Thursday, November 14, 2019

Zombies in the Fed's Soup

I’m finishing up writing my next book, Fed Watching for Fun and Profit: A Primer for Investors. I’ve had a lot of fun writing it, and it has given me a broader perspective on the making of monetary policy by the Fed in particular and central bankers in general.

In my opinion, they all suffer from group-think.

They all use the same or similar models of the economy. Some are empirical models, but most are theoretical. The empirical ones create the illusion of a precise scientific analysis of how the economy works. The theoretical ones tend to be, well, too theoretical. Both can be quite misleading, especially if they are based on faulty assumptions and logic. Put simply, most of the models reflect thinking that bears little resemblance to reality and lacks plain old common sense.

When reality conflicts with what their models suggest to be the case, the central bankers—rather than questioning their models and learning from their mistakes—resolve the cognitive dissonance by doubling down on their commitment to their models. In other words, they do more of the same, expecting that the result will eventually coincide with their models’ predictions.

A case in point is their determination to provide ultra-easy monetary policies to boost inflation to their target of 2.0%. The major central bankers have been trying to do so for over 10 years without success. They seem totally befuddled. Fed officials have recently been talking about their “symmetrical target” of 2.0%, implying that they are willing to let the economy run hot, with inflation exceeding 2.0% for a while, since it has been running below that pace for so long. That’s an interesting idea, but they can’t even get inflation up to 2.0%—why embarrass themselves further by shooting for an even higher target?

The Fed pivoted at the start of this year from signalling three hikes in the federal funds rate during 2019 to actually lowering it three times this year. Outgoing European Central Bank (ECB) President Mario Draghi loaded up his bank’s bazookas yet again as he was walking out the door at the end of October. On 9/12, the ECB’s Governing Council voted to lower the bank’s deposit facility rate from -0.40% to -0.50% and to restart the asset purchase program at the pace of €20 billion per month with no set end date. The Bank of Japan never let up on its ultra-easy policies, but it did stop projecting when inflation might get up to 2.0%. The inflation rates in the US, Eurozone, and Japan are currently 1.7% (core US PCED), 0.7% (Eurozone CPI), and 0.3% (core Japan CPI) (Fig. 1, Fig. 2, and Fig. 3).

The major central banks all are run by PhD macroeconomists as well as people like Jerome Powell at the Fed and Christine Lagarde at the ECB who have been surrounded by macroeconomists their entire careers. Most of the macroeconomists working at the central banks were trained as demand-side Keynesians. They believe that easy money should stimulate demand, which should revive inflation. That’s their core belief, in fact.

More specifically, easy money should boost consumer spending on durable goods and housing. It should stimulate capital spending by businesses. When the economy runs out of slack, that’s when it will run hot enough to heat up inflation. The central bankers admit that there has been more slack than they expected, but once the economy runs out of workers, wage inflation will rise, pushing price inflation higher, especially once capacity utilization gets to be tight enough. The Phillips Curve and output-gap models are variations of this demand-side view of the world.

There are two major flaws in this model: It fails to recognize that there are limits to how much debt demand-side borrowers can carry to keep buying stuff. And it completely ignores the impact of easy money on supply-side borrowers. Consider the following:

(1) Too much debt on the demand side. In the past, when demand-side borrowers had plenty of capacity to take on more debt, easy money effectively stimulated demand. It seems to have lost its effectiveness because monetary policy has been easy for so long, resulting in high debt-to-income ratios. Even historically low interest rates, which reduce the cost of servicing debt, don’t seem to be stimulating demand, which might explain why interest rates are historically low, of course.

(2) Too many zombies on the supply side. Meanwhile, supply-side borrowers, who produce the goods and services purchased by demand-side borrowers, can take advantage of easy money to refinance their debts at lower rates. Producers may also borrow more to keep their businesses going. The ones who are most likely to do so are the ones who would be out of business if they couldn’t borrow money. In other words, they are zombie businesses, i.e., the living-dead companies that won’t die because they are resuscitated by the cash infusions provided by their lenders. As long as they stay alive, they create deflationary pressures by producing more goods and services than the market needs.

And why are lenders willing to lend to the zombies? Instead of stimulating demand, historically low interest rates incite a reach-for-yield frenzy among creditors. They are willing to accept more credit risk for the higher returns offered by the zombies. Besides, if enough zombies fail, then surely the central banks will come up with some sort of rescue plan.

(3) Debt binges, now and then. It’s interesting to compare the borrowing binge in home mortgages that led to the Great Financial Crisis and the current borrowing binge in nonfinancial corporate (NFC) debt, including bonds and loans. At the start of 1990, the amount outstanding of both equaled around $2.4 trillion each (Fig. 4). Home mortgages then soared by 378%, or $9.0 trillion, to a record $11.3 trillion during H1-2008. Over the same period, NFC debt rose 162%, or $4.0 trillion to $6.4 trillion.

After peaking, home mortgages outstanding fell $1.4 trillion through Q1-2015, and then increased by $1.1 trillion to $11.0 trillion by Q2-2019. That was still slightly below the record high. Over the same period, NFC debt rose 55%, or $3.5 trillion, to a record $10.0 trillion.

During Q2-2019, NFC corporate bonds outstanding rose to a record $5.7 trillion (Fig. 5). NFC loans held by banks rose to a record $1.1 trillion, while “other loans” (which are mostly leveraged loans) rose to a record $1.8 trillion (Fig. 6).

The NFC data are less alarming when scaled by nominal GDP (Fig. 7 and Fig. 8). Home mortgages outstanding peaked at a record 77% of GDP during Q1-2009. NFC debt rose to a record high of 47% of GDP during Q2-2019.

(4) Central banks fueling deflation by feeding zombies. My interpretation of the data is that excessively easing credit conditions fueled the mortgage borrowing binge and housing boom that ended with the Great Financial Crisis. The strong debt-financed demand for homes stimulated economic activity and caused home prices to soar.

Since the Great Financial Crisis, the borrowing binge in NFC debt hasn’t contributed much to economic growth, and consumer price inflation has remained subdued. Apparently, a significant percentage of NFC debt is attributable to zombie companies using most of the proceeds from their borrowing to stay in business. The Fed’s May 2019 Financial Stability Report nailed it, as follows:

“[T]he distribution of ratings among nonfinancial investment-grade corporate bonds has deteriorated. The share of bonds rated at the lowest investment-grade level (for example, an S&P rating of triple-B) has reached near-record levels. As of the first quarter of 2019, a little more than 50 percent of investment-grade bonds outstanding were rated triple-B, amounting to about $1.9 trillion.”

The report also warned about leveraged loans as follows:

“The risks associated with leveraged loans have also intensified, as a greater proportion are to borrowers with lower credit ratings and already high levels of debt. In addition, loan agreements contain fewer financial maintenance covenants, which effectively reduce the incentive to monitor obligors and the ability to influence their behavior. The Moody’s Loan Covenant Quality Indicator suggests that the overall strictness of loan covenants is near its weakest level since the index began in 2012, and the fraction of so-called cov-lite leveraged loans (leveraged loans with no financial maintenance covenants) has risen substantially since the crisis.”

During his 10/30 press conference, Fed Chair Jerome Powell was asked about financial stability. He responded: “Obviously, plenty of households are not in great shape financially, but in the aggregate, the household sector’s in a very good place. That leaves businesses which is where the issue has been. Leverage among corporations and other forms of business, private businesses, is historically high. We’ve been monitoring it carefully and taking appropriate steps.”

He didn’t specify those steps. However, the Fed’s three interest-rate cuts are likely to feed the zombies’ appetite for more debt. In other words, the easy money provided by the Fed and the other central banks may be contributing to deflationary pressures attributable to supply-side borrowers. This would certainly explain why easy money has failed to boost inflation as expected by the proponents of demand-side models.

(5) Is a zombie apocalypse inevitable? If you want to read a very frightening script of how this horror movie plays out, see the October 2019 Global Financial Stability Report prepared by the International Monetary Fund. Here is the punchline: “In a material economic slowdown scenario, half as severe as the global financial crisis, corporate debt-at-risk (debt owed by firms that cannot cover their interest expenses with their earnings) could rise to $19 trillion—or nearly 40 percent of total corporate debt in major economies, and above post-crisis levels.”

There’s certainly lots to digest and think about in this unsettling report as the S&P 500 climbs to another record high. Apparently, investors expect that before doomsday arrives, even the Fed will lower interest rates close to zero again, allowing all the zombie borrowers to refinance their debts, thus postponing the zombie apocalypse.

Powell testified before the House Budget Committee on Thursday, 11/4. He said that he isn't worried about bubbles: “If you look at today’s economy, there’s nothing that’s really booming now that would want to bust.” He reassuringly added, “I think possibly the day of reckoning could be quite far off.”

I remain bullish on the economy and the stock market for now. But my contrary instincts are on full alert thanks to Powell. Stay tuned.

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