The Fed Declares Recovery and Recession Simultaneously
Earlier this year, eminent economist Martin Feldstein wrote for Time Magazine that he was worried that the monetary methods used by the Federal Reserve to save "us" from the crisis in 2008 would eventually be its undoing. Feldstein is no run-of-the-mill economist, having forged deep ties within the orthodoxy to pretty much anyone who gains notice. Larry Summers was once a student and research assistant; former director of the National Economic Council Lawrence Lindsay was also a student, while Greg Mankiw and even Paul Krugman were on Feldstein's team when he was Chair of Ronald Reagan's Council of Economic Advisors. He has been called one of the most influential economists of his generation with good reason.
In 2005, he was actually the favorite to succeed Alan Greenspan as Fed Chairman, until it was noticed that he was then a board member of AIG just as that firm was establishing its reputation for indiscretion (the "insurance company" was then under investigation for a range of problems, leading it then to restate five years of financial statements before heading off in the direction of further infamy). He was replaced in the horserace by yet another of his former students, Glenn Hubbard, though the post ultimately passed to Ben Bernanke. He is the establishment of all establishment.
Writing in June, Feldstein was apparently motivated by the obvious, that the corporate bond market was, shall we say, astray. Not only were bond prices supremely suppressed, that had been accompanied by a litany of risk-taking behavior (cov-lite and cov-less bond floatations by 2014 had not just become normal but almost universal) that most good standing economists thought had been cured by 2008. Not only that, these junk and even lower-grade corporate bonds were being held in size by mutual funds, representing a serious liquidity gate should it all turn.
"The danger, though, is that by waiting, the Fed will be forced by the arrival of higher inflation rates to raise the federal funds rate more rapidly than it and the financial markets now anticipate, causing greater instability in bond and equity markets with adverse effects on the real economy.
"The Fed's hope to return interest rates to traditional levels without destabilizing the economy is an understandable goal, but it may not be an achievable one. The Fed used the unconventional monetary policy of exceptionally low interest rates for an extended period of time to cure a very deep recession. It succeeded in doing that, but the country may have to pay a price for this extreme policy. Only time will tell."
Yes, establishment mentality - worrying about runaway inflation and economic overheating despite none that was ever evident. Ironically, we are in the midst of the very same junk and high yield meltdown that so concerned him but without any of the "inflation" that was supposed to push Janet Yellen's Fed into "tightening" overdrive. It is a curious thing, that inflation concern, as it united Fed critics and proponents alike. Not that long ago, some worried that QE's were to unleash something like hyperinflation; Feldstein and those like him worried that QE was to be so successful as to force an uneven backend adjustment. Neither of those was ever close, though no one seems to offer a credible explanation as to why.
Perhaps Feldstein's greatest contributions were delivered via the National Bureau of Economic Research (NBER). Despite the name, the institution is not associated with any government except by way of sharing personnel and a revolving door. The NBER are best known as the folks who tell us when there has been a recession, a task that was developed by none other than Martin Feldstein. In 1978, he established within the NBER the Business Cycle Dating Committee and took great pains to foment a solid reputation for business cycle research in order to gain credibility for the attempt.
The Committee never tells us, of course, when a recession is going to begin, only after it has - sometimes well after. Contrary to popular belief, they do not define a recession as two consecutive quarters of negative GDP. Relying instead on a broader range of assessments, the business cycle determination looks for definitive indications among "core" and important economic components. Among them, notably, industrial production estimates produced by the staff at none other than the Federal Reserve:
"The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales."
When there isn't a well-defined or universal recession signal, the Dating Committee might instead fall back on anything that is more glaring:
"The Committee also may consider indicators that do not cover the entire economy, such as real sales and the Federal Reserve's index of industrial production (IP). The Committee's use of these indicators in conjunction with the broad measures recognizes the issue of double-counting of sectors included in both those indicators and the broad measures. Still, a well-defined peak or trough in real sales or IP might help to determine the overall peak or trough dates, particularly if the economy-wide indicators are in conflict or do not have well-defined peaks or troughs."
With that in mind, Wednesday's FOMC decision contained the oddest, most contradictory economic assessment in monetary history. I make such a claim with no appeal to hyperbole as this is something the best satirists of any age would never be so bold to have written. On the very same day that Janet Yellen "raised rates", proclaiming once and for all that the recovery was achieved and the economy instead in danger of overheating, the Fed's very own industrial production statistic flashed unambiguously a recession sign. At -1.2% year-over-year for November, IP fell into highly uniform company - since 1950 (and I could extend this comparison back to the first estimates in 1919) there have only been three monthly instances of IP less than -1% not associated with recession, and two of those were in the summer of 1952 when the Korean Conflict was being scaled back. So out of the 137 months since 1950 where the Fed's industrial production statistic was -1% or less, only three were not associated with an NBER-declared recession or its immediate aftermath; marking November as a potential fourth quite unlikely.
Thus, the Fed both declared a boom and recession at the same time.
I have no idea whether that will be a focus for the NBER's Dating Committee now or in the future, but past, and recent past, history already suggests they will be among the last to define recession for us. In 2008, it took a full panic, a meltdown the likes we haven't seen since the 1930's, and even then a few more months before they were "confident" enough to declare what almost everyone outside of orthodox economics already well knew. On December 1, 2008, they made it "official."
"Employment declined less than is normal in a recession until about September," said Stanford University economist Robert Hall, chair of the NBER's recession-dating committee. Until that point the committee didn't expect to take action until next year, Mr. Hall said in an interview today. "Then so many negative numbers came through that made it completely clear this was a recession."
The similarities then and now are more numerous than you might think. This is not to say that I am declaring a high probability of the Great Recession repeating, nor its panic, only that the cause of the "mystery" now is still the same as then. Janet Yellen yesterday declared her "tightening" intentions (though it was, apparently, "dovish tightening", a further absurdity that tells you a lot about all of this) by proclaiming a federal funds rate target different than what has existed for seven years. As noted last week, there is nobody actually participating in federal funds.
Instead, the Fed's Open Market Desk has to undertake any number of "supplemental" arrangements to actually attempt getting money markets to comply. Having tested already its Term Deposit Facility (TDF), Reverse Repo Program (RRP), along with the Interest on Excess Reserves (IOER), there also has been talk about additional operative elements of things like a term RRP. I won't get into here the practical reasons these might be necessary, rather it has yet to dawn on anyone that this is the case as a drastic difference between this time and last time.
By last time I refer, of course, to June 2004 when Alan Greenspan initiated the last "tightening" cycle and rate increase. Only then he just said it; front-facing money markets followed. Everything from federal funds to LIBOR altered their course because Greenspan said he would unleash the Open Market Desk and any amount of OMO's in order to achieve the target rate the FOMC wanted. Janet Yellen's FOMC has to both say it and do it.
It may seem like nothing, but it is entirely profound and explains a great deal as to where Martin Feldstein's and Ben Bernanke's inflation (and our recovery) went. In very general terms, the panic that began on August 9, 2007, can be summed up as a withdrawal of money dealers from money dealing activities - interbank only, and largely in foreign eurodollars. In response, central banks, primarily the Fed, were forced to pick up the slack; only they didn't do it all at once or even willingly, since they were still thinking in 2004 terms about money and their ability upon it. The space between money dealers no longer dealing and central banks picking up the slack, which became a gaping chasm, was what came out as full panic; in other words, central banks were far too late after having been overwhelmed.
The reason for that was strictly what federal funds had become by then (meaning 2004). These traditional money markets (and federal funds dated back to 1920) had been superseded and surpassed not just by eurodollar markets (unsecured; i.e., LIBOR) but by other forms of money dealing including repo and derivatives (dark leverage). Banks and money markets took Alan Greenspan's targets in stride because money behavior had exploded almost everywhere else.
I have quoted these figures on numerous occasions before but I will do so again and again: total gross credit derivatives, credit default swaps the majority, went from $1.2 trillion as Greenspan started "tightening" to almost $13 trillion by the time he stopped, and more than $16 trillion when it all started to come apart; interest rate swaps went from gross notionals of around $60 trillion to $107 trillion by the end of the "tightening" cycle and then $175 trillion when it all blew up. Those figures are just those from OCC's examination of domestic bank call reports, leaving out huge amounts of dark leverage, in "dollars", coming in from foreign eurodollar banks (the BIS provides estimates for gross derivative exposures by type, but not by type and currency).
In addition, again as noted last week, various intragovernmental financial agencies and bodies were warning of "something" changing in eurodollar and interbank behavior. Even the Fed stopped calculating and publishing M3 in early 2006, a "money supply" figure that was mostly eurodollars and repos. By 2010, in retrospect, the BIS had estimated the "global dollar short" had built up to between $2.5 trillion and $6 trillion in just European banks, all the while the federal funds target was being raised.
If there is one common fear expressed by the economic orthodoxy in recent months, as the FOMC delayed time and again, it is a sense that their economic models might be missing something. Ben Bernanke recently expressed something like misgivings about being overoptimistic at the start of QE's because of an unexpected "slowdown in productivity." That is simply GDP math of "output" not being as robust as expected. Then there is the oil price and commodity crash of 2015 (begun in mid-2014) that nobody in the established economics community can account for (other than Paul Krugman's "deflationary vortex" that applies backwards, mathy conjecture to very real observation) - they keep looking for "inflation" and finding instead the opposite condition.
It is a very curious dichotomy because "deflation", and any predicate conditions for it, is monetary (distinguished from productivity gains reflecting in beneficially lower prices); as in a decline in the "money supply." By every orthodox instinct you would think they would take those determined observations (oil prices are no longer believed so "transitory", at least by reasonable meaning of the word instead of the two or three more years that some policymakers have assigned) of price behavior and apply their very core processes. That is especially so since we have moved far beyond just oil, picking up now foreign import "deflation" (weak US demand balanced against foreign overcapacity) and an almost forthrightly declared domestic "manufacturing recession" now broadened to include all industry (with, surprisingly to some, oil and energy only a small drag on output to this point). In almost every way, the US economy is and has been behaving as if the money supply were contracting!
To economists, such thinking is impossible given that the Fed had been at ZIRP for seven years and conducted four QE's along the way. Their balance sheet had expanded above $4 trillion, so money supply cannot be an issue - unless their view on money itself is wholly wrong.
Whenever someone at the Fed gets to thinking in that direction, they stop short as it would mean tearing it all down. The last to do so was perhaps San Francisco Fed President John Williams who at the end of October said it aloud:
"I see this as more of a warning, a red flag that there's something going on here that isn't in the models, that we maybe don't understand as well as we think, and we should dig down deep deeper and try to figure this out better."
The context for that statement was orthodox conjecture about a low or even negative "natural" or "neutral" rate of interest, which is nothing more than regression-based understanding of monetary behavior. A few months before that, former head of the Bank of England, Mervyn King, declared similar doubts about QE in particular.
"We have had the biggest monetary stimulus that the world must have ever seen, and we still have not solved the problem of weak demand. The idea that monetary stimulus after six years ... is the answer doesn't seem (right) to me."
The commentary surrounding QE is determined by the tense of the perspective; QE will be a powerful and useful economic catalyst; QE was a disappointment. That difference is explained by these econometric models. When the economist inputs QE-type "stimulus" into the simulations they come out as powerful and useful not just because that is predetermined by the assumptions within the equations and regressions but because that very subjectivity determines that the Fed or any central bank actually prints money; or, more precisely, that the public thinks the Fed or any central bank prints money whether they do or not. Thus, the economist's model expects the public to react on their perceptions of the Fed printing money whether they do or not whether the public actually will or not. It's yet another absurd, but highly appropriate, sentence to write.
And so the entire affair boils down to rational expectations theory set against practical money in a wholesale banking system. The past tense disappointment over QE's and ZIRP amount to belated reaction that the Fed does NOT, in fact, print money and that the public does not react to the threat (much beyond stock prices and "reach for yield"). In that view we can start to appreciate the difference between simplicity in raising rates in 2004 though deprived of much effect, and the unknown attempt at doing so in 2015.
In January 2011, the San Francisco Fed (why always FRBSF?) published a paper co-authored by John Williams that detailed just how ugly all the models were in the 2008 crisis. Starting from a "jumping off point" of Q4 2007, meaning one month already into what would become the Great Recession, the Fed's various models, including ferbus, its main policy forecast tool, were nowhere near reality. In just predicting federal funds alone, ferbus wasn't just wrong it existed (and continues) in a world that doesn't. At the start of 2008, with Fed already into TAF, dollar swaps and emergencies, ferbus declared a 95% confidence that the federal funds rate would be between 8% and 1.75% in early 2010. It was even predicting a range of about 3% to 6% by the start of 2009! Again, that's not even in the same world given the status of wholesale money, especially the raw and violent reversal in dark leverage, as the ZLB and the crash it took to get the FOMC there was something like inevitable; calculating otherwise just proves modeling a non-existent monetary paradigm.
What made those projections impossible was wholesale monetary evolution. The Fed's "missing" inflation has been swallowed up by continuing wholesale monetary evolution. What is more likely, that the recovery is just about to get strong and serious but some mysterious and unexplained force has pushed it all, somehow, even further into the future, punishing commodities and economic production along the way, here and overseas, in a manner that we aren't supposed to worry about, or that all those are just the wake of continued monetary dissolution? Since the eurodollar is, by default, the global reserve currency, a credit-based reserve currency, the overseas elements to our story are already contained within it.
If the economy is truly set to overheat, then why does Janet Yellen have such a hard time finding evidence for it? Why is she instead forced time and again to make excuses as to why all the factors that are supposed to hint at that are not (wages, consumer prices, asset prices, even stocks now that are in a clear downtrend having gone nowhere the past eighteen months, junk bonds collapsing along with global currencies and commodities)? It's a twisted mess that demands starting over; which the eurodollar has been trying to do since August 2007. The only difference is that policymakers have convinced themselves it isn't happening, declaring a recovery that nobody can find through a money market that nobody uses in defiance of what really is taking place and spreading. On the same day, the Fed can declare both recovery and recession simultaneously and it all makes perfect sense. Martin Feldstein can be spot on in worries about the great imbalances despite being completely wrong as to why.
It would be the central comedy of our time, were it not so tragic in repetition, that the great monetarists would depend so much on monetary theory of money that doesn't exist so as to ignore monetary behavior that does because they refuse to acknowledge the full implications of monetary evolution.