Optimal Control ++

I will have some comments on Wednesday’s Fed decision in a brief note tomorrow.

In this report, I want to establish what I think is a strong and differentiated case for a dovish tilt, which may have some shelf life, to the extent that the argument will be operative, and yet not embraced quickly by consensus.

The consensus seems to understand that the Fed is going to apply optimal control during this recovery, which I assume is what this is, even though it seems likely to play out fitfully.  The consensus also gets that the Fed is interested in some sort of make-up strategy, to compensate for prior inflation undershoots.

However, there are two elements that I suspect the consensus has not fully internalized.  First, optimal control and make-up strategy are not belt and suspenders, or some sort of redundancy, equally guaranteeing the same tolerance of an overshoot of the 2% long-term inflation objective.  Rather, the two influences are clearly, logically additive implying that the Fed will deliver policy in the short to medium term aimed at a large inflation overshoot, by being – again – surprising dovish.

Second, even if we take optimal control on its own, without bringing in the additive make-up strategy, the implications of optimal control will be much more profound if the policy is embraced at the beginning of a reflation than near the end, as last time.

At the zero bound, the implications of these considerations for the rates setting are nil. The Fed would be at zero and aggressive on the balance sheet in any event.

The relevance is that the Fed will keep rates at the lower bound for a longer period than might otherwise be expected.  And as time passes, they will be increasingly clear on the reasons why, which strike me as compelling, given their stated long-term objective, which I am strongly inclined to accept for now.

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The Covid shock to household finances

This report assesses how personal saving and other household sector “flows” have responded to the COVID shock and federal fiscal efforts to offset that shock.  There are a lot of moving parts here, and the resulting complexity can seem impossible to resolve.

However, we may be fairly confident that the saving rate itself does not contain much useful information and that the ongoing recovery of consumer spending will be conditioned much more by the progress of the virus and its impact on social distancing than by household financial aggregates implying either pent-up demand or – with opposite effect — an enduring rise of precautionary saving.

To a first approximation, the “flows” reflect perceptions of the virus and are not themselves independently incremental.  And to the extent my take here might be slightly off, the implications would be much less extreme (in terms of the quantification) than is implied by the saving rate spike.

There is one exception to this notion that the flows are endogenous.  The Pandemic Unemployment Assistance (PUA) program has made a major contribution to supporting spending, particularly on essentials among low-end (including newly unemployed) households.  If that program were to be abruptly withdrawn at the end of July, as scheduled, I estimate that consumer spending would take a hit of about 4 percent (not annualized). Depending upon how quickly other, pandemic-related, sources of restraint on consumer spending are abating two months from now, that effect could contribute to a stalling of consumer spending.

The numbers I had worked up before the jobs report on Friday were significantly larger, because I was working with a higher level of unemployment at the end of July.  Friday’s job surprise made this risk less existential, but it persists.

My base case is that DC will figure out a way to taper this hit to the economy, stretching it out over several months to avoid the stall mentioned above.  I don’t share the view that one jobs report will make the GOP indifferent to this issue and ready to put Trump’s re-election at greater risk (from their perspective) than it already is.  But this issue is worth watching closely, via your contacts in DC.   That certainly would be a better use of time than trying to draw inferences, good or bad, from the published saving rate.

This report, then, considers an important influence on the shape of the recovery.  It does not get into the epidemiology, the pace of renewed social gathering, the pressure on state and local government finances, or the likely transitory effects of the Payroll Protection Program.

But it fits neatly into my view that the recovery will be a saggy V (or Y) with a period of rapid growth as the most acute forms of social distancing are lifted, followed by a longer slog, with recovery to full employment taking a couple years.  The jobs report on Friday has encouraged many of us to move forward the starting point for that recovery and to revise down our sense of the peak output loss.  The shape is unchanged, not to imply that is the sole consideration.

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What to make of booming M2?

M2 growth has recently accelerated to 20% on a vs-yr.-ago basis.  While the link from money to aggregate demand is imprecise to say the least, this strengthening is consistent with the notion that federal fiscal supports have helped and that the private sector for now remains fairly liquid on balance.

This fits in turn my view that aggregate demand can begin to recover as soon as the social distancing begins to lift, which means right now.  I would not lean on it more heavily than that, for example, to claim that the recovery is likely to be V-shaped in level terms.  I expect cash flows to remain depressed in level terms for a long time, creating opportunities for various financial accidents.

Importantly, the strength in money (basically deposit) growth is not fueling a powerful revival in bank lending.  Bank credit growth is running at just over half the pace of M2, and all of the strength there can be explained by C&I loans, presumably heavily dominated by banks drawing down credit lines, as part of a broader triggering of buffers against the COVID shock.

Separately, the strength in M2 does not map to a particular inflation outcome, although it is probably wise to maintain some convexity to inflation risk, for other reasons.

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Jobs report clearly beat, but does not change the story

Yesterday’s April employment report from the BLS was clearly a beat.  It was less weak than expected, especially in ways of most direct interest to market participants.

Moreover, with social distancing now being lifted, a recovery of demand and production is probably imminent, if not already begun.  For the next while, the real-time growth numbers themselves may look quite strong, perhaps even V like. For the government data, we will have to wait a month or so before the turn is pervasive in the reports.

However, I see little reason to move away from my long-standing view that the recovery in level terms will be slow and staggered, especially after the initial social gathering bounce.  And durably-compressed cash flows will provide fertile ground for financial accidents over the coming quarters.

In the attached report, I document in some detail how the employment report was a beat, especially in practical terms of interest to investors.  I also develop a broader and slightly darker picture of where the labor market is, by incorporating the signal from the claims data and an alternative measure of labor market performance, specifically the ADP-FRB approach.

I conclude with a brief discussion of cyclical knock-ons from the first-wave COVID shock and references a couple interesting blog posts from “economists”, whose speculations fit neatly into the slow-recovery thesis.

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Lower Treasury yields have supported equities

The note attached here assesses the role that lower Treasury yields have played – and may play – in protecting the equity market from the COVID shock.

Lower yields have almost certainly allowed equities to incorporate a higher risk premium with only a limited decline of price.  Moreover, this influence is fundamental and durable, rather than something to be dismissed as ephemeral, like TINA, which can sound bubble-headed.

Some versions lower of Treasury yield story incorporate the notion of “financial suppression”, as if such suppression would actually be bullish risk-assets in this case.   That part of the thesis seems mistaken, but in a way that is so convoluted that it is probably best left aside for now. I plan to address it in a follow-up background note. (For now, bulk delete.)

The issue looking forward is that even if these lower Treasury yields are durable, as I expect, they cannot provide much additional support from here, simply because of the proximity of the lower bound on rates, which the Fed seems likely to respect – and to be expected to respect.  Meanwhile, the fundamental drivers of the equity premium seemingly continue pushing for it to rise, at a time when the market-implied premium is not particularly high.

Moreover, the secular backdrop of “moderation”, which I have long presumed sets the relevant valuation benchmarks (of cheap, rich and fair) seems likely to persist but is not actually guaranteed to.

So, this situation still looks dangerous and confusing, although without presenting a compelling case for being short.  As I see it, the sun is not currently shining.

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Amateur epidemiology (interpretation)

From a strategy perspective, epidemiology is irritating because it is: controversial, beyond my competence to assess, and yet extremely important.

My initial instinct was clearly to defer to the epidemiologists, on the grounds that they would know much more about this than me, or Elon Musk or Jamie Dimon.  Away from myself, people who are successful at business or corporate bureaucracy often overstate their ability to weigh in on issues outside their core competence.  You don’t want to be that person.

But about three weeks ago I began to notice that epidemiologists are a lot like macroeconomists, sensitive to their field’s underdevelopment and extremely prone to insecurity and covering up for that with assertions of credential.

My favorite example of this involves Harvard.  There is a poorly credentialed “nutrition” epidemiologist there who has radically overstated the threat from coronavirus, and continues to do so.  There is also a far better credentialed real epidemiologist who happens to have overstated the likely body count who now spends seemingly half his time slagging the pleb, who is apparently sullying Harvard’s reputation in epidemiology.  Rather than admitting his own mistake, he deflects by kicking down.  My god, does that ever remind me of economists.

That makes me a bit less shy to weigh in – very tentatively – with my own idea.  So, here is that.

A few weeks ago, the economist Tyler Cowen wrote a really interesting article for Bloomberg in which he made a distinction between the “growther’” and “base rater” interpretations of the path of the coronavirus.

Cowen had been struck by Bill Gates’ insistence that this was the scariest thing in his lifetime, and tried to explain why a guy like Gates might be outside the then-complacent consensus on this issue.

Cowen’s hypothesis was that tech folk are just much more comfortable with the notion of exponential growth, intuitively. So, they are less inclined to dismiss something with a three-day doubling time as “still minor.”  In contrast, the base raters were inclined to ask, how often does a global pandemic wreck my investment strategy?  Round I to Gates. Maybe Gates also got network effects. In the old days, going viral was good.

The way this links back to formal epidemiology is through the differential logistic. The simplest way to think about a novel contagion ripping through a “naïve” population is that it generates new infections at a rate that is proportional with those already infected but also proportional with the share of the population not yet infected, on the grounds that one cannot be infected twice.  The integral of that looks like the cumulative normal distribution, flat then steep, then steepest half way through, then flat again. In the early stages, it resembles an exponential. That’s why all the charts you now see are plotted on a log scale.

So far, none of this involves any thinking by me, which is nice.  But I suspect that the epidemiology bulls (who really do exist) have maybe overlearned the lesson of exponentials, and the need to depict an epidemic’s progress on a log scale.  And here is why.

The risk of you getting infected by the coronavirus is not actually proportional with the log of the population already infected.  It is, rather, quite a bit more complex, such that the reduced functional form varies with where we are in the pandemic.

Near herd immunity, presuming that exists in this case, the risk might actually be inversely related with the (share of the) population already infected. At herd immunity, a big share of the population has been infected. Hence that late stage flat section.

It would follow from this that innocently reacting to the log of the population already infected would actually overstate the risk of your getting infected. But at least that would be less misleading that looking at the raw value, i.e. before taking the log.

Conversely, though, if we are still a long way from herd immunity, then the risk of any individual, including say you, getting infected in any given week would be more a function of the absolute level of infections than the log level.

The reason is that, still distant from herd immunity, the count of total infections and the count of still contagious infections would be fairly tightly correlated.  And, key point here, it would follow from this that efforts to relax social distancing would generate public health costs that are related linearly, rather than log-linearly, with the prevalence of the contagion.

I am not sure people instinctively get that.  But I can tell you one thing: I am not jumping on a train to come visit you simply because the log level of infections in NY has inflected, i.e. experienced a change of the second derivative. Nor do I expect you to invite me.  And generalizing, the pace of social un-distancing will be slow, especially if it begins soon.

So, this is me doing what the credentialed epidemiologists say should never be done, weighing in with college or AP level math and nothing more. In my own defense, I comment here on how know nothings like us interpret the charts, not actual epidemiology.

There is a minor irony here.  The fact that some of the credentialed epidemiologists have been caught out overstating the risk inclines me to think for myself.  But when I do that, I actually come away thinking that the convention of looking at log levels is itself a source of complacency in the current context.

Has the Bank of England Embraced Monetary Finance

The attached report argues my high-conviction view that the British Treasury’s announcement last week that it would expand its use of the Ways and Means account at the Bank of England does not represent the first step towards monetary finance of fiscal deficits — or so-called helicopter money.

What HM Treasury is up to here is debatable.  The most attractive explanation I have heard is that the Ways and Means account is simply a quickFH-200411er and more flexible way of raising funds. HMT might also be taking advantage of some strategic ambiguity here, which would not be unusual for policy makers.  Or maybe they even fear that a flood of bills supply might disrupt the money market.  Whatever the case, it has nothing to do with helicopter money.

I would be the first to insist that these repeated imaginations of helicopter drops are largely a distraction best ignored.  Hence, I slip this out on the Saturday of a holiday weekend, perhaps for future reference.

But the relevance for investors, particularly those in risk assets, is simply to reinforce the point that reflation from this episode is going to be difficult to achieve and will take time.  It is not just a matter of central bankers recognizing the scale of the problem and pulling the obvious lever or levers.  The lower bound on nominal rates is actually a binding constraint on what monetary policy can achieve.

Of course, the Fed will act to protect the financial system to prevent this sharp output decline and likely gradual recovery from morphing into something worse.  And I concede the price action last week probably had something to do with that. It was not just misplaced optimism about reflation. But it may be useful ultimately to keep clear what is actually going on here, at least to the extent we can.

For fixed income investors, the way this issue links up with strategy is a bit more complicated.  I emphasize here, again, that there is no simple path to reflation, no magic bullet (or bazooka) the Fed or other rich-country central bank can fire to get inflation back to target.  But that is not to say that the probability distribution around inflation has remained narrow.  When the system is stressed like this, it is possible to imagine unusual outcomes.  And in the US, at least, indexed bonds would seem to have attractive convexity to that, although I do not get into that here.

 

Why shaped recovery?

Here are the slides I used in a call with ISI on April 3

The main take-away is actually a question, I ask sincerely, not rhetorically.  Why are people already preoccupied with the shape the recovery will have? It is arguably a bit premature.

Gun to head, though, it should be a Y, with the left side straight down.  Output will have a partial strong recovery off the lows, but unemployment will remain high for a long time, in the central case.

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Fiscal program accommodates needed GDP contraction

The program is unlikely to deliver much “stimulus” to the economy, as conventionally understood.  Rather, it will facilitate social distancing and economic contraction over the next few months, while leaving the economy in a stronger position to recover after the public health emergency has passed.

It will not itself contribute to any building of pent-up demand, although pent-up demand does seem likely to develop over time, now that the central case for the economy is a steep and sustained decline in spending, including that for durables, capital goods, and housing.

Somewhat separately, the popular description of the Fed’s role here as providing “helicopter money” or triggering a “fiscal-monetary nuclear bomb” is overwrought and technically wrong.  The Fed’s contribution is to cut rates to zero, eventually move to explicit yield curve control, keep the flow of credit moving, and absorb some of the defaults that will be triggered by the recession.  They are not going to be relaxing the federal government budget constraint, which is not binding anway.

What the Fed is up to here is no small task, and it probably does more to limit the extreme left tail risk than any other initiative, including federal spending.  But it is not helpful to mischaracterize it, as many seem inclined to do.  From the perspective of providing direct stimulus to demand, the Fed is largely knocked out here.

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