Monetary Data Continue to Reflect Structural Economic Weakness
* Saturday, April 6, 2013
For the past several years, the US Federal Reserve has engaged in a historic liquidity operation intended to support economic recovery. As shown on the following three charts, M0, M1 and M2 have all surged to all-time highs as a result of these stimulus programs.
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There is no question that the measures taken by the Federal Reserve during the last three years have fueled appreciation in the stock market, so, from that perspective, the programs have been a success. However, it must be noted that equity gains fueled primarily by government stimulus can be erased as quickly as they are created. The recent liquidity operations have created massive imbalances that will continue to drive violent moves both higher and lower as the system attempts to return to a state of equilibrium.
Additionally, there is absolutely no evidence to support the assertion that higher stock prices meaningfully support economic expansion. Historically, a 1.0 percent increase in the S&P 500 index has been accompanied by GDP growth of approximately 0.04 percent during the same year, 0.04 percent growth during the next year, and it has a negative correlation during subsequent years. There is also the problem of addressing the massive imbalances created by several years of artificially low interest rates. Fund manager John Hussman monitors the future inflationary consequences of current Federal Reserve policy and the following chart and excerpt are from a recent weekly commentary.
The U.S. monetary base stands at a record 18 cents per dollar of nominal GDP. The last time the monetary base reached even 17 cents per dollar of nominal GDP was in the early 1940’s. The Fed did not reverse this with subsequent restraint. Instead, consumer prices nearly doubled by 1952. At present, a normalization of short-term interest rates to even 2% could not be achieved without cutting the Fed’s balance sheet by more than half. Alternatively, the Fed could wait for nominal GDP to double and “catch up” to the present level of base money, which would take about 14 years, assuming 5% nominal GDP growth.
Of course, 5% nominal growth would likely make it inappropriate to hold short-term interest rates below 2% for another 14 years. So either the Fed will reverse its present course, or we will experience unacceptable inflation, or we will experience persistently weak growth like Japan has experienced since 1999, when it decided to take Bernanke’s advice to pursue quantitative easing. My guess is that we will experience unacceptable inflation, beginning in the back-half of this decade.
Because of the strong relationship between the size of the monetary base (per dollar of nominal GDP) and short-term interest rates, it appears likely that short-term interest rates will be suppressed by Fed policy for some time, until Fed policy normalizes or inflation accelerates. The Fed is now leveraged 55-to-1 against its own capital. With an estimated duration of about 8 years on 3 trillion dollars of bond holdings, every 100 basis point move in long-term interest rates can be expected to alter the value of the Fed’s holdings by about 240 billion dollars – roughly four times the amount of capital reported on the Fed’s consolidated balance sheet.
Ultimately, the normalization of the Fed’s balance sheet – outside of weak economic conditions – is likely to press long-term interest rates markedly higher. This would be particularly true in the event that inflation accelerates and forces that attempt to normalize, which we expect in the back-half of this decade. As a result, the next economic recovery will very likely be associated first with a significant steepening of the yield curve, and only later by an inversion as the Fed scrambles to tighten.
For better or for worse, the Federal Reserve remains locked into this course of action for the foreseeable future. Chairman Bernanke believes he has the tools and expertise required to prevent the imbalances caused by the current stimulus programs from engendering massive economic disruptions when they are purged from the system sometime during the next several years. Seeing as no central bank in history has been able to accomplish that feat, it is highly likely that he will be unable to do so as well. Further, research based on eight centuries of data has clearly demonstrated that it is impossible to solve an excessive debt problem with yet more debt. Until we stop applying superficial, temporary fixes and begin to address the root causes of our current predicament, our economy will remain structurally weak.
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