More success than regime change

The ongoing fiscal reflation is possible and bullish in isolation because it does not implicate the Fed, not because it requires coordination with the Fed.  It is probably worth resisting the macro poets on the street who are adamantly committed to getting that 180 degrees backward, even though coordination does have a bullish ring to it at the outset.

This report attempts to achieve two things.  First, it puts the just-passed fiscal legislation as well as the proposed upsizing in the context of a policy template I have been pushing. Within its own limited sphere, this template has been quite predictive, especially when contrasted with some of the kooky speculations that occasionally wash across Wall Street.

Second, it imports careful analysis from the Committee for a Responsible Federal Budget (CRFB) to provide authority behind calculations I have done on a more back-of-the-envelope basis.  The upshot is that there would have been sufficient personal income to sustain the economic expansion, at a moderate pace, beyond the Covid soft spot, even without additional legislation.  Fiscal policy would have been a headwind, not a cliff.  Of course, that assertion will now not be tested.

With the legislation, there is plenty of income to sustain strong growth, particularly on a sequential basis early next year.  If the Senate were to endorse what the House has just passed, then we might be facing a boomlet, although probably not an overheating.

What we can say with some confidence, is that the expansion is still on and that the Fed would let strong growth rip, were it to arrive.  There is no new regime, really, on the monetary side. But it is important that the Fed has helpfully committed not to wasting good luck, should it arrive. 

Who pays for Ponzi public finance?

This report attempts to complete the background discussion on Ponzi public finance by assessing the question of who ultimately pays. However, financed, the debt accumulated by running a large deficit reflects a real resource transfer that has to come from somebody, either directly or in the form of an opportunity cost, as cash or production effort.

The evolving mainstream take, which I accept and have been pushing, is that the debt is ultimately paid for by savers who accept a negative real interest rate or – more precisely – a real interest rate that is lower than the economy’s trend real growth rate.  At first approach, that take probably seems uncontroversial.  But tension can arise when we dig into what is meant precisely by “pay” and “accept.”

Are the low interest rates that underly the logic of Ponzi finance a case of redistribution from the rentier to the pleb, via financial suppression and the like?  The short answer to the question is no, at least within the model now being pressed by the mainstream.  This report describes that perspective without fully arguing it.  Along the way, it draws a contrast between the reasoning of Ponzi public finance and that of MMT, not to slag MMT (although I am not a fan), but just to illustrate the mainstream take through contrast.

Aside from being largely assertion, this report is a bit abstract and may seem somewhat argumentative and disconnected from investment strategy.  I would accept the criticism, and admit that I have been provoked by some sloppy language from The Empire on Twitter.  But there is a practical implication.   The conditions underlying the case for Ponzi public finance arise much more from general equilibrium, including importantly the preferences of savers, than from fiat, particularly in macro.  They are not a reflection of arbitrary political whim or fashion.  Moreover, they mitigate, rather than reinforce, the distributional considerations arising out of that general equilibrium. So, spare us all the martyr complex, Wall Street sales guy!

An important implication of these forces being real rather than fiat is that they are likely to endure. This does not guarantee that policy makers will react optimally to these forces.  We are seeing some hesitation on that front play out in the lame duck Congress now, which may lengthen the soft spot into which the US economy has recently entered.  But the forces themselves should persist.  If you already agree, you can easily skip this report.

Fiscal-monetary coordination is not on

There is an important reassessment ongoing, in stages, about macroeconomic policy.  That reassessment has important implications for actual policy and for its knock-ons to markets.  Most of these implications have already played out, but there is probably also some juice left in the theme. 

The point of this report is to insist that fiscal-monetary “coordination” is a mostly unhelpful way to think about the situation. For the short run, coordination sounds bullish, at least in isolation, given the environment.  That aspect is probably net helpful. But coordination also sounds — unnecessarily — radical, which might prevent people from recognizing that the correct, equally bullish, scenario is actually playing out, in large part because it is mundane.  

Over the longer horizon, coordination puts our minds in the wrong space, in which extreme things, possibly involving a lot of inflation, are likely.   Stay away from that as if it were The One Ring.

I expect “coordination” will have shelf life, just like “money printing” did. Rather than risk being monomaniacal in opposition, I will have this on the website to link to. 

Four themes in the Q3 GDP report

Originally published on October 29

In this report, I identify four enduring macro themes that this morning’s data can help us update.  Much of this will be familiar to you if you have been reading my work, but there are a couple aspects that are novel.  Generally, the themes fit into the Saggy V hypothesis that I have been pushing, while recognizing that the lift-off phase has extended a bit further than I originally expected:

  • The traditionally most cyclical components of aggregate have staged a very strong recovery recently, both outright and as a share of GDP.  Normally this would imply downside risk to the economy, but in the current unusual set-up, it more likely suggests a marked slowing of growth, rather than a renewed dip into recession.
  • Inventory investment is a cyclical component, although I treat it separately because its cyclicality is a bit higher frequency. The current flow of inventory investment remains modestly below normal, which means there is more likely a modest inventory impetus than headwind in store for the economy over the next few quarters.  However, Q3 was a massive outlier, as the swing of inventory investment alone delivered 6 ½ percentage points to the overall GDP growth rate, a 70 year record.   That is a major reason the ISM spiked.  And the completion of the impetus is a major reason the ISM has fallen.  Separately, do not react to the inventory/sales ratio.  As a timing indicator, it is useless.
  • The strength in the cyclical components of demand relate closely to the strong recovery of the goods and structures side of the economy.  This is not unusual in a cyclical upswing. But what is unusual is that the service sector bore the brunt of the decline and is still very weak in level terms.  This should contribute to a weaker growth rate but also lower economic volatility going forward. 
  • Within the tangible side of the economy, business investment in equipment and structures has been relatively muted, compared to the stronger recovery in household sector spending.  And structures investment has been weaker than equipment.  The latter fits the idea of the Covid as a reallocation as well as aggregate demand shock. And the former fits into the slow growth but not double dip central case, in part because capital stock rates are low, implying no contractionary overhang. 

The fiscal deficit, Treasury supply and important determinants of the term premium

During the past month or so, the ACM measure of the term premium at the 10-year maturity has risen about 25 basis points.  This has apparently generated some concern that the US capital markets may have trouble digesting the flood of pure rates duration supply that appears to be just around the corner, particularly if the Fed were to be hesitant to upside its asset purchase program.

The attached report assesses that worry and concludes that it is not very pressing.  It emphasizes five points in particular, some of which will be familiar to you and some of which are more novel:

  • The outlook for the economy is by no means crystal clear here.  Covid is obviously making a comeback and there are legitimate concerns about how the election will turn out and what the fiscal policy implications of that might be.  But when assessing the influence of the Fed itself, it is crucially important to focus on their objectives, and not on the path of a specific instrument, such as the balance sheet, especially when that influence is secondary, beyond its transitory and behavioral influence on risk-on vs risk-off.  The most important thing here is the thing we already know: the Fed is virtually max dovish. Let’s not waste that happy coincidence.
  • On the specific question of the term premium, the most prominent measure of it – ACM – is systematically inclined to mislead in the current environment, which is characterized by a highly unusual combination, of ZIRP, aggressive rates guidance, a Fed attempting to achieve an unprecedented inflation overshoot, a gigantic (and probably effective) fiscal deficit, and a central bank leadership asking for a larger one.  The mean reversion premise built into conventional estimates of the term premium does not remotely apply here.
  • People, even smart ones like yourself, instinctively conflate the influence of duration supply (and its manipulation via QE) on the term premium with the term premium itself.  That is definitely wrong because the far more important determinants of the term premium are bond yield volatility and the correlation between fixed-income and risk-asset returns.   In fact, bond yield volatility has historically been a more important determinant of even effective pure rates duration risk in the economy than has notional Treasury supply itself. 
  • Importantly, the depressing influence on the term premium of falling bond yield volatility and the shift to a benign stock-bond correlation has probably entirely run its course. As a result, Treasury supply and the Fed’s efforts (or lack of efforts) to mitigate it via balance sheet policy may end up the tiebreaker for the term premium during the coming year or two, especially with Treasury supply set to explode.  If this becomes an issue for the economy, then the Fed will just shift to more QE, most likely.  With or without an offset from the Fed, complete or partial, the prospect of heavy Treasury supply would reinforce what is already the base case in fixed income: the long case is not compelling.
  • For equities, this is much trickier and in a way that is probably counterintuitive. There is actually little reason to believe that a rise of the Treasury term premium driven by supply alone would even be negative equities.  A rise of the term premium driven by deeper fundamentals would very probably be damaging to equities. And people probably have that in mind when getting confused about this issue.  The implication is not that it is clear sailing for stocks. Rather, it is an issue of focusing on the right issues, and Treasury supply is probably not one.

Scarring is a forecast here, not an observation

It is a slow day for economics itself, so I figured I would formalize and tighten up some points I have been raising about the low importance of direct measures of labor market scarring.   That way I can put the report up to the blog and refer to it over time as this issue plays out, which it will.

My research into this area is now a finely tempered steel sword, and incisive even by my own very high standards! But it does not really move the dial.  Rather, it is background. 

While the most prominent direct measures of economic scarring so far are pretty much irrelevant, the issue of scarring is itself serious.   As Greenspan might say, the map is not the territory.

A desire to avoid scarring is one of many reasons that the Fed has become almost max dovish here.  As an aside, it may be worth reiterating that Fed watchers obsessing over when the Fed will upsize QE are playing a greater fool game that risks leaving them the fool. Not that this is easy by any means, but we should maybe pick our battles.  We are not waiting for news from the Fed. We got it in September.

Policy coordination is endogenous

People like to talk about and get jazzed over policy “coordination”, which these days means co-operation between the monetary and fiscal authorities.

In this report, I pull together some themes I have been pushing over the years to set out what form the monetary-fiscal coordination is likely to take – or, really, continue taking.  These are not new ideas, and my objective here is more to connect some dots ahead of the election than to prove any one particular dot. 

There are three points in particular to emphasize here.  First, many analysts severely jumped the gun by anticipating that policy coordination in its most potent form could quickly put an end to lowflation.  It seems to me that they missed an entire cycle in which the Fed was effectively forced to err on the side of ease.  It is amazing they would declare victory here. It has taken time for policy makers to internalize the secular stagnation environment and to grope toward a policy response that is plausible and likely to be effective. However, the required learning has probably been achieved, with the passage of time.  So we should now get aboard the fiscal contribution to reflation over the coming years — as opposed to from here to Election Day.

Second, this process is likely to involve a lot less drama than some of the popular stories imply.  The image of a Fed Chair and Treasury Secretary appearing jointly before the cameras to announce some novel program is hardly implausible.   The Blackrock Institute set out a workable version of that a couple years ago. And while their distillation was a very helpful advance, they relied on ideas that had been in the air a while. But the much more likely scenario is that the coordination is mostly achieved by both the Fed and Treasury reacting, i.e. endogenously, to the same real-economy forces, associated with secular stagnation.   That is r*, has fallen, outright and relative to g*. The lower r* exacerbates the constraints implied by the effective lower bound on rates, encourages a sense of urgency at the Fed about inflation expectations, and encourages an enduring shift to larger fiscal deficits, which quite obviously is already in train.  This is not something that needs to be announced.

Third, and very closely related to the second issue, the decline of r* does not necessarily make it all that more difficult for policy makers collectively to achieve the objectives that the Fed has recently formalized more explicitly.  It – arguably at least – just affects the policy mix that is required to get us there.  This is all mostly endogenous to the developments in the real economy, although inevitably with recognition lags that have frustrated the eager beavers over the past decade.  The Great Man take on events does not apply here. But we all learn, along with the markets.  Just because your favorite overconfident policy entrepreneur got it badly wrong does not disqualify evolution.

The evolution will probably extend most quickly if Fed Governor Lael Brainard ends up at Treasury.  She will explain the complicated bits to the Biden Administration and possibly Democratic Senate.  But even in other scenarios we probably get there, just more slowly.

The third question

Yesterday’s FOMC was very dovish and clearly more so than was expected.  The main reason is that, against expectation, the Fed fully operationalized its newly announced policy framework, which is itself quite dovish.

The consensus seems to have a slightly more hawkish – or perhaps less stridently dovish – take.  This may have something to do with the price action around the event. Or it may be related to a failure to internalize just how behind the inflation curve the Fed is committed to being when the expansion ultimately matures.  To quibble over raising rates off zero with inflation “only” at 2% is bizarre, given the lags involved in monetary policy and – more to the point – how the Fed itself views those lags. It seems as though people skipped too quickly over a key sentence in the Press Release. For what that is, read on!

What I take to be a mistaken interpretation reminds me in many ways of how Ben Bernanke’s talk at Jackson Hole on August 31, 2012 was interpreted in real time.  People initially viewed it as hawkish or maybe disappointing. Within a couple weeks it had morphed into the clear signal that QE3 was coming.  Yesterday’s event, though also fixed in time, is similarly inclined to become more dovish as time passes.

One question that came up in the Press Conference is how quickly the Fed can get to 2%, let alone above.  I think Powell was mostly sensible on this point, which I elaborate on in this report, which should in turn have some shelf life, regardless of the nearby price action.

But equity types have to keep a key thing in mind. Particularly in the benign scenario, although arguably in a darker one too, slow progress to 2% would just leave the Fed more pro-growth for longer. Let’s not view that as a bad thing.  Just because Liesman seemed grumpy about it does not mean you should be bearish about it.

Importantly, the Fed’s intentions for the economy and policy plans are not the only influence on capital markets.  There is particularly a lot going on now. But there is no need to mistake what the Fed’s influence is.  This is already hard enough without getting the simple stuff backwards.

Dealing with macro’s dirty little secret

The Fed has long favored a sustained burst of inflation above its long-term target of 2%.  That they have failed to deliver is about luck and minor policy errors, not preferences.

The understated preference for higher inflaton is one of the reasons they have tended to be “surprisingly” dovish over the past decade.  More recently, however, they have become more forthright on the point.  I think this reflects two things. First, they see the urgency of preventing a further decline of inflation expectations in the real economy, and of pushing such expectations higher, to the extent they can.  Second, the leadership is probably now more confident in the intuition it has held for years, and wants to keep itself focused while bringing along some of the laggards.

The leadership’s decision to be more explicit has probably contributed to the recent widening of inflation compensation in the bond market.  However, I would guess that the low-hanging fruit there has already been picked.  At the Covid-crisis tights, breakevens were out of line with even depressed inflation expectations and with the inflation convexity implied by the design of indexed bonds when inflation is low.  Most of the recent widening can be described, then, as simply risk and illiquidity on.  The Fed has obviously contributed to that, but not necessarily through the inflation communication channel.

From here, the question of whether the Fed can credibly commit to delivering on its inflation preference assumes more importance, not just for breakevens but for the markets more generally.  The point of this report is to urge its readers to update their thinking on this issue.

For many years, fans of the efficacy of monetary policy have been pushing easy solutions, such as the use of the balance sheet or maybe “coordination” between central banks and their treasuries in the form of helicopter money.  Market participants just love that term, coordination.

The fibs told around this stuff have probably been helpful to the extent they have encouraged easier financial conditions. But on the specific question of when inflation might move higher, believing in that nonsense would have made investors very early.

But there is a form of coordination that is more slowly acting and whose acceptance has been slower to develop. I refer here to central banks, including the Fed, successfully calling on governments to deliver fiscal expansion, without any funny money aspect.  You may be surprised to read – and may disagree even after you have read – that there is actually a fairly broad consensus that sustained fiscal expansion can raise r*.  Moreover, r* shows up in the logic for Ponzi public finance, just as it does in the secular stagnation thesis.  This may seem obvious, but I have not seen it explicitly emphasized.

Raising r* would immediately ease the constraint imposed by the zero lower bound on rates and thus allow monetary policy to gain traction in supporting aggregate demand and thus real economic growth.  That would be worthwhile in its own right, obviously.  But a knock-on effect of the higher demand growth would be to make it easier for the Fed to hit its higher inflation objective, which is the subject of this report.

Of course, things could work out even without this additional fiscal support. It is possible that this recovery eventually, not soon, evolves into an expansion that eventually tightens up resource use and allows higher inflation.  Importantly, this good-luck scenario does not actually rely on the existence of a Phillips Curve, implying that the resource use overshoot precedes the inflation.  This story could work out in the so-called new classical setting just as easily.

But in terms of the backstop required to make the inflation commitment credible, the most obvious candidate is fiscal expansion.  For those interested in the long-term outlook for breakevens and inflation itself, I think relying on that backstop is a bet worth making. More to the point, it is the bet you are making.


A highly simplified look at the fading CARES act

Published on July 9

The attached report takes a highly-simplified look at the (effectively) expiring CARES Act and draws an inference for what this means for the economy – and its interaction with fiscal policy – going forward.

To do proper fiscal policy analysis, one would need an extensive background in the area, such as some of the DC watchers employed by the brokers have.  But I can make a small contribution here by employing a simplification.  I isolate the three major programs that dominated fiscal policy’s impact on the second quarter.

That neatly highlights that the economy faces imminent fiscal cliffs and that the objective of Phase IV fiscal support will be to prevent the development of new headwinds, as opposed to giving the economy a meaningful jolt relative to how it is tracking now.

Just as last time, this interpretation does not mean that fiscal policy announcements will fail to move markets.  Indeed, quite the opposite. The size of the hole to be filled here, makes the news around that more, not less, important.  Beats and misses on the headlines should matter.

I am talking here about the broader question, with perhaps the longer shelf-life.  That is, how does the economic cycle itself eventually play out?  My sense of the consensus around Phase IV is definitely that it would support the Saggy V.