Chairman H-E-Double-Hockeysticks

By: Michael Ashton | Mon, Nov 8, 2010
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There is nothing quite like a national holiday on a Thursday for sapping market activity. I actually got a vacation response to an email I sent today that said the recipient was out until November 29th...and he wasn't even European! But it's hard to resist that sort of vacation: between now and the 29th of November, there are two Thursday holidays, bracketed by two sluggish Wednesdays and two pointless Fridays. Technically, to take these three weeks off requires 13 vacation days; practically-speaking, however, a trader is only missing nine days that have much chance of being interesting. Oh, wait, and one of those was today...make it eight days. Counting the 29th and 30th, there are effectively only ten liquid trading days left in November.

Heck, it's almost year-end. Happy New Year!

The FX markets were the source of most of the volatility today. The dollar had a second strong up day as the zombie crisis in Europe (I have dubbed it thus, both because it threatens to turn many banks into nationalized banking shells as well as because it continued to lurch anew. Irish bonds are the sorest spot, since pretty much every major Irish bank is either tottering or toppled, but Portuguese bonds were painted with the same brush today. Spain and Italy didn't escape the sinkhole for PIIGS bonds, but it isn't all bad news at least for politicians. Greek bonds rose slightly as it appears Prime Minister Papandreou received at least a tepid vote of confidence in Sunday's elections (see FT story here). This is a risky precedent. If politicians can impose austerity measures and survive, then before you know it someone might actually try that here. Perish the thought that Americans might try to confront our problems head-on before the currency and bond market collapses! But I wouldn't hold my breath.

Somewhat surprisingly, the markets didn't react at all to several strident comments over the weekend from Chairman Bernanke and others from the Jekyll Island conference sponsored by the Atlanta Fed. On Saturday, Bernanke said "I have rejected any notion that we are going to raise inflation to a super-normal level in order to have effects on the economy." Whew, what a relief! As long as he rejects the notion, we must be safe. I wonder if he has considered the possibility - it doesn't sound like it - that he is capable of making a mistake? This sounds like overconfidence bias. According to the Wikipedia entry on "Overconfidence Effect,"

The overconfidence effect is a well-established bias in which someone's subjective confidence in their judgments is reliably greater than their objective accuracy, especially when confidence is relatively high.[1] For example, in some quizzes, people rate their answers as "99% certain" but are wrong 40% of the time.

Traders and investors are very aware of this pitfall, and good traders develop mechanisms to check this natural tendency. It doesn't appear, from this quote anyway, that Federal Reserve Chairmen do the same.

The Fed chief is clearly somewhat agitated. Here was one of his answers to an audience question:

"There's a sense out there that, quote, quantitative easing or asset purchases is something completely foreign' and that "we have no idea what the hell is going to happen, and it's just an unanticipated, unpredictable policy...Quite the contrary, this is just monetary policy."

Well, Dr. Bernanke, I agree with you. The result of the policy is somewhat predictable. The policy will have no effect unless the LSAP finds its way into M2, and that seems unlikely to happen rapidly while IOER remains above zero. To the extent that this result is predictable, it is stupid. To the extent that the Fed doesn't consider the possible ways it might not work the way they think, they are stupid. And to the extent that it doesn't work out the way they think, then I promise you, they don't know what the hell is going to happen (see "overconfidence bias" above).

I talk about this throughout my book. It is a major theme. The Federal Reserve, when it is making bad decisions, tends to make bad decisions in the same way: it chooses a course of action that has a limited upside, and usually a well-defined upside, and an unlimited downside or a very poorly-defined one. Someone who has a decent respect for Animal Spirits will tend to have a strong preference for limited-downside policy actions. But the downside to expanding the Fed's balance sheet by $600bln Treasuries isn't a scalar of the effect of the last set of asset purchases, which were made under drastically different circumstances. It is potentially non-linear. It is potentially chaotic. It is inherently uncertain, and anyone who tells you the know what is going to happen is delusional. Sure, I believe that with IOER above zero this liquidity is not likely to pour directly into the economy, and therefore will have little effect. But even believing that, I would not pursue this policy because the damage that could occur if I am wrong is simply enormous.

Let's do a little thought experiment.

For many years during the great inflation moderation, M2 was roughly 8.5 times the monetary base (in the more inflationary times of the 1980s and first half of the 1990s, it got as much as 12.4x). In the crisis, the Fed increased the money base by about 150%, but (as we know) M2 didn't move so that M2 is now only 4.5x the money base (see Chart below).

M2 vs Money Base Chart

The crash in the M2/M0 multiple is the reason there was not inflation...LAST time

I believe, as I have written here, that the reason the money multiplier is broken is because the Fed is paying banks IOER and this keeps the money out of M2. But let's suppose I am wrong, and the decline in the money multiplier was caused by something else. Now, suppose the new $600bln being added to M0 is translated into M2 at the old 8.5 multiple. In that case, M2 would rise about $5.1 trillion, or about 58%, in something less than one year. Such a development might, um, be inflationary.

Do I know that is going to happen? I really doubt that is going to happen. But can I definitively say it won't happen? Well, do to that I would have to be able to assert that I know exactly what happened last time. Can I imagine that this is a plausible result of grossly expanding the money base during calmer economic times? You betcha.

By the way, let's go further and suppose that when the Fed applies the paddles this time, the whole money multiplier snaps back to the old 8.5x. The old money base was $0.84 trillion and now is $1.962 trillion; after the $600bln in Treasury purchases it would be around $2.56 trillion. That, multiplied by 8.5, would imply M2 around $21.8 trillion. That's a 149% rise from here. This too, might be possibly inflationary. And I can't imagine it would be good for bonds or stocks.

Again, let me state very clearly that I think these are very unlikely outcomes from QE2. But I am basing that estimation on my belief of why the money multiplier got broken in the first place (IOER), and I completely recognize that I could be grossly wrong in that belief. I want to guard against having too much confidence in that belief. But these scenarios are also not wildly implausible - it takes very little effort to generate potential effects that are very large.

So, to summarize: if the Fed's action "works," we will get money growth of something between 4% and maybe 10%. If it doesn't work, we could get 60% or 150%. As I said, the risks are non-linear. The Federal Reserve probably shouldn't be shorting those options, but I know that they shouldn't be acting so confident about it.



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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