The Fed Is Being Forced to Reckon With the Impossible

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Kansas City Fed President Esther George has taken up the argument where former Dallas Fed President Richard Fisher left off. Both are ardent inflationists and have not been shy saying so. Prior to this latest June FOMC meeting, George has taken to becoming the policy dissident, voting against the consensus "dovishness" time and again. At the April policy gathering, George was the lone dissenter against holding interest rates steady, same as she was in the middle of March. Curiously, however, there were no recalcitrant votes in January amidst the biting crush of "global turmoil"; not even Ms. George could muster inflation concerns under those conditions.

Before this latest FOMC meeting, George had voted eleven times and had been against the rest of the Committee in nine of them; her only two in tandem were December when the vote was to increase the irrelevant federal funds rate, and then the cowering in January. Wednesday makes three. Despite all the assurances practically written in stone about how the start to this year was once more "transitory" and that June would be the next hike for sure, not even Esther George could offer dissent when the FOMC once again found itself with economic conditions far different than in their models.

Industrial production is winning. By that I mean the economy is losing and the Fed is being forced to reckon with the impossible. When the FOMC gathered in December in the calm between the two (so far) global liquidations, or turmoil as convention calls them, the day they voted for full recovery was also the day that the same Federal Reserve published a contraction in US Industrial Production (for the month of November) for the first time this "cycle." IP is not some recent statistical construction of soft sample targets, rather it has a history dating back to the end of World War I. In nearly a century of data, contraction in IP is almost exclusively recession.

The data is not free from revisions, however, but those that have been so far entered only further task the Fed's monotonous reference to the recovery that is always just around the corner. The latest revisions show that the first tremor in IP was not felt in November but five months earlier in June 2015. By the time November rolled around, IP was falling at more than 2%.

But that wasn't even the worst of the revisions. As I described a few weeks ago, the benchmark revisions owing to the further incorporation of the 2012 Economic Census were downright brutal. In short, not only was industrial production in the US declining earlier and to a greater degree, it was doing so from a much, much smaller overall recovery trajectory. The recovery was shrunk, and now is giving more and more over to further shrinking.

The latest update in Industrial Production for May 2016, also coincident to this latest FOMC vote, was more of the same. Production has fallen now in nine consecutive months, with the oil sector just starting to seriously drag down the rest. The most concerning part of the report, though, was auto production. Automobile manufacturing and sales have been the lone bright spot in this otherwise atrocious climate, regardless of how artificial that may have been in the form of subprime leasing and flowing finance.

Motor vehicle assemblies, the Fed's proxy for domestic production contained within the IP report, tumbled to just 11.35 million (SAAR). That was down sharply from 12.21 million in April, and a rather alarming 9% less than May 2015. It was the same level of estimated production as June 2013. This part of the series is quite volatile, so one month isn't exactly convincing in any direction, but MV assemblies have been clearly off their trend for some time tracing back, unsurprisingly, to last summer.

Lower production is also quite consistent with figures we find elsewhere. Auto sales included in the retail sales figures for May were up only 1.6% year-over-year, the third worst monthly gain of this "cycle" (where January 2016 was the worst). The average gain in auto sales is now the slowest since February 2010. Against that topline backdrop, wholesale auto inventories have surged. The inventory-to-sales ratio in wholesale automobiles was 1.81 in April (the latest data), making six of the past seven months at or above 1.80. The ratio was 1.65 at the end of 2014 and the last time we saw anything close to such an imbalance was at the depths of the Great Recession in 2009.

To find auto production, then, slumping to some as-yet unknown degree is perhaps the least surprising outcome of this spring. When topline sales slow considerably and inventory piles up, there is only one possible outcome at that point. The FOMC and Esther George's outlook, however, have always saved a second scenario where the robustness of the Establishment Survey and the unemployment rate would actually suggest a coming resurgence in spending and sales; saving production as the inventory overhang would be readily bought rather than liquidated.

To say that the last Establishment Survey report spooked them might be one of the all-time understatements. In her speech at the end of May, Janet Yellen all but declared her itchiness. Yet, even by then there were solid indications that the labor market wasn't anything like what she was, and to some extent still is, proclaiming. To start with, all these other data series and economic accounts visibly disagree with the entire "best jobs market in decades", meaning that the actual economy hasn't correlated with the major labor numbers in a long, long time. But even setting that aside, the Establishment Survey had clearly slowed even before the May report (which was also the lowest gain of this "cycle").

In August 2014, the Federal Reserve adopted a more comprehensive measure for labor market conditions in the US. Never an institution to adopt naked branding (only the more nefarious kind like the Great "Moderation"), this new statistic was called simply the Labor Market Conditions Index (LMCI). It took the form quite purposefully of a factor model, a more dynamic approach that seeks to minimize the influence of any outlier statistics that aren't corroborated elsewhere - like, perhaps, the unemployment rate. There are 18 other data points in this model.

More than three weeks before Janet Yellen spoke about her growing confidence in monetary policy completion, I wrote:

If they remain true to that word, then there is no way there will be rate hikes soon. The Fed's Labor Market Conditions Index was negative for the fourth straight month in April. Though the change was only -0.9, slightly better than February and March, the index has not seen four consecutive contractions since 2009. Worse, the 6-month average turned negative for the first time this "cycle."

In the May revisions to the LMCI, April's estimate was revised once again in the "wrong" direction. What was "only" -0.9 in April is now figured to be -3.4, followed now by -4.8 in May. You don't need a degree in statistics to see where this is going.

But still this is all "transitory" they say. There it was yet again in the June policy statement, "Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further." Like the word "recovery", this constant reference to "transitory" has had the effect of stripping its meaning. Transitory weakness has been transitory for nearing two years now, redefining it to plead instead "nothing to see here."

That has been the literal history of these past two years, as the world that was declared at the end of 2014 just disappeared on them. I urge you to go back to December 2014 and read the mainstream economic commentary from the day Q3 GDP was upwardly revised to 5% (and for months afterward). The amount of raw confidence was in some ways inspiring as it was meant to be, but always, always flawed. They couldn't see it because they were blinded by the long, exhausting search for ultimate completion that at that moment, more than any other, seemed to be only an outstretched fingertip beyond their grasp. The myth of 5% GDP and its related "full employment" has been so powerful that it has sustained mainstream commentary through nothing but serious slowing and constant contraction.

It has had some effect, however, as "nothing to see here" is increasingly taken even by a more receptive mainstream as "what are they talking about?"

This latest FOMC meeting, while irrelevant in financial terms, is more dangerous than usual as it (and the press conference following) may have taken the last leg of optimism out from under the narrative. Without the labor market at least appearing supportive of a much better future, there is only the naked conjecture of economists who keep saying the same thing no matter how much wreckage appears around them. Baghdad Bob was in danger of being given new life.

How could they have been so wrong about it?

There are a few reasons, some of which lay in the manner in which these economic statistics are themselves constructed. More so, however, this "cycle" may not be that at all. The hallmark of the now much clearer (with benchmark revisions) slowing since 2012 has been its unevenness. Recessions are blunt, violent, and straight - "V" shaped. This is something altogether different; slowing for months, then the sudden change to minor acceleration before slowing further still. This jagged trajectory is and has been ubiquitous all over the world; even US GDP has been at best unstable no matter how many weather or statistical ("residual seasonality") excuses are made for it. Thus, 5% GDP was the anomaly, not the new baseline of monetary policy winning full recovery.

Each and every time there is one of these minor upward variances, it is extrapolated in the mainstream as if it were "the bottom." Instead, before too many more months, there is a new "bottom" lower still than the last. Because this pattern is nothing like typical recession, it is taken for expansion since there are only two choices provided by orthodox economics - if the economy isn't in recession, it must be growing. For the FOMC and economists over the past four years, growing has been slowing which to them meant full recovery was just around the corner after "transitory" factors were scattered by the full force of monetary might: QE.

Faith in QE has taken on religious devotion especially since the middle of 2014 when a slowing economy (here and globally) first turned mildly contractionary. The timing of that shift is no coincidence; it is the essence of the "rising dollar." From that we find the great divide between the economy as it "should be" under QE and the one that is falling further under the "dollar." It is a direct contradiction to everything about monetary economics as it is practiced in every central bank that has taken to QE. The "rising dollar" was an amplification of the eurodollar decay that started in August 2007, a "dollar" shortage in its baseline capacity that suddenly took on much more determined, global emphasis.

To proponents of QE, this is an impossible description let alone reality. Quantitative easing was enormous "money printing" no matter how much inflation, commodity markets, and the global economy act consistent with monetary contraction. Unfortunately for all of us, there were grave and fundamental misconceptions about QE from the start; not on our part, but by those thinking it was a solution.

First and foremost, QE was meant as a cyclical tool, an intermediate method to fill the private market's sudden funding "gap" left by the panic and Great Recession. The method of "easing" was left to bank reserves since they are the only choice open to the central bank in this format. But the panic in 2008 was an interbank, geographical divide not something like what was seen (and expected of) in the 1930's; it was a wholesale problem of wholesale eurodollar finance. In other words, bank reserves were always a poor substitute for lost capacity that was so much more than what was visible on balance sheets (the dark leverage of derivatives and beyond).

But even if we assume bank reserves were a close enough substitute, all the QE's combined fell short just on quantity terms alone. Taken by itself, the Fed's balance sheet appears daunting and maybe even impressive. Four and a half trillion dollars is not something to be taken lightly, and so it is figured more than sufficient on awe and emotion to offset whatever might have been lost.

We don't have many statistics for these wholesale funding arrangements, but what few we do are more than enough to refute this quantitative fallacy. The Fed may have discontinued M3 (where its statement regarding the ending of the data collection will, in my view, be the institution's famous last words) but it continued to collect other parcels of the wholesale universe beyond the narrow view of the official monetary statistics. Among them is commercial paper, both asset-backed and financial, as well as aggregated liabilities in the Financial Accounts of the United States (Z1; formerly Flow of Funds).

Combined, commercial paper and the Z1 calculation of federal funds liabilities plus (more so) repurchase agreements amounted to $6.2 trillion at the end of Q2 2007 - just before the events of that August. From that point forward, these wholesale liabilities have only shrunk but not in a straight line. By the time Lehman failed, at the end of Q3 2008, commercial paper, federal funds, and repo liabilities had declined a cumulative $656 billion. By the end of the next quarter, as the Fed was in full-throated emergency trying to stem the tide of enormous illiquidity, these wholesale categories had dropped another $962 billion; again, just that one quarter alone, nearly $1 trillion. Panic was a foregone conclusion and the Fed so clearly unprepared for it.

By the time the Fed actually started QE1, the total decline since the 2007 peak was an astounding $2.3 trillion. And so QE was started with one view toward bridging that funding gap until such time as the private wholesale market would in some different form regain its prior footing. That just never happened. From the start of QE1 until the end of 2012 at the start of QE4, these wholesale funding categories in total, which includes federal funds and repo, gained only $191 billion of it back. Capacity had shriveled and stayed that way (this should sound familiar to anyone acquainted with the labor force statistics).

Since the end of 2012, however, wholesale funding has only shrunk again, another $550 billion through the end of Q1 2016. The total lost capacity from the prior peak back in 2007 is $2.6 trillion. That decline is just about equal to the gain in the level of bank reserves through all four QE's, suggesting on the surface that the Fed did, if belatedly, offset that funding gap. But that reveals the real problem, meaning that our calculation of lost capacity is incorrectly understated. In other words, the funding system for a growing economy is not one that is static. The true shortfall is not what funding is compared to what it was, but where funding is compared to where it would have been had it not been interrupted.

No matter what growth baseline you figure for calculating this dynamic deficit, what you will find is that it only grows with time - even if you add the Fed's entire balance sheet to the mix. Quantitatively, the Fed was always behind and getting more so each and every quarter that the private, wholesale "dollar" system did not restart (let alone further contract). Even after the completion of QE3 and QE4, together which added a seemingly impressive $1.7 trillion to the Fed's balance sheet, the funding gap was larger after it than before it.

I have not factored in any of the other wholesale mechanics, which I will argue are even more important than commercial paper and repo (federal funds is, again, irrelevant). There are no eurodollars here, as what I have used is only the domestic side of the dollar system, leaving the hidden offshore arrangements to imagination. While that technically allows for perhaps the possibility of some expansion in these hidden areas, again the weight of evidence in monetary and global economic factors leaves it a highly unlikely one. By any balance sheet measure you wish to use, including derivatives balances, banks are shrinking in tandem with what we find in these more visible wholesale estimates. Banks are the eurodollar system. If QE could not even offset what we can see, how can we expect that it would have further offset what we can't?

These calculations again assume that bank reserves are even enough of a close substitute to dynamic wholesale funding such that the discussion over quantity is even relevant. They are not; which means QE fails as both quantitative and easing.

It is not just eerie coincidence that global economic trajectory takes on these exact monetary proportions of wholesale gaps and divergences. Similar to the history of repos, commercial paper, and federal funds, the economy experienced a sharp contraction in the Great Recession and then never came back. Now that the money supply of eurodollars and wholesale "dollars" is shrinking again post-2011 it is unsurprising to find the US and global economy to be slowing and only slowing during that time (no matter how uneven in monthly or even quarterly variations). The mainstream focused on just one of those upswings (that has been, I should point out, revised away more and more at each underlying benchmark; we'll see what happens to GDP and that 5% in the future) and missed the fundamental, textbook monetary corroboration.

They wanted so badly to believe in balance sheet expansion as if it was expansion in a vacuum, but even by incomplete statistics we see on net it never was expansion to begin with or at any point along the way. Economists have leapt to the increasingly absurd to try to explain why we can't find anything of QE in any of these economies when the answer is blindingly simple. QE seems to have just disappeared because it was so easily swallowed up by the wholesale chasm that still continues to grow only larger and in ways bank reserves will never apply.

Under these circumstances, the FOMC is neither hawkish nor dovish; it simply doesn't figure. The only relevance is what the media still gives them in terms of their proclamations, though even these are being so thoroughly devalued by events far beyond their grasp. The Fed wrote in March 2006 that they were discontinuing M3 because it didn't, "convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years." As I wrote above, famous last words. Monetary policy, real, functional monetary policy outside the PR trappings of a governmental, institutional gathering of empty suits and credentials, has been entirely contained within M3 and what was missing from it this whole time. Instead of ignoring it, they should have made it their priority, their only priority, to figure out all that lay beyond in the hidden world of wholesale, eurodollar finance.

It would have been better (for the recovery; the crash was already inevitable by then) had they done it 2006 because they are still on track to reckon with it at some point in the (near?) future anyway. It's unfortunate and tragic that we are too.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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