When Does The Unusual Become The Usual?

By: Michael Ashton | Wed, Jul 21, 2010
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Chairman Bernanke took to Capitol Hill today to discuss the economic and monetary policy outlook for the country. His remarks were, typically, fairly unremarkable. Some observers had expected him to signal a change from what had recently been discussed in the FOMC minutes - the unusual quiet among Fed speakers led to speculation that they were avoiding cluttering the message. Presumably, the change they expected was towards a softer policy, edging more towards a second round of quantitative easing. At least, the response of equities to a fairly dull testimony - they dove - seems to suggest that investors wanted more.

The only real nugget in his prepared statement was that the Chairman referred to the "unusually uncertain" economic outlook. These days, one might argue, "unusually uncertain" is pretty normal. The implication for monetary policy is that extra caution is warranted, because the Committee can be less sure of the effects of their actions.

That is mostly an illusion, though. The Federal Reserve Board suffers, as d0 most individuals and all committees, from the behavioral bias of overconfidence. Given the historical difference between the Fed's forecasts and the actual outcomes, over many many decades, the Fed should treat the outlook as extremely uncertain. The implication of that observation, however, is simple: the Fed should almost never do anything.

Policymakers fool themselves into thinking that they need to do something, and so they do something, and they very often muck it up in the process. As I argued in my book (have I mentioned recently that I am offering an on-line bargain here?), the FOMC should manage policy to minimize mistakes rather than maximize good outcomes. They are short "policy options" in which doing the right thing offers a little upside but doing the wrong thing promises a huge downside. It is great news for those of us who will bear the costs of their actions that right now they actually know that things are uncertain, and are hesitant to do anything. It's kind of like "monetary policymaker gridlock."

It may not be quite as good news for investors in stocks, who are dependent on a further steroidal lift to the market. Recent earnings have been weak in some unusual places, such as at Goldman Sachs: that firm managed to miss earnings forecasts by 60%, which is pretty hard to do since all of the Wall Street analysts tend to give each other easy hurdles to beat, on an 82% decline in profits. There have been a few other banks that have had weak earnings. This shouldn't be surprising: lower leverage, lower turnover, and lower margins adds up to lower return on equity. I guess it is surprising that it is happening so soon - the banks who are hitting their numbers are the ones that are drawing down their reserves, which is also known as "cheating."

Monetary policy makers are right to be concerned about the uncertain outlook. A whole lot of that outlook depends on whether fiscal policy gets tight soon, or whether it stays loose and gets even tighter later. It appears Congress is going to extend unemployment benefits, but it has been a challenge to get that bill through. Goldman is calling it "The End of the Road for Fiscal Stimulus" in a recent research piece. Their economics team is assuming that virtually no other major stimulus, other than the extension of the Bush tax cuts for households with incomes below $250,000, will be passed. This includes their assumption that capital gains and dividend rates will go up to prior levels. They estimate that the result of these fiscal tightenings will be a drag on GDP (also known as "payback for pulling demand forward to make the recession appear to go away") of 0.50% in Q3 and 1.25%-2.5% for each of the next five quarters - that is, for all of 2011.

I, like many others I am sure, was spooked out of being short yesterday. A short feels better today and with Existing Home Sales (Consensus: 5.1mm from 5.66mm) tomorrow it is likely to feel even better (Initial Claims, consensus 445k from 429k, will continue to be polluted by the GM non-shutdown and so not worth much attention). I don't like the entry point, but when stocks start to move lower the market may well not offer a good entry point.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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