We're Far Away From Realizing What's Actually Wrong

We're Far Away From Realizing What's Actually Wrong
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The economy of the middle 2000’s, that brief recovery period in between the dot-com cycle and the Great “Recession”, was hardly robust. Contemporary estimates of the Personal Savings Rate showed in 2005 consumers were spending more than they made in income (later revisions would turn the savings rate slightly positive). If not for the unbelievable scale of the credit binge of the day, would the US economy have been positive at all?

And yet, Alan Greenspan wasn’t one for hesitation. Starting in June 2004, he led the FOMC on a crusade to get ahead of the economy. For seventeen straight meetings the Committee voted a 25 bps raise in the federal funds target. They were undeterred despite significant questions.

The most forthright disagreement was presented by the US Treasury market. Long-term rates were not abiding the “rate hikes.” This was Greenspan’s (in)famous “conundrum” and though it was not his first (the rate cycle in 1999-00 played out exactly the same way) he would never be discouraged, nor was Ben Bernanke who finished the cycle by the middle of 2006.

This new one begun under Janet Yellen almost three years ago now, continuing under Jay Powell, comes as questions about the economy arise yet again. Only this time the conundrum is very different. To most, it’s not. Superficially, at least, the yield curve is flattening sharply as it did under Greenspan/Bernanke. The shape is not what’s different.

Instead, what truly matters is where the curve flattens, an urgent message neither economists nor policymakers seem able to comprehend. They simply don’t understand bonds; never have.

It’s not so much an inconvenience as it might have been for the “maestro” with a housing bubble temporarily at his back. The relationship between the yield curve and policymakers is now one of open hostility. Ben Bernanke said recently to just ignore the bond market, just as he once did. Which was the right call then?

To counteract growing unease about these things, in its latest policy statement released this week the FOMC upgraded its economic assessment to unqualified “strong.” They felt so strongly about the strong economy they…refrained from raising rates.

It’s a war of words waged against technical competence. That it repeats so often is something that historians will look back on this time like they now do for the 1930’s, marveling at the intellectual insouciance that marks such overt disciplinary inertia. Economists appear incapable of learning the basics.

In May 2009, while officially the Great “Recession” was still ongoing, the US Treasury yield curve “unexpectedly” steepened. And not by a little. The long end of the curve, the notes and bonds, sold off sharply meaning that nominal rates were rising.

Federal Reserve officials were shocked and dismayed. They had just begun their first QE, which was intent upon bringing interest rates lower as what they judged a necessary measure of monetary “stimulus.” One Reuters article published at the end of May 2009 perfectly captured the befuddlement:

“The Federal Reserve is studying significant moves in the U.S. government bond market last week that could have big implications for the central bank’s strategy to combat the country’s recession. But the Fed is not really sure what is driving the sharp rise in long-dated bond yields, and especially a widening gap between short and long term yields.”

What Jay Powell wouldn’t give nine years later for some of that. People still largely assume that a central bank controls all financial levers. With a theoretically unlimited cap on buying, their entry into any market is supposed to be dispositive (don’t fight the Fed!)

But it’s predicated on a great many, not just one, or a few, intellectual blind spots. All of them are self-enforced.

At the end of 2012, the Wall Street Journal’s Jon Hilsenrath published what at the time seemed like a startling admission on behalf of the FOMC. This was just after our central bank had announced a fourth program of quantitative easing (convention dictates there were only three, but the expansion in December 2012 of that third qualifies in every way as a separate program, by both difference in time, several months, as well as the target for it, UST’s rather than strictly MBS). Confidence was waning and not just within the bond market. After all, if you have to do it repeatedly maybe it’s not what you think.

The major DSGE models (ferbus, edo, and sigma) officials rely upon to tell them how their influences will be received by markets and the economy, as well as feedbacks for those influences, and even feedback upon feedback, are and have been “deeply flawed.”

“Of course, no model or human can perfectly predict the future. But the Fed models have a more specific problem. Despite all their complexity and sophistication, they have long been plagued by gaps in how they read and project the economy. One of the biggest is that they have ignored the nuances of the financial system—one of the primary channels through which Fed policy works.”

Nuance nothing. They don’t get the basics right. And their answer to this “flaw” is to incorporate this very ignorance into their operating models. It tells you a lot about the last few decades.

Yet, the myth persists that these policymakers know what they are doing. Hilsenrath’s article was lost in a sea of noise about “money printing” that by the end of 2012 had been debunked by…the bond market. But not the bond market alone, however, as all sorts of monetary issues had taken issue with “quantitative” “easing” as to both its terms. Curves were no longer normal, and their resistance over the five and a half years since that time has only grown.

The UST curve that now flattens does so around 3% nominal. The eurodollar curve that is now slightly inverted is inverted a little less than indicative forward LIBOR of…3% nominal. We live in a 3% nominal world which is nothing like, which cannot be anything like “strong.”  Curve resistance declares, definitively, that a truly strong economy is about as likely as Economists learning about bonds.

Underneath it all, policymakers are nervous. They project confidence according to personalities not rational analysis. I personally preferred Janet Yellen to either Bernanke or Powell. Not because she was any more competent, rather her skills didn’t dictate the single setting of false confidence. There was more honesty in her often comedy level blank stare.

Powell much like Bernanke betrays only arrogance. They know what they are doing, except what they know is only within ferbus, edo, and sigma. They can tell you a lot about complex equations, but almost nothing about economy and especially its relationship to…bonds.

About two months ago, Bill Dudley on the cusp of his retirement as head of FRBNY sat down with FRBNY to conduct a sort of exit interview. Like Bernanke’s book on the subject, the purpose of the publication was to rewrite history.

If there was one name besides Bernanke’s that kept coming up during the crisis era for all the wrong reasons it was Bill Dudley’s. Before running FRBNY he was head of FRBNY’s Open Market Desk, and therefore during the worst episode in the Feds’ post-Great Depression history he was staring into the very epicenter of it. Only he didn’t know it. Nor did the Federal Reserve as an institution, a fact Dudley only admits about a decade too late.

“One of the challenges going into the financial crisis, for example, if you look at the big DSGE model—dynamic stochastic general equilibrium model—it didn’t include a finance sector. So the whole experience of what actually happened during the global financial crisis—the collapse of the financial system and that taking down the real economy—wasn’t an actual possibility within the major macro models that some economists were using to forecast the economy.”

That seems like a pretty big omission, don’t you think? Downright careless. And from this basis we are supposed to believe them when they are faced with these “conundrums?”  Hardly.

But they’ve added a financial component to their models over the years since, they say. Sure, and it’s been about as effective as the prior models. What are the chances that an upgraded edo makes sense of the actual bond market rather than modeling instead how Economists still view it with hostility? You don’t need something like ferbus to calculate those odds.

Economics doesn’t listen to markets. Economists only dictate.

It was a defect that many have recognized for a very long time. Nobel Prize winner Ronald Coase once said:

“This neglect of other aspects of the system has been made easier by another feature of modern economic theory – the growing abstraction of the analysis, which does not seem to call for a detailed knowledge of the actual economic system or, at any rate, has managed to proceed without it.”

That’s fine, to a certain extent, for Economists working out stochastic formulas on blackboards at Ivy League schools. Not at all appropriate for a central bank. After all, a central bank isn’t some safe academic setting.

It’s this disparity that is causing all issues. This is the modern plague of pedigree. An Economist teaching at Princeton will be viewed with varying degrees of skepticism when he comments on the monetary system, but put him in charge of the central bank and suddenly he knows everything about the topic.

And no matter how poorly he performs in his job, a panic here, nearly one later, four QE’s there, he will remain in the highest esteem especially in the media when it looks, as it is so often forced to, for answers on why things still don’t make sense. Starting with the yield curve.

We’ve been here before. Several times in recent memory. The last time was 2014. Ben Bernanke handed off to Janet Yellen as Janet Yellen hands off to Jay Powell. Economists are certain that the economy is booming just as they were certain four years ago when they constantly proclaimed the “best jobs market in decades.” We don’t even have that anymore (or the President would’ve tweeted it by now).

What the models never see coming are the downturns in between. They can’t because they are stripped of any useful financial knowledge about the interactions not just in the financial system but more so the monetary system.

Ironically enough, in his book The Courage To Act former Fed Chairman Bernanke even goes so far as to title his 21st chapter QE2: False Dawn. Full disclosure, I’ve not read the book but I have scanned through his references used in it. The title for that chapter is interesting for everything we are discussing here, these “unexpected” downturns that keep the economic recovery only in check – and leave policymakers exposed as each upswing proves time and again to be, say it with me, a false dawn.

One of the articles Dr. Bernanke cites in this chapter on false dawns was another published in the Wall Street Journal, this time in November 2010 just days after the launch of QE2. Authored by Kevin Warsh, then a Federal Reserve Board Governor, it was a pretty good summation of things a year and a half into the presumed recovery:

“After a cyclical boost early this year, the current state of the U.S. economy is unimpressive: modest growth, high levels of unemployment, stagnant wages, low levels of consumer and business sentiment, and volatile financial markets. Extrapolating from recent data, many predict only a middling recovery in the next several years. They call it ‘the new normal.’ I call it the new malaise.”

This was, apparently, the basis for going ahead with the second quantitative easing program. Why no one thought to investigate the financial system’s role in all those conditions Mr. Warsh cited speaks loudly about the central place of ferbus, edo, and sigma in the central bank hierarchy. Maybe it was a “new normal” because QE1 didn’t work?

Such simple questions, however, were not to be answered. Throughout 2010’s false dawn only one FOMC member, Thomas Hoenig, dissented. He dissented about everything, from maintaining ZIRP to especially lifting off with another “money printing” operation. Hoenig was convinced the Fed was playing with inflation, and that they risked a spiral out of control like that of the 1970’s. No one considered instead the “new malaise” as a monetary effect.

Either QE would work, or it would work too well. Never once did it dawn that it might not work at all; that the first operation was a complete and utter failure at its main task which was restoring monetary function to a reasonably sound degree. They had no basis other than ferbus for these assumptions.

The thing is, several of the presumed key factors Warsh specified in 2010 are no longer issues in 2018. High levels of unemployment have disappeared, the extreme low unemployment rate is now the most common measure of the current “boom.” Consumer and business sentiment are sky high and have been for several years now. Financial volatility is extremely low, at least in the stock market, which for most people is all they think that matters.

And still the malaise persists. That’s the 3% curve. The bond market cuts through all that stuff and gets the economy behind the unemployment rate (the millions not officially included in its denominator, the very issue that won Donald Trump the Rust Belt vote and therefore the White House), the economy that doesn’t live up to sentiment (spending has detached from all sentiment data, even in things like homebuilder confidence that even in the stratosphere doesn’t come close to matching up with historically low levels of homebuilding), and where financial volatility actually matters in things like currency markets and collateral, substantial deficiencies that remain a key drag on function.

Functions, however, that ferbus, edo, and sigma don’t include for Jay Powell to rethink before upgrading his economic assessment.  Strong economy, or false dawn #3?

We are so far off from realizing what’s wrong that even when the yield curve comes into focus it does so for the wrong reasons. That’s the legacy of Economics, a backwards mentality that studies everything but the economy, and still it has permeated all levels of education. Economic illiteracy is rampant especially among the econometric models. Inverted doesn’t matter, especially not in this circumstance. We have Japan curves only “we” can’t see them because the economy is so “strong.”

Japanification wasn’t built on zombie banks and a deflationary mindset, rather the latter grew impermeable from all the recoveries and strong economies that never panned out. The Bank of Japan had its own ferbus as well as a stunning lack of respect for curves. After ridiculing the Japanese performance in 2003 under Greenspan, from Bernanke to Yellen to Powell they now emulate it.

Malaise is the primary symptom of a specific disease: curve crazy. It’s pathology: DSGE models.

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

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