- Price stability
- Full employment.
The first should be fairly obvious. Price stability is necessary for any economy that wants to stay alive for the long-run. Nothing can kill an entire economy quicker than hyperinflation or acute deflation. And price stability isn’t just about stable prices, either. It’s about all the things that go along with an environment that’s safe and predictable. The stuff that makes business want to hang around and do business. This is an objective that the Fed takes very seriously and they’re very well-equipped to deal with it.
But why the labor market is the responsibility of the Federal Reserve has always been a puzzler to me. Seriously. Why is it the Fed‘s job that you have a job? Even if we ignore the question of why the Fed should be in charge of this, there are plenty of problems with their ability and effectiveness to actually do so. The Fed, as an independent banking entity, was given a relatively narrow and specific set of tools. It is by no means optimal for ensuring maximum employment.
So far, that hasn’t stopped the Fed from trying.
And to be fair, they’ve done a somewhat decent job. All of the data suggest that the economy is in a significantly better place because of the Fed’s actions. I’ll agree there remains plenty of debate about the long-term cost of these measures, but so far I haven’t encountered many people in this industry who truly believe the economy would be better off if the Fed had sat on its hands.
The fact that the Federal Reserve has led the way in the economic recovery efforts should really tell you something. Especially since it’s the U.S. Congress that really has the toolkit for helping out the labor market. The Fed has been the global superstar while bodies like the European Union and the U.S. Congress seem to do everything in their power to screw things up before finally stumbling into acceptable policy.
I watched a lot of football last weekend and got my fill of political ads. Many of the Obama ads I saw were about claiming credit for the recovery in the labor market that’s happened since 2009. These ads always crack me up because this has been the worst, slowest economic recovery since the Depression. It’s not an achievement to be proud of. On top of that, most of the jobs that have been created were created between 2010 and 2012 under a Republican Congress. And, hey, if the Republican Congress wants to take credit for such a lousy window of job creation, they’re more than welcome to do so. Or maybe they’ll tell you they played a key role in the recovery!
And that’s why I love politics! It’s about telling stories. Perhaps the biggest lesson that I’ve learned in three years of writing this newsletter is that one should never underestimate another’s desire to hear the stories they want to hear.
In case you’re wondering why every romantic comedy that comes out is essentially the same movie at its core, or why all summer blockbusters follow the same formula that Homer used in the Odyssey, this is why. There are just some stories we need to hear. And we never get sick of them.
Anyway, if the President tells us we’re in a better place and on the right track, and all these Republican congressmen are telling us that we just need to re-elect them and everything will keep getting better, why the continued extreme action out of the Fed? Why keep “printing money” and buying bonds at never-before-seen levels?
I’m sure you’ve noticed that prices are stable. So why do this?
There are two interesting things about QE3. The first is that the Fed is now officially on record as being ready to do whatever necessary. This latest program is open ended and there is no termination date. The previous 2.5 QE programs all had start days and stop days, and as you’ve noticed, that creates certain problems in the marketplace when we get close to those start and stop dates. Everybody’s always known that the Fed will keep the pedal to the metal until the economy recovers or everything melts down. But now it’s official.
A better name for this policy is “Q-Infinity.”
The second interesting thing about it is that it targets mortgage backed securities. And this leads us back to that slippery half of the Fed’s dual mandate, maximum employment.
This is one of those rare things that the Fed can do to create jobs. No, it’s nowhere near as direct a job policy as Congress could enact, but when you’re dealing with the narrow toolkit that the Fed has, indirect policies are the best you can do. Targetting mortgage backed securities is the highest impact, most efficient thing that they can do to keep mortgage rates low. Historically low. Way lower than they’d be absent any policy stimulus.
The good thing about artificially low mortgage rates is that it does keep demand for housing as high as it could possibly be. Right now, it’s pretty low, which should scare you because where might it be if the market were in charge of setting interest rates? How much compensation would a bank (or you) need to hold a basket of mortgage paper? I just refinanced my house at 2.8%. If I was the bank, no way would I want to hold that loan!
When rates are low, more people want to buy houses.
See this chart?
This is one of the most important economic charts you can watch right now. Everybody in the world wants to know when the economy will recover. Well, the economy is going to recover when that chart recovers. The economy will get back to normal when we’re building over 800,000 new homes per year instead of under 400,000.
That’s when the labor market will finally start looking good, too.
Here’s a chart from the BLS that shows employment in the construction industry:
There are over a million jobs that could be created if we could get new home construction back to where it was in the normal, pre-bubble days.
The Fed is doing everything that they can do help this along. Apparently, the government seems less interested in this sector than we do, and certainly less willing to do something about it.
It’s conceivable they may not ever have to, though. Household formation is the thing that will ultimately force it back to normal:
Like a lot of charts, this one cratered too in the post-bubble years. But the good news is that it’s finally getting back to more normal rates. Every year we’re going to make new households, and hopefully, these new households will be formed in new homes.
Building new homes and forming new households is great for the rest of the economy, too. When you buy a new house, guess what, you buy all sorts of fun stuff to go along with it like sofas and lawn mowers. Companies like Home Depot and RC Willey have to hire more people to sell you that stuff. When more people are buying houses, we also need more Realtors, landscapers, and plumbers. Do you own a home? Surprise! You’re a job creator!
The economy has been totally missing out on all this since 2008. Heck, I’m amazed it’s growing at 2% as it is.
You can see why this is so important to the Fed. I’ve been writing for years that the key to the recovery lies in new home construction, and with this latest round of QE, it sounds like the Fed is serious about this too. Historically, housing has always been one of the engines to pull the economy out of recession. And you can see now why this recovery has been so lackluster. We had a bubble-burst inside that engine.
Other side effects of QE3, good and bad
With any QE program, the Fed is obviously hoping to goose consumption. To a certain degree, low rates help this. But part of that policy is now working against the initial objective. With rates so low, there’s less income to go around. Think of a retiree living off of a fixed income portfolio. When rates are abnormally low, not only is there less income to go around, but those types of people are saving even more aggressively to make up for it.
It’s ironic. The Fed, in its efforts to avoid the dreaded liquidity trap of yore, may have now given birth to a new breed of liquidity trap.
The sad thing, the thing that really upsets me about these artificially low rates, is that a lot of investors are now going farther out on the risk curve than they should to replace their lost income. Their income portfolio that used to be composed of Treasuries, Munis, and CDs now consists of corporates, higher yielding municipals, and stocks that pay dividends. Those investments are fine and I like them as a source of income. But the risk in that second portfolio is an order of magnitude higher than the first. The retiree may be getting the same rate of return they used to get, but they went from a basket of investments that was virtually risk free to one that’s guaranteed to lose value, perhaps significant value, if the economy falters or the stock market collapses.
I’m more inclined to think of this greater incentive to take risk as a cost. There ain’t no such thing as a free lunch. If you think we can wave a magic wand that makes the housing market healthier and consumers happier and the banks all smile without any consequences, you probably haven’t spent much time studying the history of markets. The cost of these policies isn’t totally known. And we probably won’t be able to say what those costs are with confidence until we actually start to bear them.
It’s possible that Bernanke’s tenure as Fed chairman may ultimately resemble Greenspan’s in the sense that we thought they were each geniuses while in office but incredibly misguided in hindsight.
Anyway, these are the unfortunate side effects of financial repression and the Fed’s quest to reignite the economy. It’s why there’s a world of people out there of have been so critical of the Fed. It’s fair criticism.
What about the stock market?
You might be wondering what this next round of QE will do for the stock and bond markets.
What’s going to happen with the new Q-Infinity?
Your guess is as good as mine! These charts seem to suggest that the market will keep rising, but honestly, I have no idea. This is uncharted territory.
I’ve been wrong about a million things since the inception of this newsletter, but I think the one thing I was most wrong about, the thing that I got fantastically, spectacularly, train-crashingly incorrect, was interest rates in 2010. I thought they were certain to rise after the conclusion of the first QE. With no one to buy them, Treasury rates would have to go up. They’d have to!
But I underestimated many things. The first was the impact that QE has on risk asset prices. Generally speaking, QE makes risk asset prices go up. There’s a fair amount of academic research on this, on cases from Japan to the U.S.
Without QE, the bottom fell out of the market in May 2010. That, of course, sent the entire planet scurrying to Treasuries and driving yields even lower. The Flash Crash didn’t help, nor did the unrest in Greece. It was a scary summer and I didn’t see any of that coming. Interest rates never go up during periods like that.
QE could make the market go up or down. If pressed, I’d probably bet on “up,” but who really knows how diminished the returns will be during this go-around. The market has grown accustomed to having Fed stimulus at its back, but there are plenty of things beyond the control of the Fed and outside the scope of their mandate. Plenty of other things to worry about.
Jeff’s Worry Closet
There are several things in my worry closet right now. But rising towards the top is a spike in oil prices. At least over the short-run.
We’ve been lucky. For the most part oil prices have remained rather stable and range-bound. I can’t ever seem to talk about crude oil without outlining the classic range trade — buy it down in the $70s or $80s and lighten up towards$100. That basic strategy has been working great for two years and I see no reason why it won’t keep working for the years to come.
Let me tell you why it works. See, there’s plenty of oil out there but it’s in places that are hard to reach and it’s expensive to extract. So that puts in a fairly sturdy price floor. Nobody wants to sell their oil for less than it costs to produce it! But with oil, there’s also a fairly durable price ceiling because of demand destruction. At some point, consumers inevitably cry “uncle” and change their behavior to buy less of the stuff.
The kicker, of course, is geopolitical risk. That’s what moves oil up and down beyond those basic supply/demand dynamics. It’s what creates the noise.
The economy right now is teetering on the brink of recession. It’s sick. And as we discussed above about, it’s going stay sick until housing gets healthy. But right now global manufacturing is slowing down and consumption is lagging too.
None of those conditions are bad enough to warrant a nasty economic collapse on their own. But it creates an environment that is highly susceptible to exogenous shock.
I know you guys get sick of hearing this over and over, but take a look at every recession in the post-war era. Every single one of them was preceded by a spike in oil prices. That’s not to confuse correlation with causation. High oil prices do not cause recessions. Crude oil spikes all the time without causing a recession. What matters is the environment during which it’s spiking.
Sometimes it doesn’t matter. Gas prices go up a dollar and we just absorb the hit or figure out a different way to pay for it. But sometimes it’s the straw that breaks the camel’s back. Sometimes we respond by cutting back consumption elsewhere or by changing our behavior in a manner that’s detrimental to the broader economy. We opt not to take that vacation or drive across town to get dinner.
Here’s another way to think of it:
I live up in the Sierras and one of the things that people here take very seriously is fire safety. This is a mountain desert and in the summer it can get pretty dry. All the brush that grew and thrived during the spring showers and snow-runoff dries up and turns into fuel waiting for a fire. The U.S. economy right now resembles the late-summer mountain desert. All it needs is an errant lightning strike, cigarette butt, or catalytic converter and… poof!
A spike in crude oil prices could represent that strike.
The good news is that you can actually do something to guard against this scenario. When oil prices spike, typically the companies involved in its extraction and production of this stuff become more valuable. Higher gas prices suck for you and your family, but they’re nice for companies like Exxon and Chevron. May as well own a little piece of those businesses. Energy companies are big pillar in my Trade of the Decade. (shameless plug!)
[Full Disclosure, Mrs. Concord does own a bit of Exxon stock in her personal IRA. But she picked it out herself!]
If you really know what you’re doing, you can construct some more interesting hedges in the derivatives markets. You can speculate on oil contracts directly, or even better, employ a trading strategy designed to take advantage of rising price trends. You can use options to limit your risk, take more risk, add additional specificity to your trade.
At its core, investing is about risk-management. It’s about dealing with the world that exists, not the world you wish there was or worry there might be.