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Can the Fed Remain Relevant?

By: Michael Ashton | Tuesday, June 19, 2012

Greece is skittering awkwardly towards temporary resolution of their crisis. Venizelos, the leader of the party Pasok (which placed third in the Greek elections) said today that the coalition may be ready tomorrow. Considering that this vote was supposedly a "referendum" on remaining in the Euro, it is surprising how long it is taking to negotiate a bare majority in the parliament. But they will, because there's no cost right now to pretending to be unified while negotiating improved bailout terms with European authorities. If better bailout terms are not offered, there is plenty of time later to splinter the coalition, or to appear to splinter the coalition, to put pressure on the negotiators from Europe.

It bears remembering that there is nothing that can be done to save Greece and to keep her in the Eurozone absent transferring big losses onto the rest of Europe. Since most holders of Greek bonds due to mature in the next few years are official institutions - such as the ECB - it isn't clear how the debt structure can be re-negotiated without opening a big can of worms. So will the European powers (aka "the Man") significantly lessen the austerity measures? Will the Greek politicians who just won an election settle for anything less than significantly lessening the measures? I don't see where these circles of interest intersect. I am sure there will be a big announcement at some point; I'm just not sure what difference it will make.

In the meantime, Greece is supposed to play Germany in the UEFA quarterfinals this Friday. Remember, wars have been fought over footy. I'm mostly kidding, but do you think Greece really wants to win this game or not?

The shortage of immediate crisis in Europe translates into a good day for stocks (+1%), adding to what is already a pretty good month; a pretty good day for commodities (+1%), adding to a positive if unimpressive month, and a weak day for bonds (10-year yields rose 4bps to 1.62%), adding to a marginally weak month. TIPS yields were higher as well, but not very much, and inflation swaps were higher by 3bps, bringing the total rise in the 10-year inflation swap rate to 5bps for the month (to 2.49%). Inflation expectations may be rising once again, and this is interesting. Consider the following two charts (Source: Bloomberg), of the 10-year Treasury (nominal) rate and the 10-year inflation swap rate, both for the same period over the last two years.

What is interesting here is that while the 10-year nominal rate keeps reaching new lows in each crisis, the 10-year inflation swaps rate keeps reaching higher lows in each crisis. The difference, of course, is the TIPS yield, which has continued to plunge faster even than nominal yields for each subsequent crisis.

In this context, we head into tomorrow's trading session in which the day's key event is the FOMC meeting. This is one of the more interesting meetings, in a sense, that we have had in a while because it's the first in which there was any meaningful uncertainty about the immediate course of policy. Twist is coming to an end shortly, so many observers believe that the Committee will use this meeting to take concrete steps to either extend Twist, offer a different version of Twist, change the verbal signaling significantly, or even signal QE3. The answer will tell us something about how the Fed is looking at the current portfolio of risks in the global economy. When I think about what the Fed will or might do - admittedly, as a cynic - I break it down this way:

What the Fed can actually do about economic growth and global crisis

There's really not much here. As the chief regulator, the Fed can help ensure that banks are adequately prepared for a possible Greek exit from the Euro. If there are key vulnerabilities in the financial sector, they can extend lines (either domestically or internationally through swap arrangements) to avert a liquidity crisis. But adding money doesn't affect growth unless there is substantial "money illusion" such that economic actors take rising cash balances in their accounts to indicate actual improvement in their financial status and, acting on this, increase real spending. Even if there is money illusion, the actual capacity at this point for an important increase in real spending - especially in the parts of the world where it is really needed - is pretty slim.

What the Fed thinks it can do about economic growth and global crisis

This is where there has actually been a little bit of evolution recently, maybe, in the thinking of at least a few of the FOMC members who are capable of thought. Until fairly recently, the Fed's faith in its ability to actually do something useful was absolute. The fact that trillions of dollars of stimulus later, U.S. real economic output is only 1.2% (not per annum - total) above where it was at the end of 2007 - with the economy threatening to sink into another recession, no less - has made some policymakers question whether the assumption of the omnipotence of monetary policy was correct. For example, it has long been an article of faith that one way that monetary policy such as "Operation Twist" worked was through the "portfolio balance channel." This theory holds that by taking away lots of safe investment alternatives at the long end of the bond curve, the Fed essentially forces investors to contribute to animal spirits by owning riskier securities. While it may be the case that making U.S. Treasury bond yields truly abysmal may have contributed to the rise in corporate bond and equity prices to unhealthy levels, Fed researchers are questioning whether that actually produces any growth. St. Louis Fed Vice President Daniel Thornton (who actually is one of the voices in the wilderness arguing that runaway money growth might actually create a threat of inflation) recently wrote a paper called "Evidence on The Portfolio Balance Channel of Quantitative Easing," and his conclusions are direct:

I present several reasons to be skeptical of the theoretical foundations of this portfolio balance channel and offer several arguments for why the effect of QE might be relatively small even if it is theoretically valid. Consistent with these arguments, an empirical analysis using a variety of interest rate variables and public debt supply measures used in the literature finds essentially no support for the portfolio balance channel.

Whoops!

What the Fed wants to be thought to be able to do

Herein lies the rub. If a hedge fund that is earning 2% on assets under management and a 20% performance fee realizes that it no longer has exceptional opportunities in which to invest its clients' money, it should return the money to the investors, with a note saying "rather than take extraordinary risks at high fees to produce pedestrian returns, we are returning this money to you so that you can earn pedestrian returns on your own, with pedestrian risks and pedestrian fees." However, we know from the periodic fund blowups we see that this hasn't historically been the response. The Federal Reserve doesn't earn 2%-and-20%, but if they ever got to the point where they no longer believed they could affect economic growth, what should they do? Their mandate says that they're supposed to do it. If they cannot, they should say so and lobby for changes in the mandate to make them solely guardians of the real value of the currency.

Good luck with that. The Federal Reserve surely feels that whether or not it actually remains relevant, it must make sure that others think it is relevant so at least "confidence will be maintained." They do this, I am sure, with the best of intentions.

And it is this third point where any policy changes will be born. If the Fed recognized the first bullet point, they would end Twist and work to start reducing excess reserves and reining in the money supply. That ain't going to happen. It is the second bullet point where most observers spend time debating. What should the Fed do to help? More QE? Is Twist enough? Should they peg interest rates at a certain level, or implement an Evans-type rule that will require them to continue bond purchases until Unemployment falls or inflation gets out of hand? All of this requires one to think that the Fed thinks it can do something, and are merely discussing what they can do.

I think that many Fed officials are no longer sure of that, but they will go along with a vote promoted by the true believers because they want the Fed to seem relevant. The Fed will not do nothing. It will do something. I am not sure whether Twist will be extended (the fact that most banks are clamoring for it implies they have all told the Fed that the market expects it and will be disappointed without it, so it'll probably be extended), but I would look for signs that an Evans-type rule is being implemented that will mechanically force something QE3-like over the balance of the year without the Fed having to explicitly decide to do it. This is also a way to side-step the whole ridiculous notion that the Fed shouldn't do anything "near the election": if there is a plan set in motion now, then presumably then can execute the plan when circumstances call for it.

None of this will do much besides ensure that the money supply keeps growing, enhancing the mispricing of commodity indices and increasing the risk of a bad (and difficult-to-contain) inflation outcome.

At least that would make the Fed relevant again.

 

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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