Yellen Has Many Questions

Ever since the FOMC’s last rate hike at the end of last year, Fed Chair Janet Yellen has sided with the committee’s doves who believe that there is no rush to hike again. They might have to settle for one rate hike before the end of the year. However, three of them (Yellen, FRB-NY President Bill Dudley, and FRB-Minneapolis President Neel Kashkari) recently have said that the economy has “room to run.” In effect, their new mantra is “Hysteresis”!

To my knowledge, Yellen used this word for the first time in a public presentation during her keynote speech at the 60th Economic Conference hosted by the FRB-Boston on October 14 and 15. The conference’s theme was “The Elusive ‘Great’ Recovery: Causes and Implications for Future Business Cycle Dynamics.” The word popped up four times in the text of Yellen’s remarks and two times in the footnotes and references. (Prior to that, it appeared only once, in a footnoted reference, in her speech at Jackson Hole titled “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future.”)

The term as used by macroeconomists means that a severe downturn in demand during a recession could have a depressing impact on supply. If so, then “strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand,” according to Yellen.

While she did say that more research is needed, she also seems to like the concept since it dovetails with her dovish view that the economy has room to run. She devoted a paragraph in her speech to the possible positive effects of “temporarily running a ‘high-pressure economy,’ with robust aggregate demand and a tight labor market.” Here is what she said:

One can certainly identify plausible ways in which this might occur. Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects. In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to more-efficient--and, hence, more-productive--job matches. Finally, albeit more speculatively, strong demand could potentially yield significant productivity gains by, among other things, prompting higher levels of research and development spending and increasing the incentives to start new, innovative businesses.

The title of all six papers presented during the conference ended with question marks. While Fed Chair Janet Yellen’s keynote address didn’t do the same, the text of her prepared remarks had 19 question marks related to her topic, which was “Macroeconomic Research After the Crisis.” Now without any further ado, here are the numerous questions Yellen asked economists to answer in her latest speech:

(1) “The first question I would like to pose concerns the distinction between aggregate supply and aggregate demand: Are there circumstances in which changes in aggregate demand can have an appreciable, persistent effect on aggregate supply?”

(2) “My second question asks whether individual differences within broad groups of actors in the economy can influence aggregate economic outcomes--in particular, what effect does such heterogeneity have on aggregate demand?”

(3) “My third question concerns a key issue for monetary policy and macroeconomics that is less directly addressed by this conference: How does the financial sector interact with the broader economy?”

(4) “What is the relationship between the buildup of excessive leverage and the value of real estate and other types of collateral, and what factors impede or facilitate the deleveraging process that follows?”

(5) “Does the economic fallout from a financial crisis depend on the particulars of the crisis, such as whether it involves widespread damage to household balance sheets?”

(6) “How does the nature and degree of the interconnections between financial firms affect the propagation and amplification of stress through the financial system and overall economy?”

(7) “[M]ost importantly--what can monetary policy and financial oversight do to reduce the frequency and severity of future crises?”

(8) “[I]s the persistent increase in the personal saving rate that we have observed since the collapse of the housing bubble primarily a result of a sustained shift toward more prudent underwriting standards by lenders? Is it something that will ultimately prove transitory once households finish repairing their balance sheets or become more confident about their future prospects for employment and income?”

(9) “My [next] question goes to the heart of monetary policy: What determines inflation?”

(10) “Does the reduced sensitivity [of inflation to the labor market] reflect structural changes, such as globalization or a greater role for intangible capital in production that have reduced the importance of cyclical swings in domestic activity for firms’ marginal costs and pricing power? Or does it perhaps reflect the well-documented reluctance--or, alternatively, limited ability--of firms to cut the nominal wages of their employees, which could help to explain the relatively moderate movements in inflation we saw during and after the recession?”

(11) “Ultimately, both actual and expected inflation are tied to the central bank’s inflation target, whether that target is explicit or implicit. But how does this anchoring process occur? Does a central bank have to keep actual inflation near the target rate for many years before inflation expectations completely conform? Can policymakers instead materially influence inflation expectations directly and quickly by simply announcing their intention to pursue a particular inflation goal in the future? Or does the truth lie somewhere in between, with a change in expectations requiring some combination of clear communications about policymakers’ inflation goal, concrete policy actions to demonstrate their commitment to that goal, and at least some success in moving actual inflation toward its desired level in order to demonstrate the feasibility of the strategy?”

(12) “Do U.S. monetary policy actions affect advanced and emerging market countries differently? Do conventional and unconventional monetary policies spill over to other countries differently? And to what extent are U.S. interest rates and financial conditions influenced by easing measures abroad?”

Clearly, she had lots of questions. In her speech, Yellen inadvertently confirmed the sad state of macroeconomic “science” and raised some serious doubts about whether the FOMC understands the economy well enough to manage it with monetary policy. Yellen might have been asking the wrong crowd for answers to her questions. Everyone at the conference was a macroeconomist. She really needs to be asking micro-economists many of the questions pertaining to consumer and business behavior. Demographers might have some relevant thoughts. Focus groups representing Americans with all sorts of different backgrounds might provide more down-to-earth insights.

Maybe the world’s economy would work better and make more sense if there were fewer macroeconomists trying to manage it. Could it be that many of the problems that confound macroeconomists result from too many of them meddling with the economy as policymakers? That’s a question that no one asked at the conference, though one economist did suggest that doing less meddling should be considered as an option.

Fiscal Policy: Cooking the Books

As ultra-easy monetary policies seem to be losing their effectiveness around the world, more economists are calling for more fiscal stimulus. Gaining altitude is the notion of “helicopter money”--i.e., that fiscal authorities should ramp up infrastructure spending with financing provided by the central banks. The problem is that the major central banks have been financing government deficits, which already are quite large but seem to have also lost their stimulative mojo. Let’s focus on the US:

(1) Measuring up the deficit. America’s taxpayers may need to hire a forensic accountant. There is a huge discrepancy between the official federal deficit, which totaled $587 billion through September, and the $1.05 trillion 12-month change in federal debt held by the public over the same period. In the past, these two ways of measuring the deficit have been nearly identical, as they should be. The previous exception was a large divergence in late 2008 related to accounting for TARP.

Apparently, a whole bunch of perfectly legit accounting maneuvers, which have gained currency recently, account for the discrepancy. An expert on fiscal matters explained them to me, but accounting was never my strong suit. Nevertheless, the bottom line is that the deficit is best measured as the change in debt.

(2) Lots of US and foreign helicopters. But wait: There are more accounting shenanigans, as you probably know. While Donald Trump has been trumpeting that the federal debt is $20 trillion, it’s actually $14.2 trillion excluding the $5.3 trillion held by the government itself. However, that’s because the Treasury issues mostly nonmarketable securities to government trust funds as a way to plunder their surpluses. There are no surpluses. There are just more IOUs that will have to be covered by more taxes or more borrowing in the future.

But wait: If we consolidate the Fed’s holdings of $2.5 trillion in US Treasuries into the government’s account, then the debt actually held by the public is $11.7 trillion. In my opinion, the Fed’s holdings amount to helicopter money since it has been used to finance some of the deficits. The claim by a few Fed officials in recent years that they haven’t been monetizing the debt is--how can I put this delicately?--an Orwellian distortion of the truth.

But wait: Foreign central banks have also, in effect, monetized some of the US federal debt thanks to the role of the dollar as the leading reserve currency in the world. At the end of September, they collectively owned $2.8 trillion of US Treasuries. We are clearly dependent on the kindness of strangers.

(3) Not shovel ready. The American Recovery and Reinvestment Act of 2009 (ARRA) was supposed to boost the US economy by financing spending on public infrastructure that was presumably “shovel ready.” Apparently, there weren’t many such projects available. Census Bureau data on public construction put in place show that it peaked at a record high of $325 billion (saar) during March 2009 and drifted down to a low of $263 billion near the start of 2014. In August of this year, it was still 17% below the record peak.

Again, we should hire a forensic accountant to see what happened to all the ARRA money before we waste a bunch of helicopter money. By the way, there may already be a shortage of construction workers in the US, so we may need to ask Mexican construction workers to come back if the government actually succeeds in boosting construction.

CAPE Fear

Last week, in his 10/5 WSJ “Heard on the Street” column, Justin Lahart had a closer look at the “cyclically adjusted price-earnings,” or CAPE, ratio developed by Robert Shiller and John Campbell in the 1990s. Shiller became a superstar in our business when he argued in his 2000 book titled Irrational Exuberance that his ratio, which is based on 10-year trailing earnings, was signaling irrational exuberance just as stocks started to plunge. Then again, just about every other valuation metric on the planet was sending the same signal. In any event, the ratio is signaling trouble again.

Previously, I’ve described judging valuation as similar to judging contestants in a beauty contest. Both are subjective judgments. Valuation judgments can be quite different depending on the metrics used to make a determination. There are lots of alternative options. I look at them all.

I am not a fan of valuation measures based on trailing earnings, especially if they trail over the past 10 years. I believe that the stock market is forward looking and discounts analysts’ consensus expectations for earnings over the year ahead. More specifically, I use S&P 500 12-month forward consensus expected operating earnings, which is a time-weighted average of analysts’ expectations for the current year and the coming one. While the forward P/E of the S&P 500 isn’t as alarming as Shiller’s CAPE ratio, stocks aren’t cheap using almost any valuation metric other than the Fed’s Stock Valuation Model, which has been showing that stocks have been increasingly undervalued relative to bonds since 2001. (See our new and improved FSVM.)

In his column, Lahart often provides excellent analyses of the stock market. In his latest piece, he observed that:

[CAPE’s] advantage is that it corrects for extreme good times and bad times by valuing share prices based on 10 years of earnings, rather than one year. … The CAPE is now at 27. That is about where it was in 2007, before the financial crisis, and it is well above its 50-year average of 20. The only times the CAPE has been higher were during the 2000 bubble and bust, and just prior to the 1929 crash, according [to] the data compiled by Mr. Shiller.

(Hence, the title of this piece, which is also a play on the 1962 movie “Cape Fear” with Robert Mitchum and the 1991 remake with Robert De Niro.) Let’s have a closer look:

(1) Measuring earnings. Lahart reported:

Mr. Shiller uses S&P 500 earnings under generally accepted accounting principles, or GAAP. That is probably the best measure of earnings because it avoids many of the tricks that companies use to flatter their numbers. The problem is that GAAP isn’t a stable concept, and has been revised multiple times. In 1993, for example, banks were required to mark to market a greater portion of their holdings. In 2001, accounting rule makers changed the rules on goodwill.

Wharton Professor Jeremy Siegel says that both changes lowered GAAP earnings.

The WSJ constructed an alternative CAPE ratio using quarterly data on total after-tax US profits from the National Income & Product Accounts (NIPA) accounts, presumably because this measure is compiled using “a consistent standard over the decades.” I compared aggregate S&P 500 reported earnings, which is the GAAP measure, to the NIPA after-tax corporate profits based on tax returns. The former is annualized but not seasonally adjusted, while the latter is both annualized and seasonally adjusted. I compared them since Q1-1964, when the S&P data start.

When I take the ratio of the S&P measure to the NIPA measure of profits, I don’t see the impact of the accounting changes mentioned above. The ratio has been volatile but has fluctuated around 50% without any pronounced structural shifts along the way since the start of the comparison.

(2) CAPE of good hope. Next, the WSJ analysis used Fed data on the total value of US stocks rather than the value of the S&P 500. I prefer to use the same measure excluding foreign equities trading in the US when we use these data for the comparable valuation measures we construct. Foreign equites held by US residents as a percentage of their total equity holdings was relatively flat around just 1% from 1952 through the mid-1980s. Then it soared to peak at 21.1% during Q2-2008. It has been hovering around 20% since then. Foreign equities should be excluded from the numerator of the ratio, because their profits are not included in the NIPA profits.

The WSJ measure of the CAPE ratio is less fearsome than Shiller’s version:

As of the end of the second quarter, according to the latest data available, the corporate-profits CAPE was at about 19--just above its 50-year average of around 17. By contrast, it was 39 at its peak during the tech bubble and 24 at the market’s peak in 2007.

That’s a relief. It would be even lower using the total value of equities traded in the US excluding foreign issues.

(3) Short trail. I can’t bring myself to compare the value of the stock market today to earnings over the past 10 years. Instead, let’s look at my ratio of the value of equities excluding foreign issues divided by the NIPA profits measure on a quarterly basis rather than on a 40-quarter trailing basis. During Q2-2016, it was 18.0. The record high was 36.5 during Q1-2000, while the record low was 4.7 during Q4-1978. Its current reading does match previous cycle highs excluding the irrational exuberance peak of Q1-2000.

Given that inflation and interest rates are lower than at any time since we can calculate this ratio, it seems to suggest that stocks are fairly valued rather than seriously overvalued. That’s about the same conclusion that Lahart came to with his version of the 10-year trailing CAPE ratio.

(4) Tobin & Buffett ratios. The CAPE ratio certainly isn’t a novel measure of valuation. It is highly correlated with the Q ratio devised by Professors James Tobin and William Brainard in 1968 at Yale University. The concept is simple: It is the ratio between a physical asset’s market value and its replacement cost. When applied to the overall stock market, a ratio exceeding 1.0 suggests stocks are overvalued, while a ratio below 1.0 suggests they are undervalued.

Measuring that ratio seems like a huge challenge. However, the Fed’s Financial Accounts of the United States has a quarterly series starting in 1952 that tracks Tobin’s Q for nonfinancial corporations. It is highly correlated with the ratio I constructed inspired by Lahart and Shiller, though mine is based on quarterly profits rather than 10-year trailing profits.

My ratio is also highly correlated with the Buffett ratio, which is the market value of US equities excluding foreign issues relative to GNP. I’ve found that the Buffett ratio is also highly correlated with the ratio of the market capitalization of the S&P 500 divided by S&P 500 revenues. I can get a more real-time read on these simply by tracking the S&P 500’s forward price-to-sales ratio.

(5) Looking forward. The S&P 500’s forward P/E (based on forward operating earnings) was 16.6 during September. That isn’t much higher than its 13.8 average since 1979, when the data begin. However, that’s well below Q2’s 21.1 P/E based on four-quarter trailing operating earnings, and 23.9 based on four-quarter reported earnings.

Had enough yet? On balance the most widely followed valuation measures all show that the market is somewhere between fairly valued and overvalued. However, bear markets are caused by recessions, not overvaluation. Recessions cause earnings to fall, which causes stock prices to fall even faster, thus depressing valuations. In my opinion, the stock market can remain overvalued as long as earnings continue to grow. That’s particularly likely now given that both inflation and interest rates are at historical lows.

Meanwhile, S&P 500 forward earnings rose to a record high during the first week of October. The same can be said for the S&P 600, while the S&P 400 edged down from its record high two weeks ago.

Just Say No!

For many years, there has been a recurring pattern of banks getting into all sorts of trouble. That’s because bankers are playing with other people’s money (OPM). They either have no, or very little, skin in the game. So they have a tendency to take more risk than they should. Just like power, OPM can corrupt some people. I don’t have any reason to believe that any of the major central bankers is corrupt, but their access to and excess with the OPM they control is a drug, i.e., it’s their opium.

When they were first established, central banks were tasked with providing an elastic currency that met the seasonal ebbs and flows of money demand. They were also supposed to provide liquidity when financial crises occurred from time to time to make sure they didn’t turn into full-blown financial contagions. They certainly were not mandated to manage the economy with the aim of keeping the labor market near full employment and stabilizing inflation around a fixed and near-zero target. Most of them originally were run by commercial bankers and lawyers, who tended to be conservative and weren’t trained to manage the economy in any case.

That changed in recent years, and now the major central banks have been overrun by macroeconomists in the policy committees, with large staffs of more macroeconomists. They’ve all been trained to manage an economy, and firmly believe that’s their job and they can do it. The leading proponent of that view in the United States is, of course, the leader of the Fed, namely Fed Chair Janet Yellen.

Central bank leaders are convinced that without their ongoing and expanding ultra-easy monetary policies--relying increasingly on so-called “unconventional” monetary tools--the global economy would have sunk into a depression following the financial crisis of 2008. Of course, they’ve been disappointed that the pace of economic growth has been subpar and that inflation remains below their 2% targets. However, they argue the counterfactual--namely, that were it not for the forward guidance, quantitative easing, and negative interest rates they implemented once their official interest rates had fallen to zero (the dreaded “lower bound”), there would have been a terrible outcome. They never consider the alternative counterfactual that their unconventional policies might be one of the main causes of global secular stagnation.

Last Thursday, in a video conference (start listening at the 9:05 time mark) with bankers in Kansas City, Yellen crossed the line, in my opinion, when she suggested that the Fed should be authorized by Congress to buy corporate bonds and stocks. After all, she noted, the Bank of Japan (BOJ) has been buying corporate bonds and stocks for a while, and the ECB has been buying corporate bonds since June of this year. That’s true, but how’s that working so far?

Not so good. The BOJ just can’t seem to stop the forces of deflation. In August, Japan’s CPI was down 0.5% y/y, while the “core core” rate was up only 0.2%. Japanese industrial production rose 1.5% m/m during August, but is actually down 5.1% from January 2014, despite Abenomics. In the Eurozone, the headline CPI inflation rate was only 0.4% during September, according to the flash estimate, while the core rate was 0.8%. Eurozone industrial production fell 1.1% m/m in July, and was down 0.5% y/y, the weakest since November 2014. On the other hand, Germany’s Ifo Business Confidence Index rose smartly during September, though the survey was taken before Deutsche Bank hit the fan. European banks are sitting on too many nonperforming loans, which is weighing on their willingness to lend, notwithstanding all the efforts by the ECB to encourage them to do so.

Yellen graduated from Yale with a Ph.D. five years before I did the same, in 1976. We both learned from Professor James Tobin, the chairman of both our dissertation committees, about the “Portfolio-Balance Model.” The idea is that assets are substitutable for each other. So if the Fed buys government bonds, reducing their supply, that will drive more demand into other bonds as well as equities. The resulting increase in wealth then should stimulate spending. (My Ph.D. dissertation was titled “A Portfolio-Balance Model of Corporate Finance.”)

In her talk last Thursday, Yellen said:

Now because Treasury securities and, say, corporate securities and equities are substitutes in the portfolios of the public, when we push down yields--let’s say on Treasuries--there’s often and typically spillover to corporate bonds and to equities as well [such] that those rates fall or that equity prices rise, stimulating investment. But we are restricted from investing in that wider range of assets. And if we found--I think as other countries did--that [we] had reached the limits in terms of purchasing safe assets like longer-term government bonds, it could be useful to be able to intervene directly in assets where the prices have a more direct link to spending decisions.

Got that? If the Fed runs out of Treasuries, “it could be useful” to buy corporate bonds and stocks. Spoken like a true central monetary planner. She would like to add that option to the Fed’s toolkit just in case the other tools used to tinker with the economy don’t work. She is very blunt about her willingness to distort our capital markets because they clearly aren’t working well enough on their own to achieve the Fed’s goals.

How can capitalism survive in the US if the capital markets are completely distorted by the Fed? The economy certainly doesn’t seem to be getting any lift from all the distortions that have occurred in the Treasury bond and money markets caused by the Fed’s policies since the financial crisis of 2008. Intervening so broadly in the capital markets is bound to disrupt the process of creative-destruction that is integral to capitalism. It will keep zombie companies in business, which would be deflationary and reduce profitability for well-run competitors. Investors won’t get to determine the winners and losers if the Fed buys simply to prop up stock prices. Depending on the circumstances, the “Yellen put” might result in a speculative bubble.

In short, it’s an insane idea. But the BOJ and the ECB are doing it, so why can’t we do it too? Could it be that they are insane? They certainly aren’t doing anything to revive capitalism’s animal spirits. Both the Eurozone and Japan have relatively inferior capital markets compared to the vibrant ones in the US. That’s one of the main reasons why the US economy is outperforming them. They still depend too much on their banks for financial intermediation. Their banks have been broken for a long time, and the flat-yield curve and negative interest-rate policies of the BOJ and ECB certainly aren’t helping their banks.

Yellen concluded her response saying:

But while it’s a good thing to think about, it’s not something that is a pressing issue now, and I should emphasize that while there could be benefits to, say, the ability to buy either equities or corporate bonds, there would also be costs as well that would have to be carefully considered in deciding if it’s a good idea.

I think it would be a very bad idea.

On Friday of last week, just by coincidence (or maybe not), Larry Summers floated exactly the same idea. The 9/30 Bloomberg reported:

Among the proposals that deserve “serious reflection" is the purchase of a “wider range of assets on a sustained and continuing basis,” Summers said in a lecture at a Bank of Japan conference in Tokyo Friday. “I’m not prepared to make a policy recommendation at this point,” he told reporters later. ...

Japan has “engaged in that type of transaction to much greater extent than other countries,” Summers said, pointing out among its initiatives the BOJ’s purchases of exchange-traded funds. “It is something that economic logic suggests should be considered in other places where the zero lower bound is a potentially important monetary policy issue,” he said, referring to the perceived lower limit for benchmark rates set by central banks.

Got that? It’s “economic logic.” Maybe so, but that too certainly hasn’t worked for Japan so far. The BOJ started buying ETFs during October 2010 at a modest rate of roughly 450 billion yen per year. That was doubled to an annual 1 trillion yen in April 2013 and increased again to 3.3 trillion in October 2014. The BOJ’s Monetary Policy Committee literally doubled down at its July 28-29, 2016 meeting, raising the ante to 6 trillion yen. BOJ purchases are averaging 2.9% of daily trading values now.

The Japan MSCI stock price index (in local currency) entered a bear market in mid-January and remains 22.6% below last year’s high. The stock market isn’t getting a lift from the government’s stock purchases because the yen has appreciated 24% since last year’s low. If the stock market is falling despite the BOJ’s faster pace of purchasing ETFs, what’s the point?

Summers acknowledged, “There are obviously important political and economic questions associated with government ownership of companies.” He said, “Some critics could term such a policy as ‘socialism.’” Sign me up for that club of critics! It’s certainly not capitalism, which would be gravely damaged in the US, as it has been in both Japan and the Eurozone by the half-baked interventions of the BOJ and ECB in the capital markets.

Interestingly, “What Assets Should the Federal Reserve Buy?” was the title of an article by two economists at the Federal Reserve Bank of Richmond, which first appeared in the bank’s 2000 annual report. (Hat-tip to Mike O’Rourke.) Back then, there was serious concern that the US Treasury would be running large budget surpluses and would pay off all of the outstanding federal debt in a matter of a few years. (Hard to believe, but true.) The authors didn’t specifically mention equities, but they strongly warned against the Fed buying private-sector securities for numerous good and obvious reasons. Summers and Yellen should read the article. Here is just one relevant excerpt:

There would be costs associated with assessing asset value and creditworthiness, whether the Federal Reserve hired staff to make those judgments internally or hired independent portfolio management. Further, the extension of even a small amount of Federal Reserve credit to a particular entity might be interpreted as conferring a preferential status enhancing that entity’s creditworthiness. The status of a particular asset or loan could deteriorate while in the Fed’s portfolio, requiring it to be sold, or not rolled over, in order to avoid taxpayer losses. It might be difficult, however, for political or bank supervisory reasons, for the Fed to sell such an asset or call such a loan.