From a macro perspective, US policy makers face a dilemma as they push ahead, illustrated in part by the charts below which measure monetary base, consumer inflation and wage growth during the course of my lifetime (pardon my egocentric reference point). In the present, Bernanke’s biggest threat are lingering high unemployment and the specter of deflation in a softening economic landscape.
In discussing prices, we need to remember that from a policy standpoint there are pros as well as cons to both deflation and inflation. Deflation, or sustained low inflation, creates a cost of living cushion for the bottom three quarters of the social pyramid who have experienced modest wage growth during the course of recent decades (note wage chart) and may also encourage more employment by sustaining that earnings trend —but it will weigh on demand like an anchor.
Inflation on the other hand provides a huge political incentive by shrinking the perception of federal, state and municipal debt loads —but it will also be viscous for the working poor and lower middle class while wage levels play catch up. Essentially this conundrum decides who pays the bill, the poor in terms of standard of living or the affluent and business in the form of lower growth and higher tax burdens. In the face of two unappealing options the course that has been chosen instead is bold, audacious even.
Our leaders are attempting to squeeze inflation selectively into specific asset classes as a form of quasi wealth transfer via policy, while fighting inflation elsewhere.
There are obvious examples of this course of action. Perhaps the most visible is housing, with aggressive efforts by both the Fed and the legislative branch to prop up home values to cushion the middle and lower class. Less obvious is the impact of recent financial reform which was inspired in part by veteran inflation jockey Paul Volcker. By castrating wall street banks in the name of reform, there is a convenient potential to alleviate unwanted inflationary pressure in other asset markets like securities and commodities while rates stay low. The granularity of this approach is significant, and mind bogglingly complex.
Note that the big losers in this scenario of course are savers, who are penalised for their virtue by low interest rates directly and price pressure from either direction indirectly. Many pundits like to compare the US with Japan to illustrate certain risk but it is certain that the cultural differences between the two nations are profound regardless of economic sensitivities. Capital in the US has a profound tendency to follow risk wherever it presents itself, and with limited options it will naturally concentrate (more on this later).
As we said this is a bold course, and there are no real historical corollaries ( no successful ones at any rate) to draw from. It is our stance that for this to work that our policy makers must be deft in their actions, free to make decisions independent of political pressure and very, very lucky. Additionally, the external event risk is huge since another Greece level crisis could cause the whole strategy to come off balance. Although we will give them the benefit of the doubt on their personal skills, we hold no such hope out for the abilities (or character) of our elected politicians and thus have a negative bias even without factoring in event risk.
What we took from yesterday’s FOMC can be summed up as follows:
- The decision to extend the Fed’s balance sheet by buying treasuries accomplishes several short term positives. First, it provides an appearance of action which will alleviate some political pressure in the near term. Second, by buying treasuries rather than mortgages, the balance sheet is hedged somewhat against future rate increases (mortgages will fall faster than treasuries in a rising rate environment). By abstaining from buying mortgages the Fed takes action while also maintaining the appearance of a degree of independence (surely our elected leaders would prefer more boosts for the mortgage market). Lastly, by accentuating the negative, the Fed has a hedge against making dramatic reversals of its public stance later. The slaughter in the stock market today is likely seen as short term, and thus an acceptable price to pay by Bernanke & co.
- The negatives in this action are equally clear: By delivering something more than promises today, they raise expectations for future intervention. Managing expectations is a tricky business, full of risk, and by increasing the prospect of more action sooner rather than later the Fed may not modify market behaviours in the way hoped.
In the near term we expect that the equity market very may well shake off concerns about lower growth prospects that have hammered it today and rally again as risk capital with nowhere else to go returns (as per our earlier discussion of savings). If this does occur, be advised that this will be a traders market only, and long term players should avoid it and probably use that strength to trim exposures. Note that this set up also continues to support the thesis for our small cap underperformance relative value trade (long S&P/short Russell) as hot money favours well capitalised operators with scalable cost structures. We realise that we remain somewhat contrarian in this call and, despite the fact that it has already done well for us, we retain high conviction in that trade at present levels.
In the long term we remain uniformly bearish across all domestic non-commodity asset classes and continue to expect that, despite the best attempts of policy makers, strong inflation ultimately is the likely result of our present situation.
This is a guest post from The Macro Report.
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