December 14, 2016

Fed Up

We’re in New York hoping to run into Janet Yellen because today the Federal Reserve probably raises rates.

In December last year the Fed hiked, and markets jumped – and then imploded. Worst January start ever for the stock market.

If you’re not right now feeling a deadening of your senses, you’re an outlier. Assemble a focus group and you’ll find folks have roughly the same reaction to the words “monetary policy” that they do to “dental appointment.”  It’s all floss, scraping and blood.

With stocks at all-time highs due more to the growth of the Fed’s balance sheet than verve in the economy, one wonders if it’s held together with dental floss. The world’s leading currency manipulator by my estimation isn’t China but us. The USA.  We micromanage the supply of dollars, and all currencies turn on the value of the dollar.

So we have to talk monetary policy. If the supply of money expands faster than the economy, inflation will show up somewhere. Inflation simply means your money doesn’t go as far as it used to.  See everything from real estate to education to stocks now.

The Fed from 2009-15 increased the supply of dollars by 62% while the economy grew 24% (about 2% per year). The adult population expanded 7%. Those employed increased 10% (but only 4% if you back up to peak mid-2008 pre-crisis jobs).

The only way an economy grows faster than population is if productivity – doing more with less – increases. Our most productive year by far in recent times was…wait for it…2009.  Yes, when the economy imploded and the value of the dollar exploded, suddenly our money went farther, and the bloat came out, and productivity spiked 5.5%.

But the Fed immediately shoved the entire economy full of bucks. Productivity nose-dived because our money didn’t go as far as it used to, as prices for everything from houses to stocks climbed sharply.  Productivity since has averaged less than 1% growth per year and totals but 5% from 2010 through the third quarter this year.

So if the supply of money is the only thing growing rapidly, we have an economy built on what the sellside analysts call multiple-expansion, which is just another name for your money doesn’t go as far as it used to.  You’re paying more for the same thing.

This, while we’re at it, is how income inequality increases.  When governments expand the supply of money, people with more (the rich) spend it on houses and cars and art and stocks, increasing the prices of those things, and the rich get richer.

But for the poor who do not have assets, the money they have doesn’t go as far because stuff like toilet paper and cereal and toothpaste costs more.  So they have less (we thus have a curious confluence in which the Fed rails against income inequality while promoting it with policies).

The ideal structure is for money to have timeless value so that technology for making things boosts productivity, and prices come down some over time (prices declined by 50% from 1800-1900 and we had our most explosively productive stretch ever) and everybody’s money goes a little farther.

The Trump administration brings a message of opportunity. That unstoppable force of hope is slamming into the immovable object of economic fact. Stocks are up some 10% without underlying change. It says how much we long for the good times to roll again.

There are two questions here as we conclude. First, do we want to build the future atop a giant pile of wobbly Fed pillows stuffed full of cash, or would it be better to ground it firmly on economic output?  Hope is a powerful elixir but it’s not empirical. Empirically, there should be a massive sale – everything must go – in America before we begin again.

And question number two is will that happen?  The US dollar strengthened sharply before the Internet bubble burst in 2001, putting everything on sale. We have valuations now matched only by those then.  The dollar is at the strongest level since then.

The strong dollar will mean weaker Q4 revenue and profits for multinationals and if it continues into Q1 next year, the economy will first slow before Trump policies may put wind in the sails. When record stock markets mash into falling corporate profits and slowing economic outcomes, expect trouble.

I’m excited about the future in America. Before it comes, we should first get Fed up.  Dump these asset prices created by a vast accumulation of cash.  Start fresh. Will it happen?  That’s the unknowable part.

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