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Incompetent But Not Weak: "The Fed Doesn't Know Whether To Shit Or Go Blind"

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The outlook for the US economy is deteriorating, yet the Fed is trying to raise overnight rates to keep unseen inflation from rising. Success in its strategy could force consumption lower, unemployment higher, and exacerbate real output contraction. But, as Macro-Allocation.com 's Paul Brodsky explains, we should not mistake apparent incompetence for weakness.

 

The August Purchasing Managers Index (PMI) came in at 49.4 last week, a level that signals contraction, not just slower growth. Within the PMI, new orders fell 7.8%, production fell 5.8%, and employment dropped 1.1% from July. Only six of eighteen industries reported an increase in new orders while only eight reported an increase in production. The report followed PMI plunges in Chicago (to 51.5 from 55.8), Richmond (to a 3-year low of -11.0 from 10.0), Dallas (to -6.2 from a 19 month high of -1.3), and New York (to -4.21 from 0.55). The weak manufacturing report follows a weaker than expected service sector report in August, which now hovers only slightly above the level of contraction.

 

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August US auto sales were also reported last week and appear to be rolling over. They declined 4% from the same month last year, the first reversal after three years of increasing demand among consumers and fleet operators needing to replace their cars following the financial crisis.

 

Meanwhile, ZeroHedge posted the graph at right to argue that the US soon fell into recession each of the seven times since 1970 when US construction spending rolled over, which it is doing now.

 

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These data points go hand-in-hand with struggling output growth. Real GDP has labored over the last three quarters to break above a 1% annual growth rate, and the most recent data lend credence to our view that a secular slowdown is now upon us.

 

Indeed, the Bureau of Economic Analysis (BEA), which calculates GDP and dates recessions, noted last week: “Real Gross Domestic Income (GDI) increased 0.2 percent in the second quarter, compared with an increase of 0.8 percent in the first. The average of real GDP and GDI, a supplemental measure of US economic activity that equally weights GDP and GDI, increased 0.6 percent in the second quarter, compared with an increase of 0.8 percent in the first.”

 

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Despite generally sunny narratives and strong equity indexes, economic data have had a bad run relative to expectations recently, as illustrated by the Citi surprise index graph abov. Economists’ dispositions remain hopeful, however, due to expectations of increased government spending in the second half, which would boost GDP.

 

All is not copacetic. How long would government spending boost output, and at what cost? Would the marketplace and markets be fooled as budget deficits soar? Right on cue, veteran bond strategist, David Ader, declared recently in Barron’s that “the federal budget deficit is about to explode”. The US debt-to-GDP ratio has been over 90% since 2010, and federal debt held by the public will be about 77% of GDP in 2016, the highest since 1950 according to the Congressional Budget Office (CBO). The CBO thinks the budget deficit will begin to grow again in 2016 by about 30% to $592 billion, and move higher from there, all else equal.

 

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Even if government spending can be increased in coming years (infrastructure stimulus from the next White House?), the overall impact is bound to be negligible or negative. Lacy Hunt from Hoisington has cited Fed studies showing that government spending actually reduces private sector output growth. Mandatory spending for things like entitlements already comprise almost 70% of total government outlays. While in the past this boosted contemporaneous income for many, it merely pushed irreconcilable obligations forward.

 

The impact is now obvious. “Real GDP expansion averaged 3.2% annually from 1970 to 2000, 1.8% from 2000 to 2016, and 1.4% since 2006”, notes Ader. How can we conclude anything else but the trend Ader cites is on track to turn negative (along with interest rates)?

 

The Fed

 

 

The Fed has very few plays left when it comes to stimulating the economy and so it is punting. Indeed, output is not even in the Fed’s formal jurisdiction. Its dual objectives are stable prices and full employment. We may agree or disagree with its mandate, method and execution, but we cannot run from the reality that the expansion or restriction of credit is the Fed’s only means of trying to tweak GDP. It cannot stimulate economic activity when funding rates are already near zero percent and QE is currently off the table.

 

So why is the Fed so determined to hike rates? Like all politically motivated bodies, it is an institution that believes motion is progress. Perhaps the Fed would like keep wage and price inflation low, which in turn would minimize the impact of declining real output growth? The lower inflation, the higher real GDP. Or, perhaps the Fed is interested in widening net interest margins for banks, especially large ones, which have been forced to rely more and more on lending? Or maybe it feels “normalizing rates” would provide comfort to the public that the Fed could again step into the breach should another financial crisis arise?

 

Fed activity recently reminds one of a Rube Goldberg rhetoric machine. Between meetings its regional presidents peck the media with knowing hints an innuendo, only to have their cryptic wisdom swatted away by the markets. Nothing obvious in its current policy and operations seem able to affect output, prices or employment. In fact, there is a bit of illusion. The market should not underestimate the Fed’s power based on its apparent incompetence.

 

Raising the Fed Funds rate would restrict credit issued from non-bank lenders (i.e., bond buyers), but not from banks, which are more sensitive to Interest on Excess Reserves (IEOR). The Fed has been paying banks the IOER rate on $3+ trillion of reserves they keep at the Fed. This is providing banks with an easy source of revenue – the risk free spread between IOER and deposit rates. It is also ensuring banks do not lend out their excess reserves to the public, where it would be at risk of loss.

 

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The Fed could easily stimulate credit issuance by lowering the IOER rate so that the risk-free arbitrage that banks are enjoying goes away, pressuring them to lend their excess reserves. The Fed does not seem to want to do this, but rather wants to raise the Fed Funds rate. We do not know if the Fed would raise the IOER rate if/when it raises the Fed Funds rate. If it does, then banks might enjoy an even wider net interest margin if they do not pass on higher rates to depositors.

 

Though a hike in the Fed Funds rate would increase bank profitability, it would also threaten the shadow banking system (fixed income markets). Investors borrowing to hold bonds would likely be charged more by banks to carry positions as Fed Funds rise. And, if the yield curve were to move higher in sympathy with Fed Fund hike, bond prices would depreciate. Alas, bond market losses from rising rates would also threaten the collateral behind loans made by the banking system.

 

The Fed is boxed with the financial economy it wrought, and so it has made it a point to communicate that it is focused on its mandate - inflation and jobs – and not on output growth.

 

As it stands, the run rate of inflation has been very stable just below 2% since 2012...

 

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...and inflation expectations remain mostly quiescent, but have begun to experience more volatility as energy prices have distorted headline inflation in both directions:

 

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As energy prices stabilize, producing less inflationary or deflationary impacts, attention naturally turns to potential wage inflation, which can greatly affect core inflation and, in turn, have a negative impact on real output growth.

 

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Many economists believe wage inflation is the primary cause of overall goods and service inflation, which may help explain why the Fed is choosing to focus its attention on jobs.

 

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With real GDP already struggling to climb above 1%, there is nothing else the Fed can do except try to lessen the economic blow it sees ahead. The Fed would never communicate that its policy is to raise the level of unemployment, but that is effectively what its policy seems to be.

 

The graph below shows a truer measure of America’s productive unemployment rate...

 

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...while the graph below shows labor participation as a percent of eligible workers before, during and after America’s secular leveraging phase, from 1982 to 2007:

 

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Meanwhile, those Americans still working have very recently begun to work less each week...

 

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...which makes sense given the incredible productivity-enhancing innovations introduced over the last ten years, but runs counter to the Fed’s fear of higher wage and price inflation. The Fed’s fear of inflation is curious in light of goods and service prices that have increased less than its 2%/year target over the last ten years, and did not even keep pace with wage inflation, which increased about 27% in that time.

 

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The US economy on a stable low growth or even modestly contracting path would not be a problem if it were not for the over-abundance of debt remaining as assets and liabilities on public and private sector balance sheets – debt that needs to be serviced and repaid by inflationary output growth. The graph below shows debt we can count today. It does not include: 1) past promises made that have to be met, such as social security and other entitlements, 2) off balance sheet obligations made by banks and other entities and 3) compounding interest on this and all other debt balances that naturally raise debt levels.

 

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Against the $63 trillion in outstanding debt portrayed on the graph above, there is a relative paucity of dollars to service and repay it, only $13 trillion in M2 and only $4 trillion in base money.

 

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Since balance sheet leverage is defined by the ratio of obligations over money (credit is simply a claim on money, not a claim on goods, services or production), GDP is coming under increasing pressure to expand. Further, GDP growth must be real (inflation adjusted). Otherwise, the growth of debt would continue to outpace production growth, which would make the leverage problem worse.

 

When we look at past debt growth vs. GDP growth (below), we can infer that without the leverage build up since 1982, production growth would have been far lower. The graph implies that for every dollar of debt created in 1982, one dollar of GDP was also created. Today, $1.00 of debt creates $0.38 of GDP.

 

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And when we consider that overnight funding rates have fallen from over 20% in 1981 to 0.25% today (graph below), we can further infer that past growth cannot be repeated...not even close. Since interest rates are at the zero bound and credit spreads are very tight, there can be no more refinancing waves that would help pull future revenues forward, or that would create a leverage-led increase in asset prices.

 

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As we have noted, the US economy is under increasing pressure to undergo structural change. The global economy and capital markets will be brought along with it. We cannot know when such worrisome macroeconomic fundamentals will rise to the level of broad public consciousness, and cannot know how the Fed will react when it does. We suspect the Fed will pull the trigger – perhaps explicitly, perhaps not.

 

It is with utmost erudition that our current read on the Fed is that until it summons the political gumption (post US election?), it does not know whether to sh*t or go blind, so it is closing one eye and f*rting. It is responding to an untenable situation as powerful institutions tend to do – by doubling down on the strategy that got it into trouble in the first place, in this case the rhetorical reliance on rigid models to produce a reasonable strategy. Its models will fail to work because systemic leverage is accelerating faster than output growth, which is compounding the problem.

 

The de-leveraging process, through debt deflation, currency inflation or some mix of both, is necessary and inevitable. We have speculated that the Fed and other monetary authorities will greatly devalue their currencies, which would diminish the burden of debt service and repayment while not sacrificing debt covenants. We stand by this position and will continue to allocate capital in our model portfolios (and elsewhere) accordingly.

 

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