The Fed is not doing what I expected - why?

[ChpBstrd]

In recent months, I've written that quantitative easing / quantitative tightening are far more powerful and precise tools than interest rates. Interest rate hikes hurt the profitability of businesses and reduce their propensity to expand and add employees. I.e. a business is less likely to expand operations when they have to borrow at 10% than if they could borrow at 5%. So if your goal is to maximize employment, you want to keep interest rates as low as possible. The risk of low rates is rising inflation - too many dollars chasing after too few goods, also known as a high velocity of money. This occurs when lots of people are making lots of purchases, causing each other to make lots of money, leading to more and faster purchases, etc.

For a long time, I've been saying that if the Feds wanted to tamp down inflation, the logical thing to do would be to first stop buying $80B in treasuries and $40B in mortgage backed securities per month. These purchases are intended to add new dollars to the economy, in order to encourage faster growth and faster velocity of money. Stopping these purchases would remove one of the factors driving up inflation - a $120B monthly injection of cash into the economy. This is metaphorically equivalent to taking one's foot off the gas pedal (stopping QE) before hitting the brakes (interest rate hikes). Additionally, doing this would not hurt the aforementioned businesses, because their interest rates would not change.

If inflation still persisted, the Fed could perform quantitative tightening, selling some of the assets off their massive balance sheet. In theory - my theory at least - the Fed could manage inflation and employment through QE/QT alone, and we'd live through an era of low unemployment and low interest rates. The power of QE/QT has been demonstrated since 2008 - it is sufficient to get us out of just about anything. Furthermore, the Fed's balance sheet is so large, they could plausibly sell enough assets to take a large percentage of the existing currency out of circulation. The federal reserve currently holds over $8.7 trillion in assets on its balance sheet (e.g. treasuries, mortgages...) as shown below.

So if I was Jerome Powell, I'd be managing the current bout of unexpected inflation numbers by:
(1) Immediately stop buying treasuries and MBS.
(2) Give it a quarter or two to see the effect on inflation.
(3) Consider selling a couple hundred billion in treasuries/MBS per month if inflation persists.
(4) Raise interest rates as a last resort, maybe in late 2023 or 2024.

Instead, the Fed seems to be doing the following:
(1) Taper down their asset purchases at a very slow rate. As recently as November they were buying $80B in treasuries and $40B in MBS per month. The latest word is that they will keep the foot on the gas pedal until after the March meeting - so not hitting zero QE until April!
(2) According to reports, most Fed officials plan three interest rate hikes this year.

So basically we'll keep giving the car gas until April, and then we'll slam on the brakes in April at the same time we have one foot on the gas pedal. IDK... does that make sense? Why is the Federal Reserve even contemplating interest rate hikes when they have so many assets on their balance sheet and while they plan to continue QE for a few more months? Why not sell some assets and pull hundreds of billions of dollars in currency out of the world economy?

Possible explanations:

1) Political: The majority of Federal Reserve Board members were nominated by President Trump. Perhaps they'd rather engineer an economy-wide slowdown than sell assets off the balance sheet?
2) Mandate Creep: Perhaps the FRB are more concerned about asset bubbles being inflated by low interest rates, and raising rates is a way to address both inflation and asset bubbles at the same time. The Fed is not supposed to worry about the housing, stock, or bond markets, but perhaps they do.
3) Roll-Off Theory: Every time one of the Fed's bonds matures, cash is paid from the broader economy into the Fed's balance sheet, where it essentially disappears from economic reality. I.e. the mere existence of a $8.7T fed balance sheet is disinflationary, because lenders are steadily paying off those loans and those payments and payoffs go into oblivion. So perhaps the Board is looking at the amount of money being sucked out of the economy by routine payoffs in the current block of assets and thinking when they stop buying more assets to replace the old ones, that will be as much disinflation from QT as they're willing to do?

Does anyone have any better theories? Like maybe the Fed is trying not to flatten the yield curve? I cannot explain this behavior, so I'm thinking about getting out of the way rather than accidentally fighting the fed.

[djadziadax]

I think #1 is very possible but it is most likely combination of all three theories - recently (under Obama and Trump) political pressure on the FED has been enormous to ease rates. Current high inflation is very bad politically for the current admin, and am sure there are also pressures to "do something visible". Raising rates is a very obvious way to ease inflation that even the general population would understand - the "politicians" are doing something!!!! (even though the FED is supposedly apolitical). Stopping QE does not have the same bang for the buck politically and does not ease general negative sentiment as most people do not understand it.

How fast would FED raise rates? I cannot imagine it being more than 25bp per raise, and that would equate to 1 percentage point for the year. Is this really enough to ease inflation which officially is at 7% (and probably up to 10% unofficially). But what if they go faster - is that good politically? Mid-terms are this year....is a seriously tanking market (-20%) for example good politically while at the same time inflation is still raging and supply chain issues are still visible?

I don't know, but to have an effect on inflation, the rates have to come up fast...is that possible at this moment?

Just my random thoughts...

[tooqk4u22]

First, QE does drive interest rates but mostly on the longer end (whereas Fed funds is shorter end) as the funds have gone into the bond market directly as you indicated and indirectly through banks excess reserves.   

Also, in addition to Fed monetary policy inflation has been caused by the many trillions of stimulus (fiscal policy) and the supply chain challenges.

But to your expectation/question, yes the Fed has not met expectations and has boxed itself in and screwed the pooch.   It hung its hat on inflation being transitory due to political pressures of managing a dual mandate of moderate inflation an full employment (with greater emphasis on full employment) and further augmented with political pressures of an unofficial mandate to social engineer the economy.   Good news is wages are way up especially on the lower end so minimum wage is now non existent and politicians can take victory laps raising minimum wage from $7-10/hr to $12-15/hr without consequence bc even the lowest of low jobs pays $15/hr now.

Bad news is everything else is higher and investment in technology will accelerate to eliminate said jobs.   

Fed absolutely should have stopped buying bonds a year ago and should be selling now and increasing rates this year.     But now being boxed in anything too sudden will hurt markets and housing, and if you think the Fed and politicians don't factor that in then your nuts. 

Longer term though we will still be fighting a deflationary environment due to population trends (low birth rate, aging boomers, low immigration) and tech/productivity improvements.   

[vand]

You can always trust the Fed to do the right thing. After they're tried everything else.

[PDXTabs]

I think that the Fed in conjunction with Congress overreacted because they thought that this was going to be another great recession only worse. This isn't a completely unreasonable fear if you look at 2020 Q1 and Q2 GDP numbers. I don't think that they saw the uptick in goods sales or the long term supply chain disruptions. Also, to the extent that inflation is better than deflation, it worked.

I completely agree with regard to QE and I would add that I think that the Fed bought us another real estate "bubble."* Running a massive QE program with 0% rates while inflation runs ~8% is unprecedented bordering on criminal negligence. If you want to read a book about some of these themes I enjoyed Engine of Inequality: The Fed and the Future of Wealth in America by Karen Petrou.

I would add that it is very hard to argue that we should have ~0% overnight rates with ~8% inflation. No one at the Fed thinks that 0% is a neutral rate.

* - not really a bubble if RE is priced correctly with current mortgage rates but then falls sharply as rates rise

[tooqk4u22]

I think that the Fed in conjunction with Congress overreacted because they thought that this was going to be another great recession only worse. This isn't a completely unreasonable fear if you look at 2020 Q1 and Q2 GDP numbers. I don't think that they saw the uptick in goods sales or the long term supply chain disruptions. Also, to the extent that inflation is better than deflation, it worked.

I completely agree with regard to QE and I would add that I think that the Fed bought us another real estate "bubble."* Running a massive QE program with 0% rates while inflation runs ~8% is unprecedented bordering on criminal negligence. If you want to read a book about some of these themes I enjoyed Engine of Inequality: The Fed and the Future of Wealth in America by Karen Petrou.

I would add that it is very hard to argue that we should have ~0% overnight rates with ~8% inflation. No one at the Fed thinks that 0% is a neutral rate.

* - not really a bubble if RE is priced correctly with current mortgage rates but then falls sharply as rates rise

I don't think the initial reaction by congress and the Fed in the months immediately after the pandemic was an over reaction but the bills passed late in 2020 and early 2021 (especially stimulus checks and high extended unemployment benefits) and the continuation by Fed of bond buying is downright negligent as you say.

Unfortunately if there is a real estate bubble there is also a market bubble for both bonds and equities. 

Real estate lending standards (housing and commercial) weren't terribly loose so while there may be some lost equity the inflated rents and incomes that will service debt (much of it fixed rate)  should weather it well.

Equities will likely just have a modest correction at some point and then earn their way into more appropriate multiples which to some extent is already happening.

Bonds .....ouch.   

[PDXTabs]

I think that the Fed in conjunction with Congress overreacted because they thought that this was going to be another great recession only worse. This isn't a completely unreasonable fear if you look at 2020 Q1 and Q2 GDP numbers. I don't think that they saw the uptick in goods sales or the long term supply chain disruptions. Also, to the extent that inflation is better than deflation, it worked.

I completely agree with regard to QE and I would add that I think that the Fed bought us another real estate "bubble."* Running a massive QE program with 0% rates while inflation runs ~8% is unprecedented bordering on criminal negligence. If you want to read a book about some of these themes I enjoyed Engine of Inequality: The Fed and the Future of Wealth in America by Karen Petrou.

I would add that it is very hard to argue that we should have ~0% overnight rates with ~8% inflation. No one at the Fed thinks that 0% is a neutral rate.

* - not really a bubble if RE is priced correctly with current mortgage rates but then falls sharply as rates rise

I don't think the initial reaction by congress and the Fed in the months immediately after the pandemic was an over reaction but the bills passed late in 2020 and early 2021 (especially stimulus checks and high extended unemployment benefits) and the continuation by Fed of bond buying is downright negligent as you say.

Sending stimulus checks to single folks with no kids with AGIs below $100k ($75k for full check, and double for married) who didn't lose a single dollar to the pandemic was too much in my book. Meanwhile the executive had eviction moratoriums and mortgage forbearance for anyone who did lose money while the Fed was buying up mortgage backed securities. Mailing everyone a check who didn't lose a dime was further than Europe was willing to go. To put it another way my wife and I maxed out 2+ retirement accounts and bought a house and didn't lose a dime (actually, our commute costs went down) and the govmnt was nice enough to mail us a check. Thanks future generations!

I, personally, think that it is disgusting. If you are a conservative you should hate it because its handing out money for no good reason and if you are a progressive you should hate it because every dollar that you sent to me was a dollar that you didn't spend on an actual poor person. Did I mention that my neighbor lives in a tent? There are actual poor people in this country and you're mailing it to a couple with a combined income north of $200k and ~$0 in student loan debt and six figure retirement accounts. But perhaps mailing me the check was less stimulative because we just put it in the bank. Everyone else I know in my situation spent it on consumer goods that they didn't need.

[waltworks]

The inflation in consumer goods will ease up on it's own, there's not really much excess demand for cars and TVs vs, say 2019. Once factories and ports are working right, that stuff is a non-issue.

Housing and big purchases that require financing for most 'muricans will be affected immediately by interest rate moves by the Fed, which is presumably why they are telegraphing that move now. It's an aspect of inflation that they can actually affect.

No amount of QE reversal or interest rate increases will help with, say, beef prices if the meatpacking plant keeps shutting down from covid (or cars/computer chips/mountain bikes/whatever). On the other hand housing prices can be brought into line, maybe.

So I don't know that it's all that illogical, or that unlikely to succeed. If you'd told me 2 years ago that we'd have low unemployment, all time highs in stock/housing markets, etc now while covid was STILL raging - I'd say the Fed did a pretty good job, given the limited ability of the legislative/executive branches to take actual action most of the time.

-W

[PDXTabs]

No amount of QE reversal or interest rate increases will help with, say, beef prices if the meatpacking plant keeps shutting down from covid (or cars/computer chips/mountain bikes/whatever). On the other hand housing prices can be brought into line, maybe.

I disagree with this. If the meat packing plant is the fire, then low rates and QE is pouring gasoline on the fire. Goosing the stock market and home prices with low rates and QE literally gives me more money to spend on the beef as well as the "wealth effect" to keep buying. Seriously, the SP-500 is up 26.9% for 2021, you think I cut back on meat, really? Because I didn't. I just paid whatever the super market wanted to keep eating exactly like I always do.

EDITed to add that the pandemic created cost push inflation for the meat industry but the Fed in collaboration with the Treasury added demand pull inflation at the exact same time.

[djadziadax]

Again, who much can they raise rates to tame the housing market or affect inflation? Is 25pb every 3 months enough at this point to achieve what they need? Can they go higher?

Personally what should one's moves be in this environment? I have been accumulating cash...

[ChpBstrd]

I've also heard the theory that higher interest rates will increase the spreads between good/less-good credit, which creates an incentive for banks to lend more. Thus, higher rates incentivize more bank lending, which might lead to more inflation. IDK if I buy this theory though.

[Mrs. Burning Bush]

"For a long time, I've been saying that if the Feds wanted to tamp down inflation, the logical thing to do would be to first stop buying $80B in treasuries and $40B in mortgage backed securities per month. These purchases are intended to add new dollars to the economy, in order to encourage faster growth and faster velocity of money. Stopping these purchases would remove one of the factors driving up inflation - a $120B monthly injection of cash into the economy. This is metaphorically equivalent to taking one's foot off the gas pedal (stopping QE) before hitting the brakes (interest rate hikes). Additionally, doing this would not hurt the aforementioned businesses, because their interest rates would not change."

ChpBstrd - I generally agree with you that it seems logical to quit QE before raising rates.  However I am not sure I agree with your last sentence above.  If the Fed quits buying treasuries and MBS, is it not possible or even probable that those rates will float up?   And if those rates go up, will other rates not follow suit? I don't know what percent of the bond market $120B/month represents, but I would argue it has been enough to distort interest rates downward on all debt instruments.  Appreciate everyones thoughts on this topic.

[waltworks]

Again, who much can they raise rates to tame the housing market or affect inflation? Is 25pb every 3 months enough at this point to achieve what they need? Can they go higher?

Personally what should one's moves be in this environment? I have been accumulating cash...

On a median $450k or so house, a .25% increase in interest rates means something like an extra $700 a year/$60 a month for a typical 20% down borrower. Not enough to move the needle, but if you do it 4 times in a row, that's real money to a typical household.

So yes, I think they can prevent further housing price increases, or at least slow them down.

LOL to accumulating cash... I guess you're not worried about inflation!

-W

[ChpBstrd]

"For a long time, I've been saying that if the Feds wanted to tamp down inflation, the logical thing to do would be to first stop buying $80B in treasuries and $40B in mortgage backed securities per month. These purchases are intended to add new dollars to the economy, in order to encourage faster growth and faster velocity of money. Stopping these purchases would remove one of the factors driving up inflation - a $120B monthly injection of cash into the economy. This is metaphorically equivalent to taking one's foot off the gas pedal (stopping QE) before hitting the brakes (interest rate hikes). Additionally, doing this would not hurt the aforementioned businesses, because their interest rates would not change."

ChpBstrd - I generally agree with you that it seems logical to quit QE before raising rates.  However I am not sure I agree with your last sentence above.  If the Fed quits buying treasuries and MBS, is it not possible or even probable that those rates will float up?   And if those rates go up, will other rates not follow suit? I don't know what percent of the bond market $120B/month represents, but I would argue it has been enough to distort interest rates downward on all debt instruments.  Appreciate everyones thoughts on this topic.

As big as the Fed's treasury purchases are, they are a drop in the bucket of the monthly trading volume in US treasuries. As recently as 2018, average DAILY trading volume of US Treasuries was almost $550 billion. Not sure why this source doesn't list 2019-21, but I cannot imagine volume has declined. If the Fed is buying a few billion a day to hit $60-80B a month, they are less than 1% of the trades each day.

https://www.statista.com/statistics/189302/trading-volume-of-us-treasury-securities-since-1990/

To me, this suggests the Fed can add and remove enormous sums of cash from the economy through open market activities alone and it wouldn't affect supply and demand for interest-paying securities in a particularly big way.

[PDXTabs]

I've also heard the theory that higher interest rates will increase the spreads between good/less-good credit, which creates an incentive for banks to lend more. Thus, higher rates incentivize more bank lending, which might lead to more inflation. IDK if I buy this theory though.

I've seen this written about before. But in practice large corporations still have access to capital through other means (bond sales, stock issuance). Raising interest rates would increase capital availability for small businesses while raising borrowing costs for large ones.

[alm0stk00l]

I think that the Fed in conjunction with Congress overreacted because they thought that this was going to be another great recession only worse. This isn't a completely unreasonable fear if you look at 2020 Q1 and Q2 GDP numbers. I don't think that they saw the uptick in goods sales or the long term supply chain disruptions. Also, to the extent that inflation is better than deflation, it worked.

I completely agree with regard to QE and I would add that I think that the Fed bought us another real estate "bubble."* Running a massive QE program with 0% rates while inflation runs ~8% is unprecedented bordering on criminal negligence. If you want to read a book about some of these themes I enjoyed Engine of Inequality: The Fed and the Future of Wealth in America by Karen Petrou.

I would add that it is very hard to argue that we should have ~0% overnight rates with ~8% inflation. No one at the Fed thinks that 0% is a neutral rate.

* - not really a bubble if RE is priced correctly with current mortgage rates but then falls sharply as rates rise

I don't think the initial reaction by congress and the Fed in the months immediately after the pandemic was an over reaction but the bills passed late in 2020 and early 2021 (especially stimulus checks and high extended unemployment benefits) and the continuation by Fed of bond buying is downright negligent as you say.

Sending stimulus checks to single folks with no kids with AGIs below $100k ($75k for full check, and double for married) who didn't lose a single dollar to the pandemic was too much in my book. Meanwhile the executive had eviction moratoriums and mortgage forbearance for anyone who did lose money while the Fed was buying up mortgage backed securities. Mailing everyone a check who didn't lose a dime was further than Europe was willing to go. To put it another way my wife and I maxed out 2+ retirement accounts and bought a house and didn't lose a dime (actually, our commute costs went down) and the govmnt was nice enough to mail us a check. Thanks future generations!

I, personally, think that it is disgusting. If you are a conservative you should hate it because its handing out money for no good reason and if you are a progressive you should hate it because every dollar that you sent to me was a dollar that you didn't spend on an actual poor person. Did I mention that my neighbor lives in a tent? There are actual poor people in this country and you're mailing it to a couple with a combined income north of $200k and ~$0 in student loan debt and six figure retirement accounts. But perhaps mailing me the check was less stimulative because we just put it in the bank. Everyone else I know in my situation spent it on consumer goods that they didn't need.

It is apparent that you understand microeconomics and how money exists in your bank account; however, the bolded part shows that you cannot seem to understand the economics of changing financial systems for the overall good. If you would like some recommendations for books on macroeconomics let me know.

[PDXTabs]

It is apparent that you understand microeconomics and how money exists in your bank account; however, the bolded part shows that you cannot seem to understand the economics of changing financial systems for the overall good. If you would like some recommendations for books on macroeconomics let me know.

If you happen to have any suggestions for a book that includes multiple economic schools in one digestible book I would be interested. Bonus points if they are laid out in chronological order of development. Also, I am particularly interested in monetary velocity as it relates to either monetarism in specific or inflation in general, classical political economy, and Georgism. Given the time period between 2007 and today I think that we are going to get some good books pretty soon. Also, I'm pretty sure that the macroeconomics of getting people housed would be net positive.

EDITed to add that we basically helicopter dropped money to 85% of households and were then surprised that it worked.

[Wintergreen78]

I’m going to recommend one of my favorite books from college. It is about how decisions are made and different frameworks you can use for understanding why a group makes one decision and not another. If you are on the outside looking in and you think a group’s decisions don’t make sense, then you might want to re-evaluate your understanding of their decision-making process and their priorities.

https://www.amazon.com/Essence-Decision-Explaining-Missile-Crisis/dp/0321013492

[Telecaster]

I, personally, think that it is disgusting. If you are a conservative you should hate it because its handing out money for no good reason and if you are a progressive you should hate it because every dollar that you sent to me was a dollar that you didn't spend on an actual poor person. Did I mention that my neighbor lives in a tent? There are actual poor people in this country and you're mailing it to a couple with a combined income north of $200k and ~$0 in student loan debt and six figure retirement accounts. But perhaps mailing me the check was less stimulative because we just put it in the bank. Everyone else I know in my situation spent it on consumer goods that they didn't need.

The most influential conservative (conservative in the political sense) economist of all time was Milton Friedman who advised presidents Nixon and Reagan (with mixed degrees of influence) as well as Margret Thatcher.  Friedman believed that inflation or deflation was primarily (maybe entirely) a function of the money supply.  He showed a primary reason for the deepening of the Great Depression was the Federal Reserve was too slow to lower interest rates.  He also coined the term "helicopter drop."  He believed in times of monetary contraction (deflation) one remedy would be to expand the money supply by simply giving people money. 

There is an old saying in liberal economics "you can't push on a string."  You can cut interest rates all you want but at some point you have to stimulate demand, the thinking goes.   So you give people money, and they spend it, just as you indicated in the part of your post I bolded.  But, enough money went to lower income people that it lifted millions out of poverty, at least temporarily. 

https://www.washingtonpost.com/business/2021/09/14/us-census-poverty-health-insurance-2020/

Could the stimulus been better?  No question.  But it was also a hair on fire emergency.  Money needed to be injected into the economy pronto.  And it worked.  We had an economic contraction, followed by a strange, but speedy recovery.  And there was something from both politically liberal and conservative economists. 

 

[PDXTabs]

I, personally, think that it is disgusting. If you are a conservative you should hate it because its handing out money for no good reason and if you are a progressive you should hate it because every dollar that you sent to me was a dollar that you didn't spend on an actual poor person. Did I mention that my neighbor lives in a tent? There are actual poor people in this country and you're mailing it to a couple with a combined income north of $200k and ~$0 in student loan debt and six figure retirement accounts. But perhaps mailing me the check was less stimulative because we just put it in the bank. Everyone else I know in my situation spent it on consumer goods that they didn't need.

The most influential conservative (conservative in the political sense) economist of all time was Milton Friedman who advised presidents Nixon and Reagan (with mixed degrees of influence) as well as Margret Thatcher.  Friedman believed that inflation or deflation was primarily (maybe entirely) a function of the money supply.  He showed a primary reason for the deepening of the Great Depression was the Federal Reserve was too slow to lower interest rates.  He also coined the term "helicopter drop."  He believed in times of monetary contraction (deflation) one remedy would be to expand the money supply by simply giving people money.

Indeed, and it "worked" in the 2020 helicopter money example. But did we need a helicopter drop? I'm not aware of a single western European democracy that mailed checks to people that didn't lose their jobs. Also the money supply alone isn't a good predictor or we would have seen much higher inflation in the 2010s. Because the money actually has to chase a constrained resource before prices will get pushed up. Giving $10T to a bank that leaves it in a vault won't raise inflation even if it shows up in the money supply.

[MustacheAndaHalf]

Last year the Fed claimed inflation was "transitory" for most of 2021, dropping the term only in November.  They went from 2 rate hikes to 4 in the past couple months, and project inflation to subside halfway through 2022.

The Fed has too much certainty, and the market too much optimism.  I think uncertainty hasn't been well reflected, which is why I sold risky assets weeks ago.  What if Omicron isn't the last variant?  What if demand from other countries prolongs supply chain problems (and keeps inflation high)?  The Fed was wrong in 2021, so what if they're wrong again?

I haven't found information on the size of the rate hikes, and my assumption of 0.25%/hike seems low.  If the Fed raises rates 1%, with 6% inflation, that doesn't make much of a difference.  So the Fed may have other negative surprises to come.

I sold my risky assets weeks ago - crypto, aggressive growth (sold half/kept half), and leveraged Nasdaq and S&P 500 call options.  All of those are likely to suffer more as rate hikes appear.  It's possible 2022 is a normal year for markets, but the uncertainty and valuations are much higher than normal years, so I'm riding it out with a high equity allocation, but none of the risky assets I had previously.

[Telecaster]

Indeed, and it "worked" in the 2020 helicopter money example. But did we need a helicopter drop? I'm not aware of a single western European democracy that mailed checks to people that didn't lose their jobs. Also the money supply alone isn't a good predictor or we would have seen much higher inflation in the 2010s. Because the money actually has to chase a constrained resource before prices will get pushed up. Giving $10T to a bank that leaves it in a vault won't raise inflation even if it shows up in the money supply.

Surprisingly, even with all the QE and such in 2008 onwards, the money supply actually contracted.   The explanation is simple.  Even though the Fed Reserve can create money out of thin air, private banks create vastly more money out of thin air.   With the near collapse of the private banking system banks stopped lending money, including to each other.   

[PDXTabs]

Surprisingly, even with all the QE and such in 2008 onwards, the money supply actually contracted.   The explanation is simple.  Even though the Fed Reserve can create money out of thin air, private banks create vastly more money out of thin air.   With the near collapse of the private banking system banks stopped lending money, including to each other.   

Not according to the St Louis Fed, but I agree that it expanded less than I would expect with tall of the QE: M2, M3. I don't see M4, is that discontinued?

Unless there is something I don't understand which is entirely possible because I'm not a professional economist. But it has increased much more this time around.

[Telecaster]

I used the Divisia money supply.   The Federal Reserve's version is called the Monetary Services Index .

But this brings up a central problem with Freidman's monetary theory: money is hard to measure.   

[ChpBstrd]

I've tentatively concluded (feel free to try to change my mind) that the Fed is reluctant to keep rates too low for too long because they fear a liquidity trap.

https://www.investopedia.com/terms/l/liquiditytrap.asp

If this is their mindset, the Fed thinks it is imperative to open up some space to cut rates in response to a future economic crisis. They will raise rates, just like they did from 2016-2019, so that they can cut rates, just like they did in 2020.

In my mind, the experiences of 2008 and 2020 both demonstrated the power of focusing on QE/QT and leaving interest rates low. The 2008-09 recession was followed by a decade of steady growth and rock-bottom interest rates that failed to ignite inflation. Thus, QE/QT is both the bigger tool and the more precise tool compared to interest rates. Interest rates create a lot of collateral damage when raised.

But the evidence is in... the Fed takes a more classical view and thinks it important that the Federal Funds rate reach the 2-4% range. Perhaps they will primarily use QT to address the inflation problem, but their first order of business is getting out of their perceived liquidity trap.

I don't think a liquidity trap can exist in a world where the Fed can make trillions appear or disappear from the economy with a click of the mouse, but the Federal Reserve Board disagrees. So we will have rate hikes.

[MustacheAndaHalf]

I've tentatively concluded (feel free to try to change my mind) that the Fed is reluctant to keep rates too low for too long because they fear a liquidity trap.

I've never heard of the Fed trying to avoid a liquidity trap.  They might want to avoid inflating an asset bubble - is that equivalent to the liquidity trap you mention?

If inflation is given enough time, a new source of inflation emerges: people know prices keep going up, so they rush to buy earlier.  That rush creates demand, which fuels more inflation.  Persistent inflation creates a feedback effect, and that can be hard to break.

[ChpBstrd]

I've tentatively concluded (feel free to try to change my mind) that the Fed is reluctant to keep rates too low for too long because they fear a liquidity trap.

I've never heard of the Fed trying to avoid a liquidity trap.  They might want to avoid inflating an asset bubble - is that equivalent to the liquidity trap you mention?

This article concisely describes what I was thinking:
https://www.investopedia.com/terms/l/liquiditytrap.asp

Asset bubbles are a whole other issue, and it is unclear whether the Fed is concerned about them. Managing the prices of financial assets clearly falls outside the Fed's mandate, but asset price collapses can certainly push down inflation and employment.

The liquidity trap theory, however, is directly related to the Fed's ability to manage inflation and employment levels. Powell can directly defend the Fed's actions to Congress on these grounds.

Maybe I should look into bear spreads on TLT?

[MustacheAndaHalf]

The liquidity trap theory, however, is directly related to the Fed's ability to manage inflation and employment levels. Powell can directly defend the Fed's actions to Congress on these grounds.

Maybe I should look into bear spreads on TLT?

TLT lost -7% YTD but has +7% for the past 3 months.
ZROZ lost -10% YTD with +10% for the past 3 months.

Zero coupon bonds are more impacted by interest rates, thus +50% greater swings in price.  So that's another option.

I think the Fed needs to be more aggressive on inflation, but I don't know how far they will take it.  Market consensus is 4 rate hikes, with the first 0.25% increase in March.

There's a tricky mix of the second rate hike and inflation coming down.  If that goes badly, your bear put spread could do badly.  And I don't think there's much profit waiting for March, since the bond markets priced in 0.25% of increase over the past few weeks.

Value stocks are better poised to handle this environment, and the two value ETFs I checked both held 1/3rd financials.

[ChpBstrd]

The liquidity trap theory, however, is directly related to the Fed's ability to manage inflation and employment levels. Powell can directly defend the Fed's actions to Congress on these grounds.

Maybe I should look into bear spreads on TLT?

TLT lost -7% YTD but has +7% for the past 3 months.
ZROZ lost -10% YTD with +10% for the past 3 months.

Zero coupon bonds are more impacted by interest rates, thus +50% greater swings in price.  So that's another option.

I think the Fed needs to be more aggressive on inflation, but I don't know how far they will take it.  Market consensus is 4 rate hikes, with the first 0.25% increase in March.

There's a tricky mix of the second rate hike and inflation coming down.  If that goes badly, your bear put spread could do badly.  And I don't think there's much profit waiting for March, since the bond markets priced in 0.25% of increase over the past few weeks.

Value stocks are better poised to handle this environment, and the two value ETFs I checked both held 1/3rd financials.

IDK. The economy grew 5.7% in 2021, and CPI went up 7%. That was with pedal-to-the-metal QE, nearly full employment, near-ZIRP, and advance payment of child tax credits, which will be missing from people's tax refunds in 2022 and serve as a sort of tax compared to previous years. With all that going on, inflation was growth+1.3%.

What will growth be in 2022? The Conference Board forecasts US GDP to grow 3.5% in 2022.
https://www.conference-board.org/research/us-forecast

If the forecast for rapidly slowing growth is accurate and the inflation=growth+1.3% pattern held true, that would imply about 4.8% inflation in 2022. "But wait, there's more"... about a trillion dollars of QE ends in 2022, interest rates will rise at least 0.5%, consumers won't get to spend their 2021 child tax credits when they get their much smaller refunds, and a number of pandemic assistance programs have expired or are expiring. Plus, there's a good chance that pandemic-related supply chain issues are resolved as the Omicron variant finishes its burn through the population, supply chain investments made in 2021 start performing, and an Omicron vaccine comes out in the 2nd or 3rd quarter. With all these factors in mind, maybe 2022inflation =growth+0.5% or less?

Maybe all these insights are why bond investors are discounting all this breathless talk of five to seven rate increases in 2022. The 5 year breakeven inflation rate is STILL only 2.76%. https://fred.stlouisfed.org/series/T5YIE
In other words, many tens of thousands of market participants controlling trillions of dollars are still in the out-of-fashion "transitory" camp. A January 2023 where TTM economic growth was 3.5%, the Fed funds rate is 1%, and inflation is around 4% is a radical shift from today's media narrative, but it's also kinda the smart money's market consensus. Smart money vs. financial media... who to believe?

The question I don't know the answer to is how much of an interest rate buffer the Fed wants in order to avoid the next liquidity trap risk event. If a 1% FFR is not yet comfortable for the Fed in a full-employment environment, they might go all the way to 2.4% like they did in 2019 during another full-employment environment. In late 2018, the market realized the Fed with its then-new chairman Jerome Powell was chasing a particular theoretical risk and raising rates despite low inflation. The result was a short-lived 20% stock correction, a -4.38% total return for the S&P500 in 2018, and two subsequent years of sub-2% inflation. Powell has to keep in mind that in the next crisis, Congress and the President might not issue massive stimulus to bail out the economy like they did in 2020, and in 2020 he no doubt already felt helpless after hitting the zero bound. Maybe Powell wants to maintain about 2.5% of Fed funds rate lowering ammunition in regular times, which is a departure from Yellen's apparent acceptance of long-term ZIRP.

[habanero]

As big as the Fed's treasury purchases are, they are a drop in the bucket of the monthly trading volume in US treasuries. As recently as 2018, average DAILY trading volume of US Treasuries was almost $550 billion. Not sure why this source doesn't list 2019-21, but I cannot imagine volume has declined. If the Fed is buying a few billion a day to hit $60-80B a month, they are less than 1% of the trades each day.

Remember when there is trading in USTs there is a buyer and a seller who meet in the market at a price both are willing to trade at. The amount of outstanding USTs hasn't changed, only the ownership has. Then in comes a massive buyer (or seller) who doesnt care about the price at which they buy or sell. They don't even care about their profit or loss on the position. That's gonna influence any market. One of the weirdest things ever said, and a standig joke in the market, is that some dude from the Europan Central Bank said they were gonna buy bonds in such a way that it didn't influence the price discovery in the market. No can do.

The current on-the-run tresuries (lastest 2,3,5,7,10,20,30y issued) are also traded in vast quantities by derivative traders to hedge their risk. Eventuelly new bonds are issued and the previous on-the-runs become off-the-runs and tend to find their life at some money manager's balance sheet and trading greatly deminishes in the issue. At 550 bn / day and 22 trading days per month it means that the majority of the US goverment debt changes hands every month. I have no idea how much USTs the treasuries trading desk and swap trading desk at say JP Morgan buys and sells every day, but Im sure its a lot. And rinse and repeat for Citi, BofA, Wells and every major market maker in USD interest rate products across the globle. Futures on USTs also trade in massive quantities. And a lot of the trading is done on an ASW basis where you dont have any outright interest rate position, only a position in the difference between swap rates and UST rates.

However, part of the reason why longer-dated UST yields haven't gone through the roof is that there is plenty of demand for the securities and a lot of the supply is sitting at the Fed. You have the same phenomenom in other markets where the central bank has done QE. There just ain't that many bonds to buy anymore becuase the central bank owns a lot of 'em. A lot of playesr have to buy because their mandate say so. They don't neccessarily think it's a good trade, but they are required to buy, for example for various regulatory reasons.

Some years ago a dutch asset manager got heat from the regulator becuase he didnt want to buy german 10y bonds at -0.50% yield. He prefered to hold short-term cash instead. He tried to explain that to the regulator that loosing 0.5% (the overnight rate) until further notice was less risky thatn a guaranteed annual loss of 0.50% (yield on 10y german govvies was -0.50%) for 10 years but the regulator didn't listen.

[ChpBstrd]

As big as the Fed's treasury purchases are, they are a drop in the bucket of the monthly trading volume in US treasuries. As recently as 2018, average DAILY trading volume of US Treasuries was almost $550 billion. Not sure why this source doesn't list 2019-21, but I cannot imagine volume has declined. If the Fed is buying a few billion a day to hit $60-80B a month, they are less than 1% of the trades each day.

Remember when there is trading in USTs there is a buyer and a seller who meet in the market at a price both are willing to trade at. The amount of outstanding USTs hasn't changed, only the ownership has. Then in comes a massive buyer (or seller) who doesnt care about the price at which they buy or sell. They don't even care about their profit or loss on the position. That's gonna influence any market. One of the weirdest things ever said, and a standig joke in the market, is that some dude from the Europan Central Bank said they were gonna buy bonds in such a way that it didn't influence the price discovery in the market. No can do.

The current on-the-run tresuries (lastest 2,3,5,7,10,20,30y issued) are also traded in vast quantities by derivative traders to hedge their risk. Eventuelly new bonds are issued and the previous on-the-runs become off-the-runs and tend to find their life at some money manager's balance sheet and trading greatly deminishes in the issue. At 550 bn / day and 22 trading days per month it means that the majority of the US goverment debt changes hands every month. I have no idea how much USTs the treasuries trading desk and swap trading desk at say JP Morgan buys and sells every day, but Im sure its a lot. And rinse and repeat for Citi, BofA, Wells and every major market maker in USD interest rate products across the globle. Futures on USTs also trade in massive quantities. And a lot of the trading is done on an ASW basis where you dont have any outright interest rate position, only a position in the difference between swap rates and UST rates.

However, part of the reason why longer-dated UST yields haven't gone through the roof is that there is plenty of demand for the securities and a lot of the supply is sitting at the Fed. You have the same phenomenom in other markets where the central bank has done QE. There just ain't that many bonds to buy anymore becuase the central bank owns a lot of 'em. A lot of playesr have to buy because their mandate say so. They don't neccessarily think it's a good trade, but they are required to buy, for example for various regulatory reasons.

Some years ago a dutch asset manager got heat from the regulator becuase he didnt want to buy german 10y bonds at -0.50% yield. He prefered to hold short-term cash instead. He tried to explain that to the regulator that loosing 0.5% (the overnight rate) until further notice was less risky thatn a guaranteed annual loss of 0.50% (yield on 10y german govvies was -0.50%) for 10 years but the regulator didn't listen.

I just don't think the Fed cornered the market for treasuries with 1% or less of the daily volume. Yes, a lot of that volume consists of asset managers trading every day to maintain a target duration, derivative exposure, or whatnot, but the U.S. government ran a $2.7T deficit in 2021. Even if the Treasury bought $980B of that new debt in 2021, the remainder still represents a radical net increase in bonds available to buy in the marketplace. Supply is through the roof net of Fed purchases and bond prices are still high. 

FWIW, I agree with the Dutch asset manager. These weird times should have funds rewriting their mandates, when possible, to allow for the insured storage of cash, as opposed to the purchase of negative-yielding securities.

[habanero]

FWIW, I agree with the Dutch asset manager. These weird times should have funds rewriting their mandates, when possible, to allow for the insured storage of cash, as opposed to the purchase of negative-yielding securities.

There were some talk about Commerzbank having toyed with the idea of holding surplus cash in actual cash. As Euro notes  yield 0% it could be preferable to depositing surplus cash at the ECB at -0.50%.

https://www.reuters.com/article/us-commerzbank-ecb-idUSKCN0YU1HW

FRANKFURT (Reuters) - Commerzbank, one of Germany’s biggest lenders, is examining the possibility of hoarding billions of euros in vaults rather than paying a penalty charge for parking it with the European Central Bank, according to sources familiar with the matter.

Such a move by a bank part-owned by the German government would represent one of the most substantial protests yet against the ECB’s ultra-low rates, which have been criticised by politicians including Finance Minister Wolfgang Schaeuble.

Although no decision has yet been taken, the lender has held discussions on the matter with German authorities, said two officials, who asked not to be named because of the sensitivity of the matter.

A spokesman for Commerzbank said it was not storing cash “at the moment” and declined to comment on whether it might do so in the future.

[MustacheAndaHalf]

IDK. The economy grew 5.7% in 2021, and CPI went up 7%. That was with pedal-to-the-metal QE, nearly full employment, near-ZIRP, and advance payment of child tax credits, which will be missing from people's tax refunds in 2022 and serve as a sort of tax compared to previous years. With all that going on, inflation was growth+1.3%.

I'm not following this comparison.  Inflation had nothing to do with growth - it was not proportional or a certain amount added to growth, as your calculation shows.

As the U.S. emerged from lockdowns, and stores reopened, demand surged.  The supply chains not only weren't ready, they still faced Covid-19 problems.  So demand surged, but supply couldn't keep up:  supply side inflation.

The Fed expects supply chain problems to clear up by the first half of this year, so you would need to predict inflation being longer or shorter than the Fed's expectation, and maybe how much it might be afterwards.

[ChpBstrd]

IDK. The economy grew 5.7% in 2021, and CPI went up 7%. That was with pedal-to-the-metal QE, nearly full employment, near-ZIRP, and advance payment of child tax credits, which will be missing from people's tax refunds in 2022 and serve as a sort of tax compared to previous years. With all that going on, inflation was growth+1.3%.

I'm not following this comparison.  Inflation had nothing to do with growth - it was not proportional or a certain amount added to growth, as your calculation shows.

As the U.S. emerged from lockdowns, and stores reopened, demand surged.  The supply chains not only weren't ready, they still faced Covid-19 problems.  So demand surged, but supply couldn't keep up:  supply side inflation.

The Fed expects supply chain problems to clear up by the first half of this year, so you would need to predict inflation being longer or shorter than the Fed's expectation, and maybe how much it might be afterwards.

I'll concede that the growth/CPI correlation is weak. CPI is affected by numerous other variables, such as forex rates, import prices, interest rates, investment flows, crises, etc. Yet, it is generally taught in econ 101 that recessions are disinflationary and periods of breakneck growth are inflationary. This makes sense when one thinks of the modern definition of inflation as an increase in monetary velocity. It is a fuzzy relationship, so the distance between GDP growth and CPI changes over time.

Inflation has typically been close to GDP growth. From 2016 to 2019, CPI was roughly GDP growth minus somewhere between 0.23% and 0.60%. Over the past 10 years, CPI has been within 0.93% of GDP growth 7 times out of 10, with big events explaining the 3 outliers.

Year          GDP Growth            CPI Change
2008         -2.01%                   3.8% (-5.79% spread!)
2009         -2.54%                   -0.4% (-1.14% spread, recession, modest stimulus)
2010         2.56%                    1.6% (0.94% spread, recovery year)
2011         1.55%                    3.2% (US loses AAA credit rating, USD loses value)
2012         2.25%                    2.1% (0.15% spread)
2013         1.84%                    1.5% (0.34% spread)
2014         2.53%                    1.6% 0.93% spread)
2015         3.08%                    0.1% (3.07% spread, Eurozone crisis, Greek default, USD gains value)
2016         1.71%                    1.3% (0.41% spread)
2017         2.33%                    2.1% (0.23% spread)
2018         3.00%                    2.4% (0.6% spread)
2019         2.16%                    1.8% (0.36% spread)
2020         -3.49%                   1.2% (2.29% spread, recession, massive stimulus)
2021         5.7%                      7%    (-1.3% spread, boom year)

The point is that if people are expecting inflation to be 5-7% and growth to be 3.0-4.5%, that kind of +2 to +3% spread between inflation and growth would be an odd year - something that doesn't happen except in years of economic crisis like 2008-09, 2015, or 2020. In recent history, CPI has only been higher than growth when a crisis was occurring. Is it more likely we'll see yet another economic collapse somewhere in 2022-23 or is it more likely the GDPgrowth-CPI spread reverts to its sub-1% levels for a few years like we've seen after the past 3 crises?

https://fred.stlouisfed.org/series/DTWEXBGS

I'm suggesting the bond market is looking at the big picture and the financial media is simply extrapolating the trends of the last two years, as they have always done.

[MustacheAndaHalf]

Ah, that really sheds light on what you mean.  But in your example, I count 6 cases where the gap exceeded 1%, in a sample size of 14 years.  Isn't that a lot of exceptions to call it a rule?

Consider the Fed's expected actions in 2022:
(1) Remove bond market stimulus ($120B/mo)
(2) Raise Fed funds rate 4 times (0.25%/each?  1%?)
(3) Possibly reverse bond stimulus by selling bonds

It may also be hard to compare to crashes that removed liquidity, since in 2020-2021 Congress & the Fed dramatically increased liquidity.  While TARP involved large amounts back in the 2008 financial crisis, those amounts were mostly shuffling between big banks.  This time, the money is actually in people's hands, being spent.  But supply chains can't keep up.

HSBC had an article claiming that China's zero tolerance approach to Covid-19 might reduce their output.  The trade relationship between China and the U.S. is the largest in the world... if China can't supply goods, then supply chain problems will continue longer than expected.

In 2021, the Fed screwed up by calling inflation "transitory" for most of the year.  They expected inflation to end sooner, and were wrong.  What are the odds they made the same mistake again?  Given the Fed isn't that good at predicting inflation anyways, I think the chances are fairly good.

I'm keeping out of high risk stocks (cloud / growth) right now, waiting to see what happens.  There's too high a chance the Fed has to catch up to inflation, and surprise the market with even more rate hikes.  That, in turn, hurts stocks with crazy P/E multiples - the most aggressive of the growth stocks.  Once all the dust has settled, I plan to resume investing in them.  Not sure what it will mean for the broader market, though.

[tooqk4u22]

I have pointed thisbout before - We have been fighting a deflationary scenario for a long time due to productivity improvements, technological advances, lower birth rates, lower immigration, etc. 

There is a reason why we had zero rates since the GFC and could barely get inflation to 2%.   It took combo of a shutdown in supply chains and an ridiculous irresponsible amount of govt money to finally get inflation.   

So the supply chains will be fixed, people will spend down excess savings ( simereports indicate it is down to $1.5T from $4T+ last year), govt money will start coming out of the system, people will start going back to work (partly bc they spent all their money).   

So unless we start reproducing more or let more people into out country we will get back to a deflationary battle in a couple of years. 

Theoretically though that shouldn't bode well for stocks.  But that's only if the Fed shrinks the balance sheet too much too quick....the reality is that is where all the market gains came from. It's all about the Fed balance sheet, not Fed funds rate.

[Mrs. Burning Bush]

Well ChpBstrd, it appears that at least one voting member of the FOMC agress with you (and me).

https://www.marketwatch.com/story/feds-george-calls-for-sharp-reduction-in-size-of-banks-8-9-trillion-balance-sheet-11643651062?siteid=yhoof2