The Broken Links In The Fed's Chain Of Cause & Effect
Excerpted from John Hussman's Weekly Market Comment,
The Federal Reserve’s prevailing view of the world seems to be that a) QE lowers interest rates, b) lower interest rates stimulate jobs and economic activity, c) the only risk from QE will be at the point when unemployment is low enough to trigger inflation, and d) the Fed can safely encourage years of yield-seeking speculation – of the same sort that produced the worst economic collapse since the Depression – on the belief that this time is different. From the foregoing discussion, it should be clear that this chain of cause and effect is a very mixed bag of fact and fiction.
To be fair, we do believe that some components of the Fed’s thinking are well-supported by economic evidence. For example, in her presentation at Jackson Hole, Fed Chair Janet Yellen observed that real wage inflation remains low, and that this is an indication of ongoing slack in the labor market that isn’t well-captured by the rate of unemployment. On this point, we would completely agree. To the extent that the true Phillips Curve (which relates unemployment to real wage inflation) describes reality, it’s sensible to assert that low real wage inflation informs us that the unemployment rate has not declined to a level that reflects labor market scarcity – though we should also recognize that real wage growth would already be much higher if there was not such an extreme gap between real wage growth and productivity growth.
Where we differ from Chair Yellen is in a variety of supposed cause-effect relationships that aren’t supported by evidence to any meaningful extent, and in the neglect of systemic risks that are undeniable if one has been paying any attention at all to the macroeconomy over the past 15 years.
Let’s trace some of the links in the chain of cause and effect.
First it’s clear that increasing the monetary base relative to nominal GDP will predictably and reliably lower short-term interest rates. This is true at least until the point that, as has occurred across history and across countries, inflation picks up rather uncontrollably – often following a supply shock coupled with government deficit spending – with very little at all to do with the prevailing unemployment rate. In any event, nearly a century of data provides very clear evidence of a tight link between monetary base/nominal GDP and the level of short-term interest rates.
The next link in the chain is the assumption that suppressed short-term interest rates are somehow good for economic growth and job creation. Here, the cause-and-effect link is much weaker. It’s certainly true that suppressed short-term interest rates result in yield-seeking and the enhanced availability of loans to low-quality borrowers who offer higher yields than are available on safe alternatives. But it’s also clear that QE does not do much to stimulate real investment, where there are numerous costs and risks beyond the cost of money (and where hundreds of billions of idle dollars are available on corporate balance sheets even in the absence of further QE). Rather, QE primarily encourages speculation, leveraged finance, and other forms of financial “engineering” where interest represents the primary expense. The objective of these activities is not job creation, but leveraging the “spread” between the return on one financial asset and the interest that one must pay to acquire it with borrowed money.
On Yellen’s inflation views, the argument that general price inflation will only follow real wage inflation is really an argument that general price inflation will only follow low unemployment. At best, this view is half right. There’s good evidence that low unemployment tends to result in higher real wage inflation (the real Phillips Curve), but it does not follow that real wage inflation is naturally associated with faster general price inflation. Indeed, because general prices are the denominator of real wages, faster general price inflation tends to reduce real wages in the absence of a spiral in all nominal prices where wages take the lead. That’s just arithmetic. Aside from some short-term cyclical pressures, we’re not terribly concerned about rapid inflation at present, but we also don’t find much evidence that unemployment, whether at current levels or lower levels, is the central factor that would determine inflation anyway.
The most dangerous assumption of the Fed is that the primary risk of QE is inflation, and that QE is somehow a benign policy in the absence of inflation risk. Yes, we would love to see lower unemployment, and agree that stronger growth in real wages would likely result from that. It’s just that the transmission mechanism from QE and zero-interest rate speculation to lower unemployment is either nonexistent or so poorly defined that the policy can only be considered reckless. The Phillips Curve dogma of the Fed has created blinders that narrow its view of risk to some abstract “tradeoff” between inflation and unemployment. Meanwhile, the speculative tenor of the markets is contributing to a very real risk of steep financial disruptions, not only because risk-assets are overvalued, but because debt is increasingly being purchased on the basis of yield rather than the careful evaluation of repayment prospects.
In short, the greatest risk of QE is not the inflation risk that may or may not emerge, but the financial distortion, overvaluation, and speculation that is already baked in the cake and is progressively worsening, in a manner quite similar to the 2000 and 2007 extremes, though less evident because the cyclical elevation of profit margins makes prices seem tolerable relative to current earnings. As I’ve frequently noted, based on equity valuation measures that are most reliably correlated with actual subsequent stock market returns, stocks are now more than double their pre-bubble historical norms, and presently suggest that the S&P 500 will be no higher a decade from now than it is today. We expect the current QE bubble to unwind no more kindly than the prior bubbles in 2000 and 2007. See Ockham's Razor and the Market Cycle and Yes, This is An Equity Bubble for additional background on these concerns.
As for the U.S. economy, conditions aren’t bad overall, but the benefits of economic activity are highly uneven. 40% of families report that they are “just getting by,” with the majority essentially living paycheck to paycheck without enough savings to cover even a few months of expenses. We could be, and should be doing better, except that this complex adaptive system of ours responds to good incentives as well as bad ones, and has been repeatedly crippled by policies that have produced waves of malinvestment, bubble, and collapse. The economy is starting to take on features of a winner-take-all monoculture that encourages and subsidizes too-big-to-fail banks and large-scale financial speculation at the expense of productive real investment and small-to-medium size enterprises. These are outcomes that our policy makers at the Fed have single-handedly chosen for us in the well-meaning belief that the economy is helped by extraordinary financial distortions. The Federal Reserve is right to wind down quantitative easing, and would best terminate reinvestment of maturing holdings, ideally beginning in October or quickly thereafter. The issue is not whether the U.S. economy does or does not need “life support.” The issue is that QE is not life support in the first place.
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