Sunday, December 29, 2019

Central Banks Likely to Keep Santa Claus Rally Going In 2020

Former Fed Chair Paul Volcker passed away on 12/8. He broke the back of inflation. Unfortunately, he had to cause a recession to do so, which broke the backs of lots of good hard-working people. He was widely viewed by them as the Grinch Who Stole Christmas. All of the Fed chairs who came after have preferred playing the role of Santa Claus, showering us all with lots of easy money. They were able to do so mostly because inflation has remained subdued ever since Volcker subdued it.

Actually, at the end of last year, Fed Chair Jerome Powell seemed more like a Grinch than a Santa. He roiled the financial markets by suggesting that the Fed would continue to raise the federal funds rate three or four times during 2019. He started to change his mind just around Christmas of last year and signaled that the Fed would halt rate hikes for a while. He completed his pivot by lowering the federal funds rate three times this year, on 7/31, 9/18, and 10/30 (Fig. 1).

As a result, the S&P 500 stock price index bottomed on Christmas Eve last year at 2351.10 (Fig. 2). It was up 37.8% to 3240.02 on Friday, 12/27 (Fig. 3). That’s a very long Santa Claus rally.

At the 7/31 meeting of the FOMC, the committee decided not only to lower the federal funds rate, for the first rate cut since 2008, but also to terminate quantitative tightening (QT) ahead of schedule: “The Committee will conclude the reduction of its aggregate securities holdings in the System Open Market Account in August, two months earlier than previously indicated.” From 10/1/17 through 7/31/19, the Fed’s balance sheet was pared from $4.4 trillion to $3.7 trillion (Fig. 4).

The Fed and the other major central banks are all playing Santa during this holiday season and are on track to continue doing so in the new year:

(1) Fed. In a 10/11 press release, the Fed announced that beginning on 10/15 it “will purchase Treasury bills at least into the second quarter of next year in order to maintain over time ample reserve balances at or above the level that prevailed in early September 2019.” More details were released in a separate New York Fed statement (and accompanying FAQs).

The initial pace of these “reserve management” (RM) purchases will be approximately $60 billion per month and will be in addition to ongoing purchases of Treasuries related to the reinvestment of principal payments from the Fed’s maturing holdings of agency debt and agency mortgage-backed securities. As the new holdings mature, the principal payments will be reinvested again into T-bills.

Many have commented that these actions look a lot like quantitative easing (QE). After all, the Fed is expanding its balance sheet sizably, possibly by up to $300 billion or more assuming $60 billion a month through March as a ballpark figure. The Fed’s balance sheet totaled $4.0 trillion during the 12/4 week, including $2.3 trillion in US Treasury securities, of which $420 billion are Treasuries maturing in one year or less (Fig. 5). This portfolio of Treasuries maturing in under a year is up $71 billion since the end of September.

(2) ECB. Mario Draghi’s term as president of the European Central Bank (ECB) ended on 10/31. Before leaving, Draghi put together a monetary stimulus package. It is designed to induce Eurozone governments to borrow at zero or negative interest rates to spend on stimulating their economies.

The package includes an open-ended commitment to buy as much as €240 billion per year of bonds issued by Eurozone governments. In other words, Draghi set the stage for the implementation of Modern Monetary Theory (MMT) in the Eurozone. According to MMT, governments should borrow as much as possible as long as inflation doesn’t heat up. All the better if the central bank enables such borrowing by lowering interest rates and purchasing government bonds—again, as long as inflation doesn’t heat up. Now it is up to the various Eurozone governments to take the bait.

The ECB terminated its QE1 program at the end of 2018. Under the program, which started 1/22/15, the ECB’s “securities held for monetary policy purposes” increased by €2.4 trillion to €2.7 trillion (Fig. 6). Draghi’s QE2 program will once again expand the ECB’s balance sheet to new record highs.

(3) BOJ. In an 11/18 Reuters interview, Bank of Japan (BOJ) Governor Haruhiko Kuroda said the BOJ has room to deepen negative interest rates, but he signaled there were limits to how far it can cut rates or ramp up stimulus.

According to Reuters, “Kuroda also said there was still enough Japanese government bonds (JGB) left in the market for the BOJ to buy, playing down concerns its huge purchases have drained market liquidity. After years of heavy purchases to flood markets with cash, the BOJ now owns nearly half of the JGB market.”

The BOJ’s QE program started in April 2013 and has yet to be terminated. This can be seen in bank reserve balances at the BOJ. They rose to a record high of ¥352 trillion during November, up 740% since the start of the program (Fig. 7).

(4) All together now. The total assets of the Fed, ECB, and BOJ rose $264 billion y/y during November to $14.5 trillion (Fig. 8). On this basis, they had been falling from December 2018 through September 2019. This total is on track now to rise to record highs in 2020.

That should be good for the stock market, which has been tracking the total assets of the three major central banks since the start of the current bull market (Fig. 9). Don’t fight the three major central banks.

The main near-term risk is a meltup that could set the stage for a correction. My S&P 500 forecast for year-end 2020 is still 3500. I just hope we don't get there well ahead of schedule. See CNBC: "A 10% to 20% pullback could strike stocks early next year, long-time bull Ed Yardeni warns."

Tuesday, December 10, 2019

Paul Volcker: The Great Disinflator

The following is an excerpt about Paul Volcker, who passed away on December 8, from my forthcoming book, Fed Watching for Fun and Profit.

When Volcker took the helm of the Fed, the Great Inflation was well underway. During the summer of 1979, oil prices were soaring again because of the second oil crisis, which started at the beginning of the year when the Shah of Iran was overthrown. Seven months later, in March 1980, the CPI inflation rate peaked at its record high of 14.8%. When Volcker left the Fed during August 1987, he had gotten it back down to 4.3%.

How did he do that?

Volcker didn’t waste any time attacking inflation. Eight days after starting his new job, he had the FOMC raise the federal funds rate on August 14, 1979, by 50 basis points to 11.00%. Two days later, on August 16, he called a meeting of the seven members of the Federal Reserve Board to increase the discount rate by half a percentage point to 10.50%. This confirmed that the federal funds rate had been raised by the same amount. Back then, as I previously noted, FOMC decisions weren’t announced. The markets had to guess.

On September 18, 1979, Volcker pushed for another discount-rate hike of 50 basis points to 11.00%. However, this time, the vote wasn’t unanimous; the Board was split four to three. In his memoir, Volcker wrote that market participants concluded that “the Fed was losing its nerve and would fail to maintain a disciplined stance against inflation.” The dollar fell and the price of gold hit a new record high.

Volcker, recognizing that the Fed’s credibility along with his own were on the line, came up with a simple, though radical, solution that would take the economy’s intractable inflation problem right out of the hands of the indecisive FOMC and the Board: The Fed’s monetary policy committee would establish growth targets for the money supply and no longer target the federal funds rate.

This new procedure would leave it up to the market to determine the federal funds rate; the FOMC no longer would vote to determine it! This so-called “monetarist” approach to managing monetary policy had a longtime champion in Milton Friedman, who advocated that the Fed should target a fixed growth rate in the money supply and stick to it. Under the circumstances, Volcker was intent on slowing it down, knowing this would push interest rates up sharply.

On October 4, Volcker discussed his plan with the Board. In his memoir, he noted, “Even the ‘doves’ who had opposed our last discount-rate increase were broadly supportive, having been taken aback by the market’s violent reaction to the split vote.” A special meeting of the FOMC was scheduled for Saturday, October 6. Holding an unprecedented Saturday night press conference after the special meeting, Volcker unleashed his own version of the Saturday Night Massacre. He announced that the FOMC had adopted monetarist operating procedures effective immediately. He said, “Business data has been good and better than expected. Inflation data has been bad and perhaps worse than expected.” He also stated that the discount rate, which remained under the Fed’s control, was being increased a full percentage point to a record 12.00%. In addition, banks were required to set aside more of their deposits as reserves.

The Carter administration immediately endorsed Volcker’s October 6 package. Press secretary Jody Powell said that the Fed’s moves should “help reduce inflationary expectations, contribute to a stronger US dollar abroad, and curb unhealthy speculation in commodity markets.” He added, “The Administration believes that success in reducing inflationary pressures will lead in due course both to lower rates of price increases and to lower interest rates.”

The notion that the Fed would no longer target the federal funds rate but instead target growth rates for the major money supply measures came as a shock to the financial community. It meant that interest rates could swing widely and wildly. And they did. The economy fell into a deep recession at the start of 1980, as the prime rate soared to an all-time record high of 21.50% during December 1980. The federal funds rate rose to an all-time record high of 20.00% at the start of 1981. During 1980, the discount rate was raised to 13.00% on February 15, then lowered three times to 10.00%, then raised again two times back to 13.00%, on the way to the all-time record high of 14.00% during May 1981. The trade-weighted dollar index increased dramatically by 56% from 95 on August 6, 1979, when Volcker became Fed chair, to a record high of 148 on February 25, 1985.

The public reaction to Volcker’s policy move was mostly hostile. Farmers surrounded the Fed’s headquarters building in Washington with tractors. Homebuilders sent Volcker sawed-off two-by-fours with angry messages. Community groups staged protests around the Fed’s building. Volcker was assigned a bodyguard at the end of 1980. One year later, an armed man entered the building, apparently intent on taking the Board hostage.

At my first job on Wall Street as the chief economist at EF Hutton, I was an early believer in “disinflation.” I first used that word, which means falling inflation, in my June 1981 commentary, “Well on the Road to Disinflation.” The CPI inflation rate was 9.6% that month. I predicted that Volcker would succeed in breaking the inflationary uptrend of the 1960s and 1970s. I certainly wasn’t a monetarist, given my Keynesian training at Yale. I knew that my former boss [at the Federal Reserve Bank of New York] wasn’t a monetarist either. But I expected that Volcker would use this radical approach to push interest rates up as high as necessary to break the back of inflation.

Volcker must have known that would cause a severe recession. I did too. Back then, I called Volcker’s approach “macho monetarism.” I figured that a severe recession would bring inflation down, which in turn would force the Fed to reverse its monetary course by easing. That would trigger a big drop in bond yields. Arguably, the great bull market in stocks started August 12, 1982, when the Dow Jones Industrial Average dropped to 776.92. On December 6, 2019, it was 27,677.79.

Thank you, Paul Volcker.

Thursday, December 5, 2019

Inflation Remains in a Coma in Major Economies, Frustrating Central Bankers

I’ve been a disinflationist since the early 1980s. I first used that word, which means falling inflation, in my June 1981 commentary, “Well on the Road to Disinflation.” The Consumer Price Index (CPI) inflation rate was 9.6% y/y that month (Fig. 1). I predicted that Fed Chair Paul Volcker would succeed in breaking the inflationary uptrend of the 1960s and 1970s when he adopted a monetarist approach during October 1979. I certainly wasn’t a monetarist, given my Keynesian training at Yale. I knew that my former boss at the Federal Reserve Bank of New York wasn’t a monetarist either. But I expected that Volcker would use this radical approach to push interest rates up as high as necessary to break the back of inflation. Which is what he did.

Ever since then, reflationists have been predicting, without any success, that inflation is bound to make a comeback. They’ve been wrong for so long because inflation is so yesterday. The Great Inflation was basically a 1970s phenomenon attributable to the two oil price shocks of 1973 and 1979 (Fig. 2). Thanks to cost-of-living clauses in private-sector union contracts back then, those price shocks were passed directly to wages, causing a wage-price spiral (Fig. 3).

The CPI isn’t the best measure of price inflation because it has a significant upward bias. The Fed prefers the core personal consumption expenditures deflator (PCED), which better reflects the prices of the goods and services that consumers are actually buying. According to this measure, inflation has ranged between a low of 0.9% and a high of 2.6% since 1995 (Fig. 4).

In recent years, I’ve often declared: “Inflation is dead.” I’ve frequently discussed the four deflationary forces (which I call the “4Ds”) that have killed it. They are d├ętente, disruption, demography, and debt. (See my 8/1 LinkedIn article, "The Great Inflation Delusion.")

The data show that at best inflation is in a coma, especially in the major industrial economies. Here is an update on the latest inflation readings:

(1) US CPI and PCED. In the US, the headline and core CPI were up 1.8% and 2.3% y/y, respectively, in October. However, the comparable readings for the PCED were only 1.3% and 1.6% (Fig. 5).

Now sit down for this one: The Fed is seriously considering a “make-up” strategy for targeting inflation. That’s according to yesterday’s FT article “US Federal Reserve considers letting inflation run above target.” Here is the gist of the plan: “The Fed’s year-long review of its monetary policy tools is due to conclude next year and, according to interviews with current and former policymakers, the central bank is considering a promise that when it misses its inflation target, it will then temporarily raise that target, to make up for lost inflation.”

With all due respect, that’s hilarious! Why do Fed officials want to embarrass themselves by targeting inflation over 2.0% when they haven’t been able to move it up to 2.0% since officially targeting that level in January 2012? Fed Governor Lael Brainard, speaking to reporters last week, said that a strict make-up rule would be too hard to explain to the public. I think she is right.

Since January 2012, the headline PCED has been tracking a 1.3% annual trendline (Fig. 6). In other words, October’s PCED was 4.7% below where it should have been if it had been tracking 2.0%. To get back to the steeper trendline by the end of 2022, the PCED would have to increase by about 12.0%, or 4.0% per year! Try explaining that to the public.

By the way, the big divergence between the CPI and PCED inflation rates during October was mostly attributable to consumer durables (up 0.5% in the CPI and down 1.0% in the PCED) (Fig. 7). In addition, medical care services was up much more in the CPI (5.1%) than in the PCED (2.1%) (Fig. 8). These divergences aren’t unusual but par for the course. Rent inflation tends to be almost identical in the CPI and the PCED, but it has a much higher weight in the former than the latter, and it has been running hotter (at 3.7%) than the overall inflation rate (Fig. 9).

(2) Eurozone CPI. An 11/28 Bloomberg article reported that the European Central Bank (ECB) is expected to “tweak” its inflation target in an upcoming review of monetary policymaking: “The institution’s first fundamental assessment in 16 years might conclude with a goal of 2%—instead of the current ‘below, but close to, 2%’ which some governors worry risks leaving inflation too weak.” One word comes to mind: “Lame.”

During November, the Eurozone’s CPI inflation rate picked up to 1.0% from a three-year low of 0.7% in October (Fig. 10). The core rate was 1.3%, the highest in seven months.

On 11/22/19, Christine Lagarde delivered her first speech as ECB president, “The future of the euro area economy.” Remarkably, she spoke about monetary policy almost in passing, in just one paragraph in fact. Instead, she presented a case for fiscal policy to focus on more public investments in infrastructure, R&D, and education. She also said she wants to see more economic integration in the EMU. She is one of the few central bankers who seems inclined to acknowledge that monetary policy may have lost its effectiveness.

(3) Japan CPI. An 11/18 Bloomberg article reported that the Bank of Japan (BOJ) may be running out of ammo to boost inflation in Japan: “Speaking in parliament on Tuesday, [Bank of Japan Governor Haruhiko] Kuroda said there was still room to lower interest rates further, but added that he had never claimed the BOJ’s easing ammunition was endless or that there was no limit on how low rates could go.”

In fact, he is running out of support for additional monetary stimulus measures.The article observed: “Such low yields have gradually pushed institutional investors and regional banks out of the JGB market and into riskier assets. Many analysts see bankruptcies looming among beleaguered regional banks, where the old model of borrowing short and lending long has been upended both by a flat yield curve and a diminished demand for credit.”

The BOJ has been reluctant to follow its peers around the world in easing policy this year, suggesting that the days of shock and awe from Kuroda’s BOJ are over. There is more talk about doing more to stimulate the economy with fiscal policy, but it’s all talk so far.

Meanwhile, Japan’s CPI inflation rate is on life support. The headline rate was up just 0.2% during October (Fig. 11). The core rate, which includes oil costs but excludes volatile fresh food prices, rose 0.4% y/y in October. Excluding the impact of the sales tax hike rolled out in October and the introduction of free childcare, annual core consumer inflation was 0.2% in October, slowing from 0.3% in September.

(4) China CPI. China’s headline CPI inflation rate jumped to 3.8% during October (Fig. 12). That was the highest since January 2012. However, it was boosted by soaring pork prices, which lifted overall food-price inflation to a more-than-11-year high, as consumer demand drove up prices for pork alternatives including eggs and other meat products. Hog prices have soared this year at the fastest pace on record as a result of the deadly African swine flu. Excluding food, the CPI was up just 0.9% during October!

(5) Bottom line. Inflation is in a coma. The major central banks continue to provide ultra-easy monetary policy to revive it. All their efforts have been frustrated by the four powerful forces of deflation. Their ultra-easy monetary policies continue to drive stock prices higher, while keeping interest rates at record lows.

(6) Contrarian alert. Contrarians on inflation can take some comfort from the front cover of the April 22, 2019 Bloomberg Businessweek shown above.