Global Macro Commentary Diagnoses Matter Tuesday, May 03, 2016

Guy Haselmann (212) 225-6686 Director, Capital Markets Strategy

    

Diagnoses Matter 

It is generally believed that the Fed has a dual mandate of full employment and a 2% inflation target.  However this is not really true. The Fed’s legally mandated ‘Monetary Policy Objectives’ are set out in Section 2A of the Federal Reserve Act.   

o Section 2A reads: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long‐term interest rates.” 

This ‘jambalaya’ of words when stated more clearly basically says that ‘the Fed is to maintain a growth level of monetary and credit aggregates with the intent of trying to achieve a few broader goals’. Therefore, if incorrect assumptions are made about how money and credit works, then all resulting conclusions will be erroneous. Slight differences in the assumptions about how monetary aggregates behave could (even) result in the conclusion that easy monetary policy, is, or has become at some point, counter‐productive (See March 8th note, “The H‐Curve”)   

It is in these assumptions where the debate between supporters and critics of experimental central bank policies arise.  Most central bankers believe that expanding the supply of money will increase growth and inflation; while lowering long‐term interest rates will increase credit aggregates leading to the same results. These long‐standing first‐order conclusions might be taken for granted and actually be a grand mis‐diagnosis for the following reasons:   

o The Fed can ‘spill’ money into the system, but it cannot control where it flows.   o Low long‐term interest rates should not assume that both credit demand and supply increases. When credit 

spreads fall and the yield curve flattens, the supply of credit will likely decrease due to a fall in bank NIMs (net interest margin).  The velocity of money has plummeted globally for a reason. 

o Banks ‘borrow short’ and ‘lend long’, so a flatter curve disincentivizes lending activity.  Would the yield curve be steeper if the Fed did not do twist, or if it were not ‘reinvesting’ its balance sheet out the curve? These maybe counterfactual, but I found them interesting. 

o Regardless, banks have been hit with a slew of new regulatory measures that also contract lending incentives. Lenders (banks) will not lend if they believe they are not being adequately compensated in terms of counter‐party risks and balance sheet costs. 

o Borrowing may not increase just because the price of money falls from a negligible amount to a deeper negligible amount.  Borrowers will not invest in fixed capital projects if there is a lack of visibility on the payout of that endeavor.  Visibility is low due to uncertainties: tax code, health care costs, politics, time frame for artificially low interest rates, EU refugees, global indebtedness, and Chinese shadow loans, among other factors.     

Draghi’s ECB is arguing that there is a savings glut that is limiting investment opportunity (page 4 of today’s FT).  Yet, imposing a tax on savers will not encourage the freeing of that money for investment purposes. Negative rates and asset purchases does not increase visibility or make capital investments look more attractive.  On the contrary, they are fueling more savings, further worrying consumers, causing further retrenchment and moving savings into real assets or into cash hoarding.  

Japan’s number one problem is a shrinking and aging population which cannot be addressed by the BoJ’s negative rate or asset purchase policies 

The Fed appears to be trying to prevent an Irving Fisher type of debt deflation dynamic.  Balance sheets typically have fixed liabilities but variable asset prices, so it is essential that asset prices and incomes do not decline relative to fixed liabilities.  Should that occur, debt or assets might have to be sold to service the outstanding debt. These sales results in ever‐lower asset prices, creating a spiral where the liquidation defeats itself as even more sales become necessary.   

The current paradigm of growing corporate debt issuance combined with factors artificially‐generating asset froth is highly combustible. The lack of investment visibility and impairments to credit normalcy will act to limit economic growth. Throw in paralyzed fiscal levers and exhausted monetary tools and the mix is problematic. 

Making matters much worse is the decision yesterday by the China Banking Regulatory Commission to crack down on their shadow banks. Their banks will no longer be able to disguise loans as investment.  Buy Treasuries.     

“Get your facts first, then you can distort them as you please” – Mark Twain  

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