Markets Rally on Expectations of QE3

Fed Chairman Ben Bernanke delivered his much anticipated speech in Jackson Hole, Wyoming this morning. I have criticized Bernanke for his reluctance to make clear that the economy's problems must be addressed through fiscal reforms. Well, today he spoke up strongly about that. Bernanke said, "Uncertainties about fiscal policy, notably about the resolution of the so-called fiscal cliff and the lifting of the debt ceiling, are probably also restraining activity, although the magnitudes of these effects are hard to judge. It is critical that fiscal policymakers put in place a credible plan that sets the federal budget on a sustainable trajectory in the medium and longer runs."

Thanks, Ben, for making that clear. The market rallied in response to Bernanke's remarks, but not because he called for fiscal reforms. It rallied because, once again, the Chairman implied that more monetary stimulus could come. To critics (like me) who believe the economy's problems are not due to high interest rates, Bernanke said, "Early in my tenure as a member of the Board of Governors, I gave a speech that considered options for monetary policy when the short-term policy interest rate is close to its effective lower bound. I was reacting to common assertions at the time that monetary policymakers would be 'out of ammunition' as the federal funds rate came closer to zero. I argued that, to the contrary, policy could still be effective near the lower bound. Now, with several years of experience with nontraditional policies both in the United States and in other advanced economies, we know more about how such policies work. It seems clear, based on this experience, that such policies can be effective."

I would say such policies were not nearly as effective as changes to fiscal policies would have been, but that's beside the point. The point is that Bernanke is saying that despite near zero interest rates, he believes that even more quantitative easing will help. Does this mean he will actually do more? These two sentences from the speech answer that question. "Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation, and it is important to achieve further progress, particularly in the labor market. Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability."

Bernanke is giving Congress cover. He says fiscal reforms are a must, but he also says more quantitative easing will help. Let there be no doubt. QE3 is on the way.

Two Interesting Papers From NBER

I noticed a couple of interesting working papers on the National Bureau of Economic Research (NBER) website. The first (NBER Working Paper No. 18075) has to do with how changes in housing wealth affect college choice. You might expect that as the value of a family's home grows, the more likely that family is to send their child to a better (and more expensive) school. Indeed, Michael Lovenheim of Cornell University and Lockwood Reynolds of Kent State University document that for every $10,000 increase in housing wealth, the probability of attending an elite public university increases by two percent. Furthermore, they found that the effect is strongest for the lowest income homeowners. However, their study was limited to the 1993-2003 time period, which is well before the housing bust began. It would be interesting to see what has happened to college choice now that so many homeowners are under water on their mortgages. It would also be interesting to see what is going on at the very expensive elite private universities. I suspect only the very poor and very rich are able to attend these kinds of schools. The very rich, of course, don't really care how high tuition goes. They are more than happy to write a big check to send Johnny to a top school. As for the poor, they are eligible for all kinds of grants. (Harvard, for example, waives tuition for students coming from families that make less than $60,000 per year). As is usually the case, it is the middle class that gets squeezed. They are considered too well off to qualify for grants, yet they are not well off enough to be immune to the pain of writing a large tuition check.

The second paper (NBER Working Paper No. 18035) has to do with how recent recessions have affected the income of the wealthy. Conventional wisdom says that the wealthy are immune to recessions. No matter what happens, they continue to roll in the big bucks. Indeed, the authors, Fatih Guvenen, Serdar Ozkan, and Jae Song argue that in past recessions, lower income individuals suffered larger drops in income than did the very rich. They find, however, that just the opposite occurred during the most recent two recessions. I suspect the authors' findings may be related to sources of income. For example, the very rich are more likely than the poor to generate a substantial amount of income from interest, dividends, and capital gains. The most recent recessions, of course, have decimated investment income. With interest rates so low, interest income has all but disappeared; and income from dividends have not made up for large capital losses. Some people might applaud the low interest rate environment and the toll it is taking on wealthy savers. They should not rejoice. Low interest rates punish every saver (rich or poor) who is trying to plan for the future.

Housing Market Improves Marginally

There has been a lot of talk in recent weeks about the improving housing market. One of the most closely followed indicators, the S&P/Case-Shiller Index, came out today. The results were consistent with the thesis that the housing market is improving. The 20-City Composite index showed marginal improvement on both a month-over-month and a year-over-year basis. Indeed, the numbers have been improving for five months in a row. (See the tail end of the chart above.) Because Case-Shiller is delayed by almost two months, the most recent figures reflect sales in June. As a result, it is entirely possible that the housing market is actually stronger than what the latest numbers indicate.

Keep in mind that Case-Shiller does not examine new home sales. It examines repeat sales of existing homes only. Since the existing home market is much larger than the new home market, the improving figures are all the more encouraging. Despite the improvement, however, the gains are minuscule and the index remains depressed. In fact, the year-over-year gain was less than one-half of one percent. The Case-Shiller index remains 32% below the all-time high set in April 2006. According to the index, on average, homes purchased after June 2003 are now worth less than they were then.

Despite the most recent improvements, housing prices are not about to escalate. The most we can say for now is that the declines might be over. We would need to see much stronger job creation before any meaningful housing appreciation occurs.

A (Tall) Tale of Two Armstrongs

This has been a tough week for folks named Armstrong. First, Lance announced that he was giving up his fight to prove that he didn't take performance-enhancing drugs. He was immediately stripped of his seven Tour de France titles. Those victories will be awarded to the "clean" runners up, no matter how deep they have to go to find them.

After the news about Lance, we learned that Neil passed away. Of course, Neil is famous for being the first man to walk on the moon. But soon after Neil's death, it was revealed that he, too, had dabbled with performance-enhancing drugs. Some experts believe this gave him an edge, allowing him to beat Buzz Aldrin out of the escape hatch of their spacecraft. It seems that Neil will be stripped of his title. From now on Buzz will be known as the First Man to Walk on the Moon, assuming of course that he was clean.

Speak the Truth Ben

On August 1, Darrell Issa, Chairman of the Congressional Committee on Oversight and Reform, wrote a 10-page letter to Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System. In this letter, Issa asked 22 specific questions about the economy and what it takes to bring it out of its current malaise. Issa extensively cited the opinions of Allan Meltzer (an economics professor at Carnegie Mellon University), David Stockman (former Director of the Office of Management and Budget), and Andy Kessler (a noted investor). All three individuals have been critical of Federal Reserve policy.

Bernanke's answers to Issa's questions are revealing, often more for what they don't say than for what they do say. For example, in his first question, Issa asks if forcing interest rates even lower than they already are will do much good to promote growth and reduce unemployment. Without actually saying so, Bernanke implies that the answer is no. Issa's next three questions are about bank reserves. He wants to know if these reserves are excessively high and if they are helping the U.S. economy. Bernanke dances around those questions and instead focuses on how reserves got so high. Reading between the lines, however, it seems that he thinks that, yes, reserves are too high and, no, high reserves are not doing much good to help the economy. 

Another point that seems to come through loud and clear is that the Fed's so-called dual mandate (maximum employment and stable prices) is making the Fed's job extremely difficult. Of course, Bernanke does not say this directly. Nonetheless, he seems keenly aware that pressure to maximize employment today is increasing the risk of significant inflation tomorrow.

The Fed Chairman is clearly caught in the middle of an ideological debate taking place in Congress. Democrats want him to continue doing whatever it takes to reduce interest rates and maximize employment. Republicans want him to admit that current monetary policy risks significant inflation and that it is no longer doing any good anyway. Republicans want Bernanke to say loud and clear that the economy's problems must be addressed through fiscal policy.

Indeed, it should be crystal clear to every observer that the Fed has done enough already. It has ballooned its balance sheet and it has driven interest rates to historic lows. It is impossible to believe that the economy is suffering from excessively high interest rates. It also impossible to believe that reducing rates even further will do any good. On the contrary, low rates are punishing savers (especially older Americans who tend to keep their capital in bank accounts) and increasing the risk of future inflation. Perhaps Bernanke finds a need to be "political" when responding to inquiries from politicians. It would be refreshing, however, if he'd simply say what he really believes.

Hanke's Prescription for Tight Money

In a forthcoming article in Globe Asia, Steve Hanke argues that, contrary to popular belief, the money supply in the U.S. is tight and that this is keeping the economy from growing. He reaches this conclusion in his article, Money: West vs. East, by looking at the combined liabilities of the central bank and the banking system. He says many economists make the mistake of focusing on the former and ignoring the latter. What's key is that the state money supply is dwarfed by the bank money supply.

Sure enough, state money has almost tripled since the collapse of Lehman Brothers in 2008. This is because the Federal Reserve has flooded the economy with dollars. At the same time, however, bank money has contracted thanks largely to new regulations and increased capital requirements. Indeed, Hanke shows that the bank money supply, which makes up more than 90% of the total supply, has shrunk almost 10% since the Lehman crisis.

Hanke's best solution is to relieve the banking sector of some of the onerous regulations imposed since 2008. He recognizes, however, that this can't happen quickly enough. Therefore, he prescribes a more immediate remedy. He says the government should borrow short-term money from the commercial banks and use the proceeds to purchase long-dated government bonds from the public. In effect, the government's net debt obligations remain the same, but the average duration of its debt decreases. When the government buys debt from the public, that money gets deposited into banks. As a result, this action increases the money supply without increasing net government debt.

This all sounds a bit like quantitative easing, but Hanke argues it is very different. With QE, the purchased bonds land on the Fed's balance sheet. They don't disappear. With his recommendation, the bonds are purchased directly by the government and are simply canceled out.

With interest rates so low, perhaps it would be better for the government to borrow long term from the banks and use the proceeds to buy back short-term bonds. Duration will rise, which does not seem like a good thing at first--unless, of course, you expect interest rates to rise in future periods. An outcome that appears quite likely.

Rudisha is the Greatest

Perhaps it's true that nothing is certain, but picking David Rudisha to win a gold medal is about as certain as anything gets. He broke the world record, too. I can't wait to see a sub 1:40 800 meters.