Bernanke's Successor Errs Despite a 2002 Promise

Bernanke's Successor Errs Despite a 2002 Promise
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The Census Bureau reported this week that retail sales rose 5.30% year-over-year unadjusted in November, the best gain since February. That followed, however, an increase of just 1.96% in October. Generally speaking, retail sales grow at a rate of 6-9% during periods recognized as consistent with normal economic gains. They grow at 3% during periods of declared recession and their immediate aftermath. The exception to this hardened relationship has been the past few years, where clearly the NBER has yet to make a cyclical determination even though so many statistics, like retail sales and more importantly Industrial Production, continue to suggest something very wrong.

But it's not just that low results that is relevant to our attempt at classifying this economy, as there is, I believe, a great deal of information in how these levels have been achieved. The dramatic variation between retail sales in October and November has become a regular feature of this overall climate. The seasonally adjusted series is suggesting that seasonal factors played a significant role in that variation, where October wasn't nearly as bad as it seemed unadjusted, and, conversely, November nowhere near as good. Seasonal factors, however, are a constant factor and in the past we hardly ever noticed them.

The wild swings in retail sales are found in other recent months, too. For December 2015, the Census Bureau figures retail sales grew by 3.4%, one of the better months of last year, and then falling off to just 0.93% in January and one of the worst months in the entire data series. The very next month, February, retail sales rose almost 7%, which was a higher growth rate than any in 2014 or 2013; the best since March 2012 when this whole slowdown business began.

For all these seemingly good months, seasonal factors or not, there are an equal or greater number still of bad ones. The 6-month average for retail sales in April 2016 was 3.19%, which included February's almost normalcy. Sales jumped to 3.54% in June during what appeared to be the usual spring rebound, only to decelerate in July back under 1% all over again. The 6-month average for both June and July was 3.21%. The 6-month average for retail sales after October and November's gyrations is 3.19%.

If you look back in the history of the data, this is peculiar both as the level of its growth tendency and the high degree of variation which results in only around 3% and a recession-like atmosphere of consumer spending. In 1999, for example, a time period that should be comparable to now, any variation was almost universally upward. Retail sales began the year that January at just under 5% but accelerated to over 10% by March; for the next three months the growth rates were, 6.94%, 6.97%, and 6.90%, in that order. Then it was another jump to 10% in August 1999 followed by 9.80% in September. There was a down month with variation to 5.65% in October, but then right back to around 9% or 10% for the next five months into the year 2000, the only exception among those five was 13.56% growth in February 2000.

It isn't just retail sales, of course, where unevenness has become the dominant form of regularity. One of the most extreme examples is the ISM's Chicago Business Barometer. Designed under a different name and intended to give us a sentiment picture of manufacturing in that crucial part of the Midwest, it has this year been all over the place. At various times the index has surged by 12 points, 6 points, 7.5 points, and finally 7 points again for the latest reading in November. From just those positive changes, you would expect the PMI to be through the roof, indicating a truly robust manufacturing environment. The 6-month average, however, is just 54, which is about where the average was in the latter half of 2012 and to start 2013.

Perhaps the most prominent example of this uneven economic condition is found in GDP. In 2014 for example, there were again these huge and contrasting extremes. Out of the frozen snows of the Polar Vortex, GDP was initially estimated in April 2014 to have been just 0.1% for that first quarter. A month later, more complete information forced the BEA to calculate GDP had fallen by 1% in Q1, and through all the revisions benchmark and otherwise to this day it remains a negative. Since this was the quarter immediately following the Fed's taper of QE, it was thought to be an impossible result, surely an aberration of non-economic factors.

That view was seemingly confirmed throughout the rest of that year where GDP accelerated to 4% and even 5% the next few quarters. So if you discarded Q1, as economists and policymakers did, the year started to look absolutely splendid, the perfect results by which to claim "liftoff" and final recovery. But then it happened all over again the very next year, in Q1 2015.

The track of the BEA's estimates were eerily similar to those from the year before; the advance estimate released in April 2015 showed just a 0.2% gain, revised down to -0.7% at the second estimate. The response in the mainstream was entirely emotional and biased, exemplified "best" by Steve Liesman of CNBC who on April 22, 2015, declared that a CNBC investigation of 30 years of GDP statistics showed "a longstanding problem of underreporting Q1 expansion." Under the scientism label of "residual seasonality", Liesman wrote that, "Over some time periods, in fact, first quarter growth is so weak it appears to be measuring a different economy altogether..."

That was certainly the view of most economists and policymakers who were stumped by these constant "anomalies" in GDP and other accounts. They preferred to, as they did in 2014, create some alternate explanation as to why those really bad quarters, unusually bad quarters in fact, could not be real given that QE surely had worked and the recovery then finally and fully underway.

But that was the point that they missed, or in their bias refused to accept; these negative quarters are very, very unusual for any growth periods. That they showed up was meaningful, plural. The first quarters of 2014 and 2015 weren't even the first time it had happened, nor, as we saw for Q1 2016, was it the last. In Q1 2011, there was yet another negative sign for GDP. Residual seasonality or not, over the past almost 70 years of GDP statistics those processes have always been a part. Yet, despite Liesman's insistence, there had until Q1 2011 never been a negative sign for GDP in any quarter during so-called boom years. In fact, there were only rare occasions where GDP was less than 1%.

From 2002 through the end of 2007, there were no negative quarters including those that were surely just as cold and snowy first quarters that were never an issue before. There were three less than 0.5%, two of which occurred after the housing market peaked in the middle of 2006. From 1992 through the end of 2000, there were no quarters either negative or less than 0.5%, and only two less than 1%. From 1983 through the second quarter of 1990, again no negatives, none below 0.5%, and only three below 2%; and two of those were during the S&L crisis among the three quarters just prior to the 1990 recession.

I could keep going but the point is made; there is always variation, but in the last seven years it appears to be much higher and pivoting around a far lower mean. It has become so ridiculous and obvious that economists convinced only of recovery have appealed to snow and statistics to suggest, more so to themselves, why it isn't or really can't possibly be real.

I typically refrain from using analogies, mostly because they require an oversimplification that leaves out too much needed appreciation for complexities. In this case, however, there is one that does fit without sacrificing too much fine detail. An airplane is actually more stable in flight the faster it goes. As it slows for whatever reason, including in order to land back on the ground safely, it becomes far less stable to the point that if it decelerates too much its wings will be deprived of airflow and the craft will suddenly plummet to earth.

I think that is an apt representation of this economy and its regular, downward variation. It is growing too slow for it to be, or have been, stable. Janet Yellen should never have been so cavalier about Q1 2014 GDP being an anomaly, because what was most important about GDP in 2014 wasn't the high levels in the middle, it was the wide degree of variation and the tendency for the downside of that variation to be historically atypical.

In the aeronautic analogy, there is, of course, a role for money. We could say it is the engines that drive the frame, but in reality that is capital. Money is the fuel which allows the engines to perform that efficient and stable thrust; deprive the engines of sufficient fuel, and the whole vehicle will slow regardless of how powerful and finely tuned the motors.

The Federal Reserve's job in this analogy is to ensure the "right" amount of fuel flowing to the engines to maintain stable and level flight. They obviously failed at that task, self-assigned it needs to be pointed out, starting in August 2007. So in response to that failure, which was in this situation an almost total fuel blockage, the Fed attempted to retool the flow but only by changing the fuel lines to a larger variety.

The fuel pump itself was something that was built in the 1920's and last remodeled and updated in the 1950's. Rather than re-examine the pump to determine its continued suitability, the Fed instead slapped on a wider, higher capacity fuel hose to the pump and attached the other end to each engine, without examining either end, expecting immediately better results. They were in that initial stage much less than desired.

So again they fashioned a larger fuel line and attached it to the system as if that was the totality of necessary action; no monitoring of flow, no examination of what was coming out, or going in, just a bigger hose. The sum total of their mechanical feedback was the overall level of flight and its stability. When it proved to be unstable and slow, the Fed as airplane mechanic downplayed these downstream performance parameters until its instability became dangerously unstable, like in 2012. Then, as usual, they just attached a much larger fuel hose, expecting simply more hose would equal more fuel flow, and away it all went all over again.

What happened this week at the FOMC, using this analogy, was that the monetary committee finally declared that it is done swapping out fuel hoses. This does not mean the aircraft has achieved stable and level flight, far from it. As we can see from the continued high degree of unevenness, instability, and the low levels of both in the parameters of flight (retail sales, PMI's, GDP, etc.). They have declared the insufficiently normal operation to instead be related to the engines, the air surfaces, or some other structural issues beyond their capabilities.

By raising the federal funds rate a second time (and it is more than just that one action), the Federal Reserve has declared there is nothing more for it to do. What you see in the economy today is what counts now, for their purposes, as completed recovery - even if that means fifteen straight months of contraction in Industrial Production. There can't be a fuel problem because they changed the fuel lines four times.

Where this analogy breaks down, of course, is that in the physics of flight there are only known quantities and parameters. An airline operator just as an engine manufacturer knows very well just how much fuel is necessary to efficiently produce sufficient thrust. The pilots know almost exactly how fast they need to go to produce the minimum level of windflow over the wings to generate lift and steady flight.

There are no precise physical quantities in economics or money; and there never will be. This is not, however, how Economics presents itself, starting with QE. The whole idea of QE is that it was quantitatively determined, an intentional PR maneuver planned to increase confidence in it rather than how it might reveal its construction and design. Furthermore, Economics particularly through econometrics believes in some degree of quantity theory, governed by a modern interpretation of the Phillips Curve. Thus, in very simple terms, the Fed and its compatriot central banks want you very much to believe they can determine the exact right amount of monetary fuel for the economic aircraft.

Therefore, if the aircraft continues to misbehave it is sufficiently proved to them by the single act of changing the fuel lines as beyond a fuel problem. As I wrote last week in the related "surrender" of the ECB:

"If you believe that 2% inflation and a true 5% unemployment rate represents the right balance for the right economy, that is where you stop. If you believe that 2% inflation and a questionable 5% unemployment rate shows up, you might continue with "stimulus" in the belief that those questions will be answered with enough time and accommodation. If the 5% unemployment rate instead remains highly questionable no matter what, then monetary neutrality demands that you start to accept that that is just the way it is."

Because they did the one thing they are absolutely sure is the only thing that matters, to them it thus cannot be anything else within their wide sphere of responsibility.

Owing to the imprecision of all social "sciences", we can never be sure exactly what is wrong. In many ways, the answers we are seeking are often of questions nobody is willing to even ask, or in the case of central banks forbidden and banished from the most basic discussion. In other words, rather than fiddling with QE, ZIRP, or interest rates at all, we should be thinking about what could be, or might be, money. The Fed never examined anything other than the size of the fuel lines, ignoring fully what might have been flowing through them (or, as we can easily surmise, what wasn't). If the engines sputter, it might be the mix of fuel, and thus what is fuel, rather than simply its quantity or potential quantity.

Inevitably when doing so, just the simple action of bringing up the topic leads to accusations that you (meaning I) know what that correct amount of money might or should be. I certainly don't, nor would I ever claim to. What I do know with a reasonable degree of certainty is that whatever quantity there exists now is not it.

In every economics textbook there is described the case of monetary deflation. Deflation itself is often written out as a misconception, sometimes where productive deflation is lumped together with the money variety, though they are distinct processes that produce very different results. We want, badly, productive deflation as it is on the flipside the advance of society and living standards. We want to avoid, at all costs, monetary deflation because behind that is only the worst of the worst cases.

This is why monetary authorities and central banks around the world are committed to 2% (or more) inflation targets. Zero inflation and perfect price stability is a laudable goal, even to most economists, but they feel it has no insurance. Better to get a little inflation, so the thinking goes, than to be at risk for outright deflation. At 2% on the CPI or PCE Deflator, there is margin for error; within the confines of my airplane analogy, enough altitude so that if the engines start to sputter the fuel problem can be fixed in time before impacting catastrophically the ground.

Textbook deflation, however, doesn't have to be the worst case scenario. There needn't be a repeat of 1929 or 2008 with which to suggest monetary disambiguation. When an actual airplane loses altitude, the pilots know it straight away because there is a physical gauge that can precisely determine altitude. If an economy loses altitude, it's not as easy a determination. It requires an objective review of a wide survey of data.

That has been one of the biggest impediments to realistic determination over the last almost ten years; policymakers have a preferred set of statistics and prices and refuse any other information. In 2007, as I wrote about a few months ago, Bill Dudley and the rest of the FOMC refused the blaring alarms going off in eurodollar futures because they had surveys of other economists who, using the same types of mathematical models, echoed their thoughts exactly. In 2015, Janet Yellen leaned heavily on just the unemployment rate, as GDP had failed her by then, even though there was practically nothing related to wages and spending to suggest the unemployment rate was anything other than misleading.

A broad review of economic data, which would include notice and appreciation of this regular economic instability, starts to conform almost perfectly to the textbook case of monetary deflation. From commodity prices to output growth that only slows, all signs point in the same direction. And it isn't just the United States, as chart after chart of economic accounts drawn from foreign data often of national economies that should in theory behave unrelated to our own all show the same pattern. Even more compelling is that they exhibit the same timeframes and inflections for these patterns - and those all match up to eurodollar events.

The only way that can happen is as if by a single unifying force, a factor that not only touches each of these distant systems (or what are thought to be distant and rarely connected) but is monetary in its nature. After all, if we are talking about global deflation then it must be global money. Again, I have no idea what the right amount of global money might be, nor would I ever try to figure that out, instead I can plainly observe the unstable and low level of flight for the global economy and very reasonably assume that the current monetary state remains (mildly) destructive.

As the airplane analogy suggests, the economy is awful, though not just awful but awful in a very peculiar way that always can be traced back to monetary problems. An engine that sputters, hems and haws due to a lack of fuel acts and sounds very distinctly. The whole history of the Great "Recession" and its aftermath is itself monetary. Can there really be an argument about that? Central bank after central bank around the world has been thwarted, several in spectacular (and ongoing) fashion. Every form of "stimulus" to this point imagined has been swallowed up as if it didn't even make a dent. And all the FOMC can do to explain this is Baby Boomer retirement? Worker skills mismatch?

What's truly ironic in that familiar tragic sense is that this country has been through all this before. Not only that, the lessons derived from that prior catastrophe were even made the centerpiece for all money policies around the world, including those having been practiced in the US for decades. In November 2002, Ben Bernanke spoke on the occasion of Milton Friedman's 90th birthday, talking about what Bernanke called, "the leading and most persuasive explanation for the worst economic disaster in American history." The future Fed Chairman offered his pledge to not repeat the monetary errors of that earlier age. To Friedman he said:

"Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

Yet he did. His successor just led the same policymaking body to vote almost ten years into it for that depression. All that's left is to accept why.

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

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