The Root Of The Problem

By: Michael Ashton | Tue, Oct 12, 2010
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Your view of something often depends on the position from which you view it. I don't mean this in the Theory-Of-Relativity sense that a moving observer perceives time differently from the stationary observer, although it is true there too of course. I mean it in the more prosaic sense that a tightrope seems higher when you are standing on it than when you are looking at it from below.

As observers of the economy, our initial position - our 'null hypothesis,' as I sometimes refer to it - will very much drive our response to economic data; our market position may, if we are not very careful about it, affect our view of the likely future direction of the market.

The Federal Reserve today released the minutes of their most-recent meeting, and it looks to me as if their perspective about the necessity of quantitative easing is more biased than we had previously believed. While the minutes reflected (as they often have, especially over the last two years) a diversity of opinion, the following notation grabbed my attention:

Several members noted that unless the pace of economic recovery strengthened or underlying inflation moved back toward a level consistent with the Committee's mandate, they would consider it appropriate to take action soon.

Notice the subtle difference between this and what actually was agreed to be released as the FOMC's statement for that meeting:

Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.

"Longer run" in the second phrase seems to conflict with "soon" in the first phrase, making it appear that the official statement was a compromise with at least several members pushing for action "soon." But that cadre also sets the bar quite low. They aren't saying the Fed should ease further if things get worse, but that they should ease if things don't get better quickly enough.

That's a very activist slant. While this group appears to be in the minority, we know from the various speeches that it isn't a minority of one. QE certainly appears more likely every day that we don't get positive blow-out economic news.

What is the justification for easing on the basis of a too-slow improvement? I imagine much of this concerns a fairly obscure debate about whether economic growth is "unit root" or not.

Stay with me here. This sounds esoteric, but it matters.

It isn't important to understand the mathematics behind determining whether a time series is generated by a process with a unit root; if you're interested, you can read the Wikipedia article on 'unit root.' For our purposes, what it important to understand is this: if economic output is not unit root but is rather trend-stationary, then over time the economy will tend to return to the trend level of output. If economic output is unit root, then a shock to the economy such as we have experienced will not naturally be followed by a return to the prior level of output. Actually, the Wikipedia chart is pretty helpful at understanding this - see below.

Wikipedia Unit Root Chart
This picture taken from the Wikipedia article on "unit root" (see above for link)

So, the red line is what we have experienced the last few years (stylistically, not literally). If growth is "unit root" then the trend basically picks up from where output is in the immediate aftermath of the shock; if growth is trend-stationary then the recovery should see a period of faster-than-trend growth to get output back to the prior trend level.

Note that in both cases, we are assuming no specific contribution from monetary policy. If you believe that growth is trend-stationary, then monetary policy merely serves to get growth back to trend more quickly, thereby minimizing the welfare loss from the output gap (schematically, the area between the dotted line and the "actual" red/blue line). Thereafter, monetary policy takes the pedal off the metal and lets growth converge with trend. If, on the other hand, you believe that growth is unit root, then monetary policy is either trying to arrest the decline in the red line to put the economy back on the green line, or it is (dangerously) trying to accelerate growth back to a "trend" that is not really a trend. I expect this is the substance of Hoenig's objection - if we're back near the green line, and output is unit root, then goosing the economy more "will lead to future imbalances that undermine stable long-run growth" (the phrase from the FOMC statement where Hoenig's dissent was noted).

Clearly, most of the Committee doesn't believe that output is unit root, because if it did then it would tend to be more suspicious of the ability of Fed policy to reduce that welfare loss. It is true that it is difficult to reject the unit root hypothesis for many economic time series - the ratio of noise to signal in economic data means it tends to be pretty hard to reject many hypotheses that are in the ballpark of being reasonable. But it matters.

Problems like this, where the downside to being incorrect are possibly quite large compared to the upside to being right, argue against dramatic Fed action. However, the sense of heroism inculcated in us at a young age by Superman's exploits argue in favor of heroic measures. Most of us, though, aren't actually bulletproof.

I will make one final observation about this that throws another wrench in the works. What if we don't know where the dotted line in the picture above actually lies? Long-term economic growth has changed over time as the economy has matured, as population growth changed, and for other reasons. Suppose the unobservable dotted line actually intersects the right-end of the red line? In that case, the current debate takes a totally different patina. If trend growth has actually slowed down in the last decade, then arguably the economic and financial crisis may just have been returning us down to the real trend. In that case, further aggressive Fed action would be essentially trying to restore those dangerous imbalances. This, too, could be part of Hoenig's argument. And this possibility, too, argues for conservative policy actions.

In economics, unfortunately, we don't have a map we can look at where a bright red dot indicates You Are Here. But wherever we are, it seems that an increasingly influential minority at the Fed wants to be somewhere else. They are likely to get their wish.

The markets responded to all of this today in sleepy fashion, with one exception. The VIX plunged, dropping not only below 20 for the first time since April but also dropping below 19. The degree of confidence being expressed by the stock market here, heading into earnings season followed by a difficult holiday sales season, is chilling. It is hard to let go of suddenly-performing equities, but I am making sales here of some of my lower-yielding and less-conservative equity holdings.

Other than some import price data tomorrow, there is little on the calendar. Chairman Bernanke is giving a speech on business innovation, but be alert for Q&A.



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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