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Today we will take a look at the markets, taking a snapshot of where things stand as the most massive bout of fiscal and monetary intervention in history comes ever closer to winding down. The old Wall Street adage of 'sell in May and go away' may well prove to be good advice again as the anniversary of the 'flash crash' approaches. In the wake of the extraordinary monetary stimulus provided by the Fed, the prices of all so-called 'risk assets' (stocks, commodities, high-yield bonds) have increased to levels where they have once again become extremely risky to own. Given that Ben Bernanke himself has stated that pushing up stock prices and lowering risk premia more generally in order to create the so-called 'wealth effect' was one of the policy's goals, some people argue that 'success' has been achieved. One person so arguing is none other than Paul Krugman, who now calls the rising stock market the 'new monetary policy transmission mechanism', which is supposed to have 'replaced housing' as the 'transmission mechanism' of yore. Krugman wisely left a back door open by stating that he is unsure of the sustainability of the recovery. As one perceptive reader wrote in the comments section:
“Since economies don’t have or need “traction”, your Krugmanite model is silly, worthless and misleading. We always know what the “transmission mechanism” for money dilution is: Theft of purchasing power from those holding the existing money and other Cantillon Effects. If the new spending was based on an increase in stock prices, no new “wealth” was created. Instead, the Fed’s manipulations merely shifted existing purchasing power to those purchasing or owning stocks. The rise in stock values did make the owners of those stocks richer in the short run vis-à-vis people who lost purchasing power and induced them to spend more than they would have without the artificial grant of stolen purchasing power.”
There is no doubt that when monetary pumping is underway, some prices will rise, but the central bank has no control over which ones. This is amply demonstrated by the fact that the US housing market remains firmly in the dumps, with prices falling back to their 2009 lows after the effect of the 'first time buyer' tax credit has waned. However, it is a good bet that the Fed was hoping to hold up prices in this market more than any other. If you wonder why we are asserting this, consider the chart below:
Real Estate loans at commercial banks – declining from the bubble highs due to write-offs, but still at a lofty level, to put it mildly. The fact that the market prices of the collateral behind these loans are still falling is probably of major concern to the Federal Reserve – click for higher resolution.
We can also be fairly certain that the Fed is unhappy to see commodity prices rise as strongly as they have – of course the Fed denies responsibility for this – as we have noted before, Fed chairman Bernanke has insisted in the past that rising commodity prices have little to do with the Fed's inflationary policy. The above linked NYT article mentions an exchange between Rep Paul D. Ryan and Bernanke:
“Mr. Ryan all but accused Mr. Bernanke of devaluing the dollar, saying, “There is nothing more insidious that a country can do to its citizens than debase its currency.”
Mr. Bernanke said the rise in commodity prices was mostly “a result of the very strong demand from fast-growing emerging market economies, coupled, in some cases, with constraints on supply.” He did not mention China by name, but he has in the past.
He added that overall inflation was “still quite low” and that longer-term inflation expectations, which can influence short-term changes in prices, were stable.”
According to Bernanke 'inflation is low', but that requires redefining inflation as just one of its effects (rising prices). Defined properly, as an increase in the supply of money, inflation has been and continues to be extraordinarily high:
US money supply TMS-2 ('broad' Austrian money supply, via Michael Pollaro) – inflation has been on a tear. According to Bernanke, there has been 'very little' of it. According to the money supply data, there's been plenty – click for higher resolution.
Back when Kartik Athrea wrote his jeremiad against unwashed economic bloggers, he mentioned Gregory Mankiw as 'one of the exceptions'. This was probably due to Mankiw's infamous NYT editorial of December 2007, which advised us that in order to 'avoid recession' we should 'let the Fed do its work' (that didn't quite work out, but what the heck…we shouldn't judge modern day macro-economists by the practical value of their theorizing and planning, right?). Mankiw closed his article by saying:
In the meantime, the Fed's 'crack team of PhD economists' has come to Bernanke's assistance, with propaganda disguised as economic research. The latest coup of these taxpayer financed econometric magicians: a study that reveals that money printing (i.e., 'quantitative easing') not only is not responsible for rising commodity prices, but actually leads to falling commodity prices. As Economic Policy Journal.com informs us:
“Two economists at the Federal Reserve Bank of San Francisco, Reuven Glick and Sylvain Leduc have just reached the conclusion that Fed money printing doesn't cause price inflation. In fact they go one better, they claim that Federal Reserve asset purchases (which create money out of thin air) are deflationary. I am not making this up. Here's the introduction to their argument:
Prices of commodities including metals, energy, and food have been rising at double-digit rates in recent months. Some critics argue that Federal Reserve purchases of long-term assets are fueling this rise by maintaining an excessively expansionary monetary stance. However, daily data indicate that Federal Reserve announcements of large-scale asset purchases tended to lower commodity prices even as long-term interest rates and the value of the dollar declined.
What makes them so sure about this price deflation? They start off by telling us this:
…commodity prices have surged since Chairman Bernanke’s Jackson Hole speech. The Goldman Sachs Commodity Index, a heavily traded broad index of spot commodity prices, rose 35% between the Jackson Hole speech and the end of February. The increase was widespread, spanning a range of commodity categories. Industrial metals rose nearly 30%, energy prices climbed 35%, and food prices rose close to 50% during the six-month period.
So how with these facts do they reach their conclusion. They argue this way:
The LSAP [Large Scale Asset Purchases] announcements about monetary policy may have signaled that the Fed perceived economic conditions to be weaker than previously thought. Alternatively, they may have increased market worries about risk and made Treasury securities more desirable as safe-haven investments. Thus, an announcement that makes investors feel that conditions are worse than originally perceived or that heightens risk concerns may lead investors to increase their demand for Treasuries, lowering their yields. These concerns also could reduce investor demand for other assets, such as commodities, resulting in lower prices.
They then go on to report on an absurd empirical study that they completed. There are methodological problems with empirical studies in the first place in the social sciences, but this study is over the top in its poor structure.”
You couldn't make this up. We will however continue to stick with economic logic and that tells us that when the supply of money increases markedly, numerous prices are likely to rise. It is no coincidence that the prices of commodities and titles to capital (which is what stocks represent) are rising very strongly. An artificially low interest rate does after all tend to increase the prices of higher order or capital goods relative to those of lower order or consumption goods. This can be easily understood by picturing the temporal ordering of the production structure – the further away a good is from becoming a present good, the more influence the interest rate by which its present value is discounted will have on its market price. One can look at the effect also from a different angle – a low interest rate would normally indicate that time preferences have become lower, i.e. that consumers are increasing their savings. An increase in savings in the here and now means that consumption is being deferred in favor of production with the aim of consuming more in the future. A low interest rate therefore signals that the pool of savings is sufficiently large to enable more time-consuming and hence more productive production processes than before. More investment will be drawn toward production of higher order goods as a consequence. Monetary pumping has the same effect, as it artificially lowers interest rates and the additional money created so to speak masquerades as actual savings.
We have previously noted that real estate can be regarded as a higher order good for analytical purposes – so why are real estate prices still under pressure? The answer is that during the last boom so much capital has been malinvested in this sector that the Fed's monetary pumping has so far failed to significantly arrest the process of liquidation that is still ongoing in housing. Since houses are especially long-lived goods, an oversupply problem in the sector is not easily or quickly resolved.
We would also note, Bernanke's assertion about emerging market demand for commodities is not entirely without merit. After all, the Fed is not the only central bank that has vastly increased the money supply. For instance, China's central bank in conjunction with the country's commercial banks has done exactly the same and the resulting building boom in China has greatly contributed to soaring demand for commodities. Lastly, commodity prices were immersed in a bear market from 1980 to 2000 following the boom of the 1960's and 1970's and it takes a long time for investment in the sector to turn around and increase supply. This is mostly due to the massive regulatory hurdles commodity producers have to contend with, but also a matter of the enormous capital investment involved. Producers have to be reasonably certain that prices will remain high enough to justify investment in new production capacity. It is e.g. estimated that from the discovery of an economically viable ore body to the commissioning of a new mine up to ten years or more can pass.
As a result of all these factors, commodities are nowadays a favorite target for speculative investment as investors desperately seek to preserve the purchasing power of their savings in the face of enormously profligate monetary and fiscal policies.
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