WHY THE FED CAN´T SAVE US / SEEKING ALPHA

Why The Fed Can't Save Us

Sep. 26, 2014 4:15 AM ET 


Summary

•Myths about monetary policy.
•The importance of the business cycle.
•The shrinking middle-class and the pressure on real income growth.

The article I wrote for Seeking Alpha last week on the latest twist in Fed policy (There is No Bubble, There is No Timeline, There is No Exit Strategy) sparked a fair amount of controversy about Fed policy. It also elicited a series of battles, notably between stock market bulls and bears, but also between monetarists and Keynesians, precious metals believers and non-believers, optimists and pessimists. As the commentators warmed to their themes, the rhetoric was heated at times.

The tenor of the comments encouraged me to write a follow-up piece. Allow me to preface it by saying that while I readily confess to increasing skepticism about rising asset prices over the last couple of years, as well to being a firm debunker of the never-ending hype that the economy is just about to turn the corner to higher growth (this time we really mean it), I have nevertheless not called for a bear market. On the contrary, on those rare occasions when the market was getting a short-term beating, I have advised that it was not the start of something bigger. While I do believe that valuations are excessive, my base scenario is that they will get even more so first - probably followed by another very bad ending. The world isn't as simple as a two-fold division into those who wholeheartedly embrace stock market valuations, and those who are frustrated bears.

I should also add that I'm not writing about the central bank vis-à-vis the current wobble in the stock market. I'll address the latter another time. My central thesis is that monetary policy is neither an economic panacea, nor an invincible security blanket for asset prices that a steadily increasing number of market participants have come to believe in (sometimes called "the myth of central bank omnipotence," a phrase I wish I coined but did not). A combination of record low bond yields - mainly the result of central bank intervention - non-negative earnings growth and non-recessionary economic data have allowed the stock market to reach very elevated valuation levels (not as lofty as early 2000, but if you're waiting for that bell to ring again, you're going to have live a long, long time).

The central banker's central bank, the Bank of International Settlement (NASDAQ:BIS), took central banks to task for excessive policy accommodation in its annual report this past July. It used to be accurately repeated by Fed officials that monetary policy is a blunt instrument. In recent years, it seems as if the credo has been forgotten on some closet shelf.

As it happens, the BIS has not forgotten about it and takes the same position that I do. In its annual report, the bank writes that "while some monetary accommodation is no doubt necessary, excessive demands have been made on it post-crisis" and adds that the current Fed policies of forward guidance and quantitative easing (QE) "do have an impact on asset prices and markets, but have clear limits and diminishing returns." I want to stress that sentence, because it seems that everywhere I look, be it equity fund managers or stock market strategists or Seeking Alpha denizens, someone is repeating the magic formula: Stock prices cannot go down while the Fed stands guard (perhaps more often stated as that they can only go up).

Since I suspect that there is more immediate interest in my second claim (one I've stated in the past) that monetary policy is not the security blanket that many think it is, let me get right to it. It's a very widely held belief that bull markets only end when the Fed raises interest rates. It's not so: Bull markets end when the market accepts that the business cycle has turned down. That's actually quite sensible, since prices should have some relation to earnings, wouldn't you agree? Falling earnings beget falling prices. Disappearing earnings beget disappearing prices.

Note that I did not say, "when the cycle has turned." Not only is it virtually impossible to discern the turn of the cycle in real time, it's almost irrelevant anyway - what drives prices is what the market believes about the economy and profits, not some arcane data point. There's no magic rule - in the past, the market has been both early and late in incorporating the cycle turn into its outlook, sometimes jumping the gun multiple times, other times waiting to be hit over the head with a brick.

What is true is that business cycles last about six to eight years, and that the latter parts of cycles beget certain phenomena that prompt central banks to raise interest rates. The longer the cycle lasts, the more likely is it that the central bank will raise rates. The biggest fear is inflation, which once let out of its cage can endure through recessions and multiple cycles. For that reason, many have come to believe that central banks precipitate recessions by raising rates, because almost by definition, rates peak at the end of the cycle - once the latter is clearly downward, banks usually want to ease. Ergo, the inference is that high rates made the economy fall.

Central banks can cause recessions, of course, but the last one that the Federal Reserve brought to life was the 1980-1982 recession, when then-chair Paul Volcker squeezed the life out of the money supply in order to finally defeat double-digit inflation.

I don't want to oversimplify - rising real rates do have an effect on credit growth, and that does have some influence on the end of the cycle - but not by that much. Cycles end anyway. The point of higher real rates is to prevent credit excesses that would lead to higher inflation and/or the harder landings that ensue from excessive speculation.

As a cycle ages, complacency grows, sometimes into euphoria, and lending gets increasingly goofy. Hence the inverted yield curve - because the private market supply of credit is still plentiful, corporations continue to have no trouble at all borrowing money for three years and up. The Fed, on the other hand, will do various things to check the kind of short-term funding growth that continues to add leverage to a system already running near capacity. As the cycle ages, an increasing pile of short-term money can lead either to inflation or to the kinds of balance-sheet mismatches that crush lenders when the cycle turns. Interest rates prior to the last two recessions were not high enough to impede credit growth - they simply weren't low enough to facilitate a never-ending explosion in overnight funding.

It's also true that a central bank raising rates might be a signal that the cycle is near an end, and hence a useful warning light. However, banks sometimes raise rates simply in an effort to normalize policy - i.e., rates were too low, a crisis is over - rather than out of concern for strains in production or credit. When stock prices do keep rising after rates do - nearly always the case - a typical result is a certain amount of hysteria in some quarters of the equity markets. Monetary policy effects do operate with a lag anyway, one that may or may not overlap the turn of the business cycle, but the stock market tends to neglect such nuances in favor of the preferred rule: ride the trade until it breaks. If you think I'm being snide, I'm not: for a trader, betting with the herd is a lot safer than betting against it.

The implicit corollary of the stock market theory that equities can only go up while the Fed maintains zero rates is that the central bank has repealed the business cycle: we cannot have a recession while short-term rates are zero. I have seen many comments that state as much explicitly. Let me assure you that it is not so: there is no cure for the business cycle. What is true is that extended periods of low inflation without recession or bear market invariably give rise to the hope that the cycle has finally died. Let me repeat a Bob Farrell rule: There are no New Eras.

That is part one: the central bank cannot save us from the end of the business cycle, and stock prices will fall once profits and production fall, regardless of what level interest rates are at. You can't win by betting on a dying horse, no matter how good-looking the jockey.

A great deal of money has been hoovered up by low-grade securities and leveraged bets requiring very low funding rates to be profitable. What the effects will be on these securities once the Fed starts to raise rates (to a still-low level) is unknown, but I suspect that the transition is going to be problematic. The Fed worries are probably very much the same, which would explain why it's been cracking down on leveraged loans and has been so maddeningly incremental in its talk about ending ZIRP - the Fed is trying to give the credit markets lots and lots of time to get their crops out of the field and keep from going bust again. Whether the warning gets heeded remains to be seen, but the Fed will not raise rates next year out of fears over runaway economic growth. They'll raise them out of fears that zero rates for too long will make the credit markets too goofy, as well as keep the bank defenseless against a business cycle that is getting well into its senior years.

The other thing that the Fed cannot do to save us is repair the economy. Certainly monetary accommodation helps, but two problems remain: One is that of the cycle of the financial bust. The BIS estimates that financial cycles (as opposed to business cycles) that end in crises "last much longer than business cycles. Irregular as they may be, they tend to play out over perhaps 15 to 20 years." Ironically, CNBC regular (and trader) Jack Bouroudjian was on this week recently declaring that we are "only halfway through the greatest recovery in history" and then amended it moments later by saying "we're in the early stages," implying that it's the business cycle that will run fifteen years instead. I don't know Jack personally, but I do like him, even if I think he's a nut (my apologies for being unable to find a video link).

Some aspects of the balance-sheet repair process are in good shape, so far as I can tell, while others (such as mortgage finance) may need to serve the full fifteen-to-twenty year sentence before parole is granted. I don't think that the BIS meant that nothing would recover for a long time, but I'm not going to talk about the balance-sheet repair process here anyway, partly because the banks might indeed be able to help, and partly because I don't believe that any central banking chief thinks he or she has a firm grip on the right solution. I know I don't.

The Fed-proof repair problem that I wanted to talk is thus not the balance sheet, but our anemic growth rate. Central banks can provide all the water in the world, but they cannot make the horses drink, as the two liquidity traps that the followed the Great Depression and the Great Recession (the current amount of excess reserves is nearly $3 trillion) can attest to.

The aspect I want to focus on here is the pressure on incomes and the middle-class. It's a broad and controversial subject, and I'm not going to try to sort it out in its entirety here. What I do want to do is point to one substantial, glaring problem that cannot be solved by monetary policy: our diminished productive capacity.

In August of 1990, 22.1% of the U.S. employment base (using BLS payroll statistics) were engaged in the categories of work that make up "goods production:" Mining and logging, manufacturing, and construction (apart from transportation, energy-related production is included in these three categories). By August of 2014, the percentage had fallen to 14.1%. More than half of the damage occurred from 1990-2003, when the Great Outsourcing of the 1990s was at first partly offset by the tech bubble, then aggravated by the tech wreck.

The housing bubble helped cushion the effect in two ways. Housing-related employment rose, from construction to mortgage banking and broking. That helped offset some of the losses in higher-paying production jobs, though aggregate real income was largely stagnant. The lion's share of the income loss was made up by borrowing, in particular real-estate related lending. We were able to maintain consumption patterns based upon earlier, higher incomes by borrowing the difference.

In the meantime, over a not-quite parallel period, the percentage of people employed in the Chinese "industry" classification (includes mining and quarrying (with oil production), manufacturing, construction, and public utilities, the last making up less than 0.5% of US employment) rose from 17.9% in 1998 to 29.5% in 2011, according to the World Bank (2011 being the latest year for which the Bank has data and the date of the last Chinese government statistical yearbook).

In Germany, the comparison is made complicated by the 1990 East-West reunification process that added more than 20% to the size of the official German labor force while almost immediately obsolescing a great deal of East German manufacturing (the legendary East German car Trabant, or "Trabi," went from a reported 3-year waiting list at the time of reunification to going out of production a year later). Nevertheless. official production employment stood at 24.7% of the total at the end of last year, down from 35.7% in 1991 but still 75% higher than U.S. levels.

There are some obvious qualifying factors behind the data, including the rapid industrialization of China compared to the mature U.S. and German economies, as well as the role of automation and other manufacturing efficiencies. But the trend is unmistakable, and I would argue that we cannot achieve real income growth without a healthier goods production sector. The 1990-1999 employment share was 20.4% on average, falling to 17.2% from 2001-2007 and to 14.1% from 2009-2014. Some of the change is attributable to technology, but some is not: the US decline from 2000 to 2014 is double the rate of Germany, a country that boasts extremely advanced manufacturing technology.

It's a complicated issue, and I can't propose a comprehensive answer here, only saying that the memes of the far left ("only the damned are rich") and far right ("only the damned are poor") have only served to obscure the discussion, however much they may do for political fund-raising. Nor am I proposing any sort of death knell for the U.S. - I'm as hopeful as any that innovation will continue to be one of our economic strengths. I am sure, however, that it's a problem beyond the reach of monetary policy, and one we will not solve in the current cycle - which could very well peak sometime next year, being eight years from the last peak.

In sum, the Fed cannot save us from the end of the business cycle. It can save us from hastening its demise by refraining from making predictions about its impending death, and so we should not expect the bank to ever do so, but the end will come nevertheless. Nor can it force the kind of investment or structural and fiscal policies that result in higher levels of real income growth. It can provide accommodative policy, but employment growth is far more sensitive to the business cycle than to the absolute level of interest rates. Employment mix itself depends on many factors, most of them beyond the reach of central banking.

Bull markets don't last forever, and no one ever says that they do: They just insist instead that the end is still a few years away. Whatever we at Seeking Alpha (or elsewhere) want to believe about interest rates, or the Fed, or Keynes or Hayek or gold or shale oil, the cycle will still end and somewhere around its turn, the financial markets will begin to discount the event, early or late, with or without interest rate shifts, and prices will begin to move accordingly. Valuation and risk preferences might well shift in response to interest rate sentiment, yet there is no reason to expect a bear market to begin without a turn in the cycle or a shock to the system.

On that basis, I expect the stock market to work its way higher into 2015, though it could be a struggle at times. That's not to say I think the market is safe, because there essentially is no margin of safety in current valuations. In addition, I have thought for many months that this fall would mean treacherous footing for equities, raising the probability of a significant correction, albeit one that would probably be followed by the usual climb to new highs. It is what it is, but the Fed cannot stop time