatically lower the foreign exchange value of the euro. Over in Japan, the essence of Abenomics over the past year was to use massive monetary easing to depreciate the yen and boost inflation. But the shock-and-awe may be wearing off already. Central bankers may soon have to consider the possibility that they aren’t as powerful as they believe themselves to be against the forces of deflation.
(Based on an excerpt from YRI Morning Briefing)

Monday, April 7, 2014

Draghi Has To Start Walking the Talk
While the yen and the Nikkei are marking time waiting for more stimulus from the BOJ, Eurozone bond yields are plunging, especially in the peripheral countries, on expectations that the ECB soon will counter mounting deflationary forces by providing another round of monetary stimulus. The Italian and Spanish 10-year government bond yields are down by about 100bps since late last year to 3.2%. The French yield is down to 2.0%, while the German yield is at 1.5%. Even the Greek bond yield is down to 6.1%. (See our Global Interest Rates.)

In his 4/3 press conference, ECB President Mario Draghi raised those easing expectations when he said:
The Governing Council is unanimous in its commitment to using also unconventional instruments within its mandate in order to cope effectively with risks of a too prolonged period of low inflation.” During the Q&A session, he explained: “So this statement says that all instruments that fall within the mandate, including QE, are intended to be part of this statement. During the discussion we had today, there was indeed a discussion of QE. It was not neglected in the course of what was actually a very rich and ample discussion.
On Friday, Reuters reported that according to The Frankfurter Allgemeine Zeitung, the ECB “has modelled the economic effects of buying 1 trillion euros” as part of a QE program, estimating that it would add 0.2-0.8 percentage points to inflation. Frankly, that seems like very little bang for some much additional liquidity. Furthermore, it was also reported that “an unnamed senior central banker was extremely concerned about possible market distortions that could result from such an intervention, and feared such purchases could create a bubble in the corporate bond market.” There certainly seems to be a bubble in peripheral bonds already.
(Based on an excerpt from YRI Morning Briefing)
Bank of Japan Deserves Some Credit
The Bank of Japan deserves lots of credit for devising “unconventional” monetary policy tools during the previous two decades that other central banks have subsequently adopted to respond to the most recent financial crisis. During the 1990s, after Japan's stock market and real estate bubbles burst, the BOJ lowered its official interest rate from over 8% at the start of the decade to zero by the end of the decade. ZIRP (or NZIRP) is now the fashion among the other major central banks (the Fed, ECB, and BOE).

During the first half of the previous decade, the BOJ was the first to implement QE. Another round of QE was implemented during 2011 and 2012. Then a year ago, the BOJ implemented QQE (quantitative and qualitative easing) as the first of the three “arrows” of Abenomics. The aim is to boost inflation to 2% by 2015 by doubling the monetary base. In addition to purchasing Japanese government bonds (JGBs), the BOJ has also been buying exchange traded-funds (ETFs) and Japan real estate investment trusts. The BOJ is unique among its peers in the major developed economies in its high-profile purchases of ETFs, which it began in December 2010 as part of aggressive easing measures.

The BOJ’s policy committee met on Monday and Tuesday. This past Sunday, Bloomberg reported the results of a survey of 36 analysts, who predicted no change in the central bank’s target for the yearly expansion of the monetary base. However, the consensus is that more monetary easing is likely in coming months and could be implemented by a doubling of ETF purchases and more buying of JGBs.

Japan’s CPI inflation rate rose to 1.5% y/y during February, up from -0.6% a year ago. However, the core CPI inflation rate (excluding food and energy) was up only 0.8% during February. That’s certainly an improvement over -0.9% a year ago, but still awfully close to zero despite all the liquidity provided by QQE.

Contributing most to boosting inflation has been the 24% drop in the yen since September 6, 2012. However, most of the decline occurred during late 2012 and early 2013, suggesting that QQE is losing its effectiveness. That’s why there are widespread expectations that more monetary easing is coming. Maybe so, but this time, the yen isn’t falling and stock prices aren’t rising on those expectations. The Nikkei is currently just about where it was a year ago.

I met with a few of our hedge fund accounts in Connecticut yesterday. The head of one of them was profitably positioned for the big jump in Japan’s stock prices during late 2012 and early 2013. He remained bullish earlier this year, but has turned more cautious recently. We both agreed that Prime Minister Shinzo Abe probably isn’t Japan’s Ronald Reagan.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, April 2, 2014

Yellen’s Second Rookie Mistake
As I argued yesterday, Fed Chair Janet Yellen made her first rookie mistake during her first press conference on March 19 when she defined the “considerable time” mentioned in the latest FOMC statement to mean “something on the order of around six months or that type of thing.” That was widely interpreted as suggesting that the Fed might start raising the federal funds rate six months after QE was terminated, which is widely expected to happen by the end of this year.

She seemed to back away from that prediction in her extraordinarily impassioned and personal speech on Monday in Chicago, when she said that the Fed remains committed “to do what is necessary to help our nation recover from the Great Recession.” In her speech, she briefly described the struggle of three workers in the Windy City--Dorine Poole, Jermaine Brownlee, and Vicki Lira--in the labor market, implying that she intends to maintain ultra-easy monetary policy until they and people like them have good jobs

That was her second rookie mistake. On April Fools’ Day, Jon Hilsenrath reported in the WSJ:
One person cited as an example of the hurdles faced by the long-term unemployed had a two-decade-old theft conviction. Another mentioned as an example of someone whose wages have dropped since the recession had a past drug conviction. Academic research suggests people with criminal backgrounds face unique obstacles to employment.
Sadly, this is no laughing matter. I’ve heard from a few CEOs that they would like to hire more workers, but they are shocked that even if candidates have the right skills, quite a few don’t pass their drug tests. I’m shocked that a “Fed spokeswoman said Tuesday that Ms. Yellen knew of the people's criminal backgrounds and that they were ‘very forthright’ about it in conversations with the chairwoman before the speech. In her remarks she said they exemplified the trends she was discussing, such as downward pressure on wages or the challenge of finding a job for the long-term unemployed."

Wait a minute: What can ultra-easy monetary policy do to help people with criminal convictions and drug problems get a good job? Nothing, of course. Perhaps, the Fed should commission a survey company to determine how many of the long-term unemployed have these issues. Furthermore, how many of those who have dropped out of the labor force have these issues and obviously prefer to receive government benefits than continue to hunt unsuccessfully for a job given their flaws?

The survey results should show that the vast majority of the unemployed and labor force dropouts have clean records and don’t abuse drugs. Yellen’s idea of humanizing the problem of the unemployed is a good one, but it should be based on statistically valid samples rather than three people.
(Based on an excerpt from YRI Morning Briefing)

Tuesday, April 1, 2014

Yellen’s Rookie Mistake
Janet Yellen, the Fairy Godmother of the Bull Market, spoke yesterday, and stock prices rose. President Ronald Reagan often said that the most terrifying words in the English language are “I'm from the government, and I'm here to help.” In her speech yesterday, Yellen said that she is from the Fed and here to help:
Although we work through financial markets, our goal is to help Main Street, not Wall Street. By keeping interest rates low, we are trying to make homes more affordable and revive the housing market. We are trying to make it cheaper for businesses to build, expand, and hire. We are trying to lower the costs of buying a car that can carry a worker to a new job and kids to school, and our policies are also spurring the revival of the auto industry. We are trying to help families afford things they need so that greater spending can drive job creation and even more spending, thereby strengthening the recovery.
So far, the Fed’s ultra-easy monetary policy seems to have benefitted Wall Street much more than Main Street. In her speech in Chicago, she briefly described the struggle of three workers in the Windy City--Dorine Poole, Jermaine Brownlee, and Vicki Lira--in the labor market. Yellen said, “I see that there remains considerable slack in the economy. … Slack means that there are significantly more people willing and capable of filling a job than there are jobs for them to fill.”

She noted that the Fed has been committed “to do what is necessary to help our nation recover from the Great Recession. For the many reasons I have noted today, I think this extraordinary commitment is still needed and will be for some time, and I believe that view is widely shared by my fellow policymakers at the Fed.”

How does this square with Yellen’s press conference on March 19? The FOMC had just issued a press release stating that interest rates wouldn’t be raised for “a considerable time” after QE was terminated. During the Q&A session, Yellen was asked to define “considerable.” She seemed to make a rookie mistake by saying, “it probably means something on the order of around six months or that type of thing. But, you know, it depends.” Stocks fell on her comments.

There is still a debate over whether Yellen made a rookie mistake at her first press conference or whether she was wisely signaling a tougher monetary approach to reduce the risk of speculative asset bubbles. Her speech yesterday confirmed my view that she intends to maintain ultra-easy monetary policy until Poole, Brownlee, and Lira have good jobs. Stock prices rose yesterday.

By the way, in her press conference, Yellen added the growth rate in wages to her dashboard of indicators suggesting that there is too much slack in the labor market. In her speech, she specified that she is watching hourly compensation in the Employment Cost Index and average hourly earnings for all employees in private industries. In a footnote, she observed that they’ve been growing no more than 2-1/4%. In her press conference, she said they should be growing 3-4%.
(Based on an excerpt from YRI Morning Briefing)