Anti-Ants

By: Michael Ashton | Mon, Aug 9, 2010
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As we look to Tuesday, it is easy to recognize that the FOMC meeting is the signal event of the day. It may also be the signal event of the year, and even more than that if there is any significant change that results.

I believe it is fairly likely that the Committee will make some important changes to the statement at this meeting. The article by James Bullard, released a week ago or so ("The Seven Faces of 'The Peril'"), was interestingly timed. It was a "preprint" of the article which is to appear in the St. Louis Federal Reserve Review in the September/October issue. I can't think of many reasons to publish a "preprint" only a week before an FOMC meeting unless there was already some fairly in-depth discussion about it going on around Fed circles (if there wasn't before, there surely is now!).

To review, the article concerned Bullard's contention that the decision by the Fed to not only lower rates to zero but also to telegraph that rates would remain so for an "extended period" runs the risk of causing the economy and monetary policy to become trapped in a stable equilibrium of low rates and mild deflation, as has been the case in Japan for the last couple of decades. I have written before that in my opinion, the Japanese experience is easy to avoid although if you don't like the medicine - in this case, fairly aggressive money printing - then sure: you will stay sick.

Bullard recommends that we take this medicine. He argues that the Federal Reserve should not only remove the "extended period" language, which (in his view) causes expectations to decline and to trigger the stable lower equilibrium, but also to embark on quantitative easing again. However, he argues that instead of buying mortgage securities the Fed should buy Treasuries. The difference is that the latter is functionally equivalent to turning on the printing presses, while the former is not.

I don't think it is coincidence that the Bullard piece was released when it was, although I suppose you could argue that it could raise inflation expectations by itself. Now, I don't think the Fed will announce QEII tomorrow - and that may be very disappointing to equity investors who pushed stocks higher today so that we are again very close to the June 21st highs. I believe, though, that the Fed will remove the "extended period" language; by doing so after the Bullard piece has been circulated, they hope that the reaction which otherwise would have occurred (a big selloff and a pricing of near-term tightening) will be short-circuited since the market will understand that the change more likely means easy policy rather than tight policy.

All of this reinforces what I have argued for years and years, including in my book. Fed "openness" is an absolute disaster that causes investors to become overconfident and complacent about monetary policy, inducing more leverage and higher risk-taking. Consider the quirky decision tree the Committee faces. If they say in the statement anything about deflation (or "an unwelcome decline in prices"), they will telegraph that perhaps we should be worried about deflation. And if they don't say any such thing, investors may well worry about deflation because they don't mention it and investors are worried the Fed might not "get it." They probably want to remove the "extended period" language, but by doing so they might accidentally imply they are tightening soon...or, following the Bullard piece, they might imply they are about to embark on QEII soon.

What a mess, and another great example of why it would be good for them to be quiet and let us all assume they're working on it. "Transparency" is one of those things that always sounds good in theory but may not be so great in practice. If you don't believe me, try being "transparent" to your spouse about how she really looks in that dress. Sometimes, silence really is golden [although not in my case, dear, because you always look stunning].

The question for me is not whether the Fed does or says something different. They must, or I predict stocks will get killed with disappointment. The question is how fast they actually do something. I don't think it will happen tomorrow, and probably not at the September meeting unless the data turns south rapidly, but likely not long after that. The FOMC would probably like to wait as long as possible to see if any deal is forthcoming about extending the Bush tax cuts and diverting the fiscal asteroid heading towards Earth. They can't wait much longer than the November 3rd meeting to make QEII happen, given the lags involved, and such a delay would also allow them to evaluate the results of the mid-term elections (November 2nd) and whether the supposed populist tide of fiscal conservatism is real or not. Anyway, that's my educated guess.

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As an aside, some people might wonder why I am so worried about fiscal retrenchment when I am ordinarily very vocal about the opposite: that fiscal stimulus doesn't work in the long run. If that's true, then isn't the opposite also true, that fiscal restraint doesn't cause damage in the long run?

It isn't that I am a Keynesian only in the negative way. Fiscal restraint is good in the same sense that spending increases are bad. Tax cuts are inherently better than spending increases, because the latter increases the amount of resources consumed inefficiently by government, but both tax cuts and spending increases just move money from time A to time B.

Big changes in the fiscal balance, though, definitely affects the short run trajectory of growth, and I've never claimed otherwise. The stimulus plan caused growth in '09 at the expense of growth in '11 (or later, if the Bush tax cuts are extended), and cutting the deficit now would trade contraction in '11 for somewhat more growth than otherwise would have happened in '13. The danger of this is twofold. First, we have seen that it is very unusual for deficits to be reversed because it is easy to vote for hedonism but hard to vote for asceticism. Second (and more relevant here since it actually looks like asceticism is gaining adherents) is that if the short-term nature of the fiscal policy action isn't understood it can lead to bad monetary policy action. That is to say that the proper response to the coming fiscal restraint, from the monetary policy side, is probably nothing since the earlier stimulus wasn't met with a counterbalancing tightening of policy.

In this case it will lead to a technical double-dip (since we were technically 'expanding' mostly thanks to G in C+I+G+(X-M)) and this is likely to have serious repercussions on the Hill. That's not an ant hill we want to kick, because unlike a normal ant hill Congress doesn't typically get organized and do smart things to lessen the damage - they get disorganized and do dumb things. They're more like anti-ants.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

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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