The Fed's 'Not Seen Since 2009' Economy

Late last week the Federal Reserve policymaking body changed the language in its monetary policy outlook. The FOMC noted in its June 20th statement that it "is prepared to take further action as appropriate". In the July press release, the wording changed slightly to make sure that markets know the Federal Reserve System "will provide additional accommodation as needed". Maybe that doesn't mean much and is not really subtlety at all; perhaps this is just the FOMC getting tired of saying the same thing over and over again, repeatedly after nearly four years of, at best, malaise.

There is the chance, however, that the professional economists that dominate policy positions inside the FOMC are looking at the latest economic data and are growing more worried. No one denies (at least not anymore) that global growth is slowing and that the pace and scale of the trajectory are atypical of a recovery. That slowdown, despite assurances that the US would decouple from the rest of the globe, is hitting the US. Yesterday morning wholesale trade estimates for June were well below expectations, as both sales and inventories fell "unexpectedly". Worse for the economy, sales fell faster than inventories, bringing the inventory/sale ratio up to 1.20, the highest level since 2009.

Just over a week ago, the ISM Manufacturing survey for the month of July indicated a second consecutive monthly reading below 50. The ISM survey had not been below 50 at any point since 2009. The NAPM export orders sub-index fell to a level not seen since early 2009. Baltic Capesize, Supramax and Panamax shipping charter indices, as well as the Baltic Dry index, have spent all of 2012 at levels not seen since 2009.

In Germany, the IFO survey of the business climate has been falling since the middle of 2011 and now rests at a level not seen since 2009. The Markit/BME Germany Purchasing Managers' Index® fell to 43.0 in July, as the overall index registered a level equivalent to June 2009. Overall output and new orders sub-indices fell at the fastest pace since, you guessed it, 2009. This pattern and phrase is repeated in data all over the globe, from US Fed regional survey sub-indices to Chinese trade data and beyond into a broadening section of key developed economy variables. If the world, particularly the economic elite, is expecting these powerhouse economies to pull the whole system forward, then these results are not the stuff of subtlety.

If "unexpected" was the key modifier of economic data for the first half of 2012, "not seen since 2009" is fast becoming its replacement. More than anything, I believe that has got the Federal Reserve looking at its own language. But beyond statements of intended intent, Boston Fed President Eric Rosengren has gone a step further. Earlier this week he suggested an open-ended bond buying program that would target real economic variables.

"What I would argue for actually is to have it open-ended, that we focus on economic outcomes. It would be setting a quantity that you're going to continue to buy until you get the economic outcomes that you want."

Alarmingly, this statement was well received. Five years of low interest rates, including almost four at the zero lower bound, a couple of QE's, a Twist or two to the US treasury yield curve (that flattened rather than twisted), and numerous emergency interbank lending and dollar swap programs have not kept the economy from suffering the approaching abyss of "not seen since 2009". As with so many things in conventional economics, the answer is always to go bigger.

What we are really talking about here is the ephemeral notion of monetary-driven inflation. But, as I discussed last week, it is not really "monetary" in that there is no money in monetary policy; it is an encumbrance policy. Central banks' sole policy tool is debt that acts as an encumbrance on both present and future income and therefore exhibits real costs apart from stated interest rates. Central banks aim to increase the level of credit production, and therefore usage. It is a simple macro-focused approach that homogenizes the very nature of the interplay between money and economy.

For some reason there persists in modern economics a wall of separation between the macro world and the micro world. Central planning, apparently, is consistent with free market capitalism as long as it never passes into the micro sphere. The only way to maintain this discrepancy of market manipulation as consistent with a "free market" capitalist system is to define the marketplace as ending at the water's edge of the micro context. Any means of interfering exclusively with macro variables is fair game and not at all inconsistent for policymakers that consider themselves "free market" adherents.

To separate the macro from the micro requires a high degree of homogenization. There cannot be any difference between individual macro units - a job is a job, a loan is a loan, spending is spending. This gives rise to smooth macro variables, such as employment, consumer spending and, the big macro chief, aggregate demand. Monetary policy, theoretically operating beyond the water's edge in the macro world exclusively, simply massages normalized macro variables into achieving macro goals. Since macro variables operate in a distinct subset of the larger system, so this thinking goes, the free markets of the micro world simply take these cues and through their own volition fulfill macro targets.

In assuming the beneficial effects of a macro-distinct change in price levels and perceived purchasing power, inflationary and targeting proponents are really counting on two simultaneous transformations in the micro world of markets. First, they are expecting that rising inflation expectations, the macro variable, will demonstrate or force consumers and households to re-evaluate the relative tradeoff of savings and spending. If savings are more "expensive" in macro monetary terms, then it is expected that on the micro level individual units (whether people or businesses) will trade saving for spending, creating economic activity. Nothing more needs to be said or described because any and all economic activity, aggregate demand, is uniformly desirable.

The second intrusion of macro into micro is the increase of lending availability for businesses and people. The flow of new or newly available credit money in the economy is assumed to create demand for activity in the micro world simply because supply of credit is assumed to lead to demand for credit. The existing level of demand for credit is always considered on the macro level to be below optimum levels in any recession, so increasing supply harmonizes this disequilibrium. The result, in the academic theoretical universe, is generic activity rising to meet some aggregate and generic demand target.

If we actually examine the interplay of inflation expectations and credit, however, we see beyond the skim of homogeneity. While inflation expectations are supposed to force consumers to re-evaluate the cost of savings, for businesses any increase to inflation expectations is supposed to trigger a re-evaluation of production needs. If the macro price level is expected to rise, it is somewhat logical to assume that businesses seeking a micro-level profit will uniformly decide to increase current production to minimize the profit impacts of those rising input costs. The kickstart of generic activity is in the production impact of macro-driven expectations to force businesses to re-evaluate inventories.

The desire to add to production and stockpile inventories increases the level of production above whatever current demand may actually be at that given moment. Inventory is, after all, excess production above current demand. Since inventory stocking is largely financed through debt, available credit money is vital to the whole macro-driven approach. The twin imposition of debt and inflation expectations is macro-positive in the uniform desire of businesses to expand production to maximize profits before the tide of input costs overwhelms their profit capacity. Under such pressure, businesses should therefore be hiring new workers at a quickening pace.

In the homogeneous world of aggregate macro demand it really is that simple. In the real world it is suicide. Let's assume that there exists a type of business that does not exhibit this kind of generic behavior in relation to rising input costs. For these businesses, rising input costs, rather than forcing profit seekers to increase production and build inventories to capture lower input prices while they last, actually coerces them to reduce their exposure to productive activities.

A dentist, hairdresser or an accountant cannot increase production to capture the FIFO profit potential of rising input costs. If the dentist sees energy, medical supplies or tax and regulatory costs rising he is likely to respond not by increasing production above demand but by further cutting inputs elsewhere: cutting back the hours of the receptionist, using cheaper and fewer medical supplies or delaying the hiring of additional clinical staff. An accountant cannot pull forward 2013 income tax returns or corporate audits because the perceived value of his share of the profits is being diminished by the steady erosion of commodity inflation in 2012. If food and gas prices are hitting the service sector entrepreneur in the pocketbook, that service business owner can only respond by offsetting input costs within the service business. To increase income to maintain purchasing power means increasing prices (and losing business) or redirecting monetary interference toward the biggest cost of that service business - labor.

The reaction of the service sector to rising commodity prices or narrowly defined inflation is often wholly different than the production sector. Whereas inflation expectations might pull forward enough future production to kickstart the virtuous circle of inventory production and excess labor, in the service sector it is poison of the first order. The result is a bifurcation of that economic order, where parts of the economy do well and other parts lag and languish significantly.

Since the service sector is by far the largest sub-segment of "aggregate demand", inflation by diktat is the economic equivalent of homogenized malaise, or, as the instances of "not seen since 2009" rise, re-recession. Credit and debt availability do not change this dynamic - the service sector business under cost or purchasing power pressure has absolutely no use for further encumbrances to income. Debt under these circumstances does not follow macro expectations for the role of inflation in the dynamic of borrowers' calculations for future margins - the cost of debt is not diminished by inflation, it is amplified.

Where inflation ends up most beneficial is in exactly the places it is needed least. Those with high exposure to rising asset prices (when asset inflation is the preferred "market" channel of explosive monetary encumbrance) in either equities or credit will do extremely well compared to those that derive their wealth from productive activities. That means the wealthiest individuals that have large stores of financial assets, but also banks and the financial economy. Small businesses (service sector businesses tend toward smaller scales) and those with only wage income (as well as the unemployed that are no longer under the beneficial umbrella of wage income) have little exposure to asset inflation - a small business owner's equity is tied to the condition of cash flows not external "market" pricing.

As the economy further bisects along the lines of monetary intrusions, those on the less fortunate side have little use for additional credit or debt. Worse still for the homogenization/macro approach, these unfortunate and often unemployed "units" cannot or will not part with savings no matter how much monetary repression is visited upon them. A person or household in the depths of non-uniform economic despair will, fully rationally, hold on to whatever savings they have no matter what happens, rather than be left potentially without any means to even subsist. In fact, despite the rising "costs" of saving, rational households without inflationary means will do anything and everything to increase their level of savings in a fit of survival instincts. Increasing the cost of doing so is axiomatically repressive.

The instinct toward preservation simply reinforces the travails of the service sector still further. Instead of expanding service activity, those without monetary beneficence will actually end up doing more for themselves. They will put off going to the dentist until an actual emergency, cut their own hair, or buy Turbotax instead of paying the accountant's bill. The "wealth effect" of macro lore instead reverses at exactly the same time macro prices are expanding. The economy instead of reaping the "wealth effect" of asset inflation actually devolves into the micro reality of diminishing marginal labor specialization. The incongruity of micro results is the source of confusion, or "headwinds".

The acts of monetary encumbrance in the macro environment have very different impacts on a micro scale because the macro framework does not really exist outside the classroom. There is no wall of separation between the macro and the micro. The macro is simply the aggregation of individual micro actions and activities, the very human instincts to survive repression of all forms: from intentional monetary inflation to regulatory suppression to the certainty of the eventual increase in the tax bill. It will not matter what real economy variable the Federal Reserve or any central bank targets, the macro world is an illusion of academic posturing and mathematical necessity. The various micro responses are what matter as the free market of labor and production extends to goods and services, wages and capital. Favoring any specific macro transformation of monetary inputs or prices will always lead to disfavor and, more importantly, disharmony in output. Maybe that is an unsolvable paradox for central bankers, but to me it's just common sense.

There is no macro level of inflation that is "beneficial" and malevolent across a uniform economic spectrum. That malevolence only extends to the well-connected. Perhaps there is some boost to inventories and the production of goods, but in an economic system that is now far more service-oriented intentional inflation is, again, economic suicide. The drag of inflationary repression in the service sector and among the lower income and unemployed will eventually drag down even the sub-sectors that are actually responding according to macro designs. Perhaps, then, there is uniformity after all, except that it will show up not as the promised land of central bank macro utopia, but as unexpected, homogeneous weakness not seen since 2009.