We got it all wrong.-
I came across some old reads regarding the Taylor rule for the monetary policy imposed rate of interest -the fed funds rate (not to be confused with the Wicksellian, natural rate). As most economists would have done, I immediately engaged in a quick mental check of the implied rate applicable in our actual economic conditions -both for the Euroarea and the US. You can think for yourself, it is pretty straightforward to calculate -if you can trust the published inflation rate, and figure out the output gap with some sense of accuracy (I suggest you better just trust the official liestatistics).
And then, I began to think about its components. It was built for the US, and, as a consequence of the dual mandate, it sports two weighted structural components. The inflation weighting, arbitrarily set at 0.5%, and the output gap coefficient also at 0,5% (in the original formula). Both figures stink of a Solomonic compromise between the two mandates. No scientific backing is to be found for those equal weightings. His guess is as good as mine -or any other.
What’s more, the math also includes an “out of the blue” implicit inflation target at two per cent, and a Wicksellian-estimated long term equilibrium real interest rate of 2%. Take all those subjective factors in, put some faith to play (of the religious kind), and assume they are right. Now, that, and no other, is the run of the mill amount of predefinitions that apply even for a relatively simple (and brilliant) formula. Just imagine what the formula would be like with a DSGE model like math. No matter how good the formula is, the estimated pre-introduced parameters are bound to be wrong. We are following the wrong economic manuals.
Do you really think that any of us can get those parameters consistently right -much less so the mediocre FOMC? Come on! We have to be realistic. Give me the formula and the chance to chair the Fed, and I will provide you with some decent arguments for a Taylor rule rate calculation with a double result. And a spread between the two numbers in hundredths of basis points! They are really playing “God”. And they like it so much… They feel powerful. It’s like pretending to be Superman. Some say power is a great aphrodisiac. Maybe. I have to give it a try someday.
Once you decide that monetary policy plays not only a role, but even allows for a dual mandate, it is all a downhill walk to arrogance. Planetary arrogance. The equation (or its most basic principles), is also applicable for China, Japan, or the Eurozone, provided we can convert it into a somewhat more sophisticated algorithm. Why only two mandates?
The ECB may not have an explicit dual mandate, but de facto, and viciously late, it always goes all the way to “whatever it takes”. At least ever since we lost good old fashioned Jean Claude Trichet. Talk about crappy dual mandates like in the US. You want to be generous and open minded. Dragui and Co feel they have a spherical multipolar mandate to do, whatever it takes, for any end that they feel might be desirable. It gets better yet with Chinese monetary policy. When it comes to the Chinese we really need a half a dozen formulas. Monetary policy, credit growth, child birth policy or fiscal profligacy are all levers to fine tune the economic engine. And I am missing some more. Fine tuning? Or gruesome manipulation?
Maybe Taylor should work on his math and take climate change, social distress, and immigration policy -or any other relevant issues that suit the politburó, as new elements for the formula. He can give them equal weighting (following up on his previous Solomonic strain) or opt otherwise. Maybe he can give climate change an 80% weighting. Or he might even enjoy introducing some ideological factor with a relevant weighting to please the Chinese communist party. Does it matter?
Conventional wisdom has it that monetary policy really solves it all. It’s just magic. People are beginning to whisper the miraculous result of joint immunotherapy and NIRP in the advanced treatment of cancer metastases. Can you imagine that? Once you do think that monetary policy is a tool for anything other than stabilizing the value of our medium of exchange (money), you are booked into Hotel California. You can never leave. You will need more and more of the drug. And while you are still booked in, why not try to use the hotel drug saloon-spa to bulge investment, lower unemployment, or combat corruption or climate change with it. The whole set up smacks of arrogance and insane reasoning. And yet nobody dares question this axiom.
If you manage money, and you are serious about it, you just have to double-check all the economic conventions constantly. This is a rapidly changing world, and you’d better see risks before others do. On this particular rule, and the implied wisdom underlining it, the validity of the recipe is crucial. Right or wrong, I like to think, and challenge conventional wisdom in key axioms. Some of us are perpetual dissidents in whatever area of science we happen to be involved. Actually, believe me, it is very tiring to question daily what everybody else takes for granted.
The Taylor rule is like the ten commandments list. Everybody is wholeheartedly confident that it is the work of a genius. In fact I have nothing but praise for the maths in the formula. My discrepancies go much deeper. Why do we need a formula?
Taylor’s algo has certainly helped provide a coherent explanation for the interest rate levels set by the FOMC since Volcker -up to roughly 2010. Alan and Ben adore it, so I have to be extra-careful about my critique. Right now, it is suggesting no tightening for the USD -that most likely wouldn’t last long because of instantaneous further deterioration of the real economy. To be very honest, I really don’t care. And anyway, as of late they are actually ignoring it. Interest rates have to go up, but not because of Taylor rule numbers, inflation expectations, or taming the cycle. And the best we will get, if we do get it, is a “one and done” job.
The issue is not if this is the applicable formula or we should use any other. It is not about dual or even single mandates. The issue is if monetary (and fiscal) policy guided economic activity is the way to go, or a self-perpetuating delusion.
I am treading a land mined area now. A dissident’s perception is always fraught with dangers, because it implicitly seems to convey some disrespect for the sanctified economist that thought the rule. Not the best way to make friends in your field. And I continue to yearn for Keynesian cocktails, with beautiful women and “Vega Sicilia” bottles of wine. Not to forget fine Beluga caviar. I need Keynesian friends for that, because Austrians remain far too close to Sicilian pizza. Too bad for our diet. We have to be happy though, at least it doesn’t cause cancer -according to the WHO.
Let me thus previously solemnly disclose my solid respect for the figures of John Taylor, William Phillips (Phillips curve), John Hicks (IS-LM model) and JMK, the super God, and the hand that rocks the cradle for most economists (and 100% of the actual politburo members of our beloved CBs). They were much better economists than I am. (Footnote, Keynesian Party invites can be sent to my home office in Barcelona)
That was the best I could say for them. Unfortunately, in all certainty, and admittedly playing with the advantage of hindsight, they were wrong -in some key aspects of their theories and recipes. I am not smarter than they were. I have just lived long enough to see their propositions at work.
And they don’t work at all. That is a fact, unless you buy the perennial argument that everything is awesome, and we just need a higher dosage -of the same drugs- for much longer (4ever). Four trillion additional USD reserves, and seven economic-healing years elapsed, ought to have been enough to evaluate the results. McCulley and friends obviously think otherwise. Cognitive dissonance and conventional non-thinking are constant barriers to moving forward, regardless of the prowess and general consensus of the economists involved. I can’t help viewing things through Twain’s lenses.
Einstein is also a constant reference for my thinking. Let’s recall insanity can be defined as the continued repetition of the same experiment -expecting a different outcome. If we want to leap forward (and we assuredly desperately need to do so right now), we sometimes have to take a step back -and question the unquestionable. Like Copernicus did, in order to prove that it was the earth that moved around the sun -and not the other way around. I am no Copernicus, but we have tried the Sun goes around the Earth assumption endless times with hopeless results. And so it must follow that the theory is plain wrong. Harsh? Should we run the same experiment for longer? Maybe, but I don’t think so.
I’m sorry for the above mentioned brilliant economists, because we all make mistakes (Copernicus included). There is no genius in my Austrian-flavor proposed new axiom. Just careful, and, disrespectful as it may be with our mentors, unbiased observation of facts.
Keynesianism will not ensure us a warm meal at the end of the day, particularly in the midst of a severe winter storm. And we went all in for it. No precautions, no VaR limits. In retrospect, we should have been careful not to place all the eggs in just the one basket. Particularly if it was the conceptual basket of an undoubtedly brilliant character, who liked to underline the fact that the long term future didn’t matter, because by then we were all dead. Smart as he may have been, he was the economic parallel of a “Bon Vivant”. I share his vital philosophy, now the basis of the “surfer style” of living. We should all live today, like there will be no tomorrow. I can fully agree with his philosophy as a starting point for a life style, but incontrovertibly not usable as an economic manual.
No, this is not the best keystone to be found, for our global, complex, economic building. Needless to say, a macroeconomic set up has to be thought for the Keynesian reviled long run. A short-book with a collection of easy and fast cooking recipes should not be the preeminent book reference in our monetary altars. And, unfortunately, it is.
Even the bible was better for that. For sure the Bible wouldn’t have validated allowing the traders inside the temple (Goldman Sachs style bankers all over the place in our monetary politburos). Forced to choose I would rather opt for virgin sacrifices. Self-interest by the priests is not nearly as evident.
Uncommon sense would also offer a better set of principles for an economic strategy. Do you still think inequality is an unlucky side effect of the current state of affairs? Then just let them take one last shot at you, they will take just enough to save the economy. And please do not forget to smile (we’ve just got to hold on to our sense of humor)!
Above all, uncommon sense suggests you don’t want to put a wolf to shepherd your flock. Unfortunately, world population increasingly moves like flocks, herds or mobs, so if you mistake a shepherd for a wolf, it is an unmitigated disaster. The wolf goes overweight, and sheep provide no more wool. No wonder Goldman Sachs bankers make a killing in this context -under the benign supervision of their former colleagues. Some quarters, they only have one or two down days in their books. They are so good, they are never wrong! I definitely want to be a Goldmanite in my next reincarnation.
I don’t think it is difficult to construct some practical consequences of the previous heretic line of thinking. Just in case I have not been clear enough, and in genuine inverse Greenspan style, I will orderly state the conspicuous conclusions to my previous analysis (Upset Keynesians please don’t shoot to kill, after all, everything I say is only for the sake of arguing).
- The so called Phillips curve is wrong, and the subsequent and elaborate NAIRU concept is not a valid criteria to conduct monetary policy. Phillips only stated a relationship between wages and employment levels. He went no further. There is no Phillips curve trade-off between inflation and unemployment. Nairu is an elegant economic concept that nobody can put a precise number to, because it is really a “non-applicable inflationary ratio unpredictable” parameter.
- The IS LM model is every bit as elegant, but again wrong. The cost of capital is not the only factor influencing investment -save for the financial sector where the cost of money is tantamount to the ability to generate financial carry. The perspective of a a solid aggregate demand for new products is a lot more relevant to the decision to invest or expand production facilities. At least nowadays. Lowering interest rates does not enhance growth in a stable way (it only brings about short term stimulus -and asset inflation).
- Monetary and fiscal policy are to economics what paracetamol and ibuprofen are to medical treatments. They should be used sparsely if at all. And only for the overwhelming Keynesian short term.
- It is false that deflation is a beast that undermines our economic prosperity (please read Friedman -a monetary history of the United States- for eloquent proof of that). Price rigidities to the downside should be eliminated via the actual legislation that supports them. Other than those, and accumulated credit, there is nothing wrong with deflation. An inflation target of 2% can be rated as a planetary mistake.
Central Banks should have a brand new dual mandate (and no other)
- Maintain a stable value for money as a medium of exchange, ensuring that monetary aggregates remain -on average- anchored to the size of the underlying real economy.
- Prevent unbridled credit growth maintaining credit balances anchored to stable levels relative to the size of the real economy.
As Ludwig Von Mises would have stated it: CBs should strive only and exclusively to make sure that we avoid credit and easy money boom and bust cycles. Other than that, politburó members should be forced to stand aside. Let’s not allow them to mess around with the economic infrastructure that helps us feed ourselves and sleep under cover.
Using the BIS’s 84th report wording, with an additional home-made salvo between brackets:
“The only source of lasting prosperity is a stronger supply side. It is essential to move away from debt (and monetary and fiscal policy) as the main engine of growth.”
A recession is probably not far away. I still think the party is over. Only new printing by the Fed will avert a depression and reignite markets sustainably.
I found this fresh quote from Mario Dragui -via Zero Hedge. But you can read the lot of what he said at the ECB website. The Zero Hedge excerpt is a must-read-twice paragraph.
The conditions in the economies of the rest of the world have undoubtedly proved weaker compared with a few months ago, in particular in the emerging economies, with the exception of India. Global growth forecasts have been revised downwards. This slowdown is probably not temporary. To illustrate the importance of emerging markets, it is recalled that they are worth 60% of gross world product and that, since 2000, they have accounted for three-quarters of world growth. Half of euro area exports go to these markets. The risks are therefore certainly on the downside for both inflation and growth, also because of the potential slowdown in the United States, the causes of which we need to understand fully. The crisis led to a sharp drop in incomes. It is up to us to push them up again.
Mario has been very clear indeed.
1.- Whatever mediocre growth we had, has stalled. And it is not a temporary slowdown. Goodness gracious! It was obvious to me months ago. Is it possible that I could be smarter than Mario? (to-do list: must apply for a job at Goldman Sachs asap).
2.- He, together with San Francisco Fed’s Williams (two full time Gods of Mount Olympus), does not understand why the US economy has slowed this year. They have been explicit about their inability to find an explanation in their Keynesian book of economic recipes … or in their DSGE models. They will never find it. They’ve got their textbook wrong. Somebody should help me let them know.
3.- Please donate one USD to an offshore account (to be coordinated with some other readers), in order to pay Dragui and friends (foreign friends like Yellen, Kuroda, Ingves, Jordan or Carney included) a full sabbatical year -in an isolated island with no internet. The last two phrases are the worst. Mayday! Mayday! Mayday! Somebody please stop them trying to fix things again.
Okay. Enough is enough about what’s not going to happen. So I will take some solace in financial sex -meaning trying to make money in the meantime (without risking your capital).
Global Equity.- What a global equity rally we have seen from the end of September lows. Stunning. All my respect for POMO desk members. Dragui was serious about their job to try to get incomes up again. Well, not exactly incomes, but paper gains should be good enough to fool most of the people a little longer. We sure have great plunge protection teams all over the world -that have been attentive to every detail in his speeches.
So equities had their best month in … Underneath the headline, unfortunately some caveats do apply -as is always the case. Nothing in life is flawless (hey, not even my thinking -I am not a Goldmanite!).
HY did not follow suit (even though it obviously improved). The private sector continues to transfer risk to sovereigns (trading advice, sell sovereigns and buy corporate high investment grade!). Sovereigns are bankrupt.
Market breadth or volume were not staunch supporters of the rally as well. But we ought to give POMOs some more time. They will work on that later, you can be 100% sure. And they still have the year-end seasonals filling their spinnakers, with a likely low volume period for Christmas to help their gruesome manipulation.
Nevertheless, no matter how hard I press myself, I cannot think of a valid reason to expect multiple expansion without yield compression. And I can’t see why yield compression should be forthcoming (in a stable way) -unless we increase liquidity again substantially. We need lots of incremental excess liquidity to force the herd to compress risk premiums again. If not, POMO desks will have a hard time forcing spreads down. HY is not like equity. There is no stop-losses to be front-run, or anxious fund managers with a career risk at stake. Global default risk, and particularly sovereign default risk, continue to grow as I write. Why should risk premiums decrease in a stalled economy -or recessionary environment, with incremental debt being accumulated by the hour?
The only way up, other than adding liquidity, or manipulating prices by POMOS, is EPS growth. And enterprise profits only have an outside chance to improve again, before we get rid of this economic model. I don’t think it will happen. Bottom line improvement is exhausted, or will be exhausted over the next two or three quarters. And top line improvement is only possible if we get some Martians into our shopping malls. Highly unlikely. After tax profits don’t look good either because taxation will get a lot worse for multinationals over the next couple of years.
Denominator tactics to increase EPS, are up against their natural limits (leverage ratios and free cash flow). Share buy backs are dwindling. And sovereign funds and CB balance sheets are closer to disinvestment than to increase their securities portfolio (save 4 additional QE).
I am quite sure that this is the top (take this with a grain of salt please). All in all, I cannot think of a valid reason for equities to rally from here. Nevertheless, facts are facts. and I have to acknowledge that, in order to make sure I remain humble, POMOs have graciously stopped me out of 65% of my S&P E mini shorts (please keep this as a secret until I apply for that Goldman job -they wouldn’t hire anybody with a trade success rate below 99%).
I have to think positive. I lost no money there, even though I gave away most of my unbooked profits. I have, since then, built back to 50% of my total VaR tolerable bearish stance. And, yes, like Bizet’s Micaela, I am afraid. My size is reasonable now, but big enough to hurt if the S&P 500 goes on a tear.
I paid for my stops, licked my ego self-inflicted wounds, and remain short with a medium size position. If only because I am convinced that you have to feed POMO desks if you want to generate safe returns in this environment. You have to waste some sardines to go for the tuna. And CB manipulated prices are the best tuna in this environment. SNB finally gave in this year -to my delight, and I expect the FED to be overrun sometime (finally accepting an inevitable downturn in equity pricing). The Riksbank will be humiliated sometime as well (finally allowing for some SEK appreciation to the 9.00 level against EUR). Trading CB imposed inefficient market pricing is the low risk way to go long term. But you have to be resilient, and very patient. Forget about not fighting the FED. It was silly to do that in the good old times with lots of alternative investment opportunities. Right now, fighting CBs is all that’s left. Over time, fundamentals protect your stance.
Glaring price discrepancies between fundamentals and market prices are nowadays mostly the by-product of a large CB playing its hand. The battleground resembles playing David and Goliath, now and again, but the reward is sweet. Your fight is for the big money -hidden in the CB induced asset mispricing. I hate to fight, but the alternative options are only three, and I like none today.
- Option one. Assume zero nominal return (if not assume being nirped away daily)
- Option two. Embrace the Graham and Dodd securitiy analysis procedure, subsequently buy and hold the best stocks in relative terms, and forget macro. You may buy yourself a lot of alpha -but your beta can wipe you out in a month!
- Option three. Hedge fund, beta neutral, long short strategies. POMO desks know your positions and for them it is like shooting a lame duck. See Hedge fund returns to check the reality of this assertion.
No good choices left. So I’m reluctantly happy to pay POMOS my dues, provided it is not too often. When prices go back to normal, I will get my option premia expenses back. Thereafter, I will love to go back to Graham and Dodd investing. The real investing. But I want realistic base prices for that.
So I am still looking down and not up. The market is generating value overpricing assets because of monetary policy and POMO desk rigging. Value is not to the upside but to the downside. I remain firm, but for a smaller size, and flexible short, with stop loss levels for the remainder of my trade clearly defined.
In yet another discrepancy with our beloved God, JMK, long term survival is a concern to me, even though I do agree that in the real long term we are all dead. So maybe my precautions are a waste of time and money. Who cares! I don’t think the perspective of death should change our behavior. If one has to change something in his financial portfolio, family relationship, or social attitude, in the event of an immediate death threat, it means we should change now. I firmly believe we cannot live one way, with a large life expectancy, and a different life if we think we are going to die soon. The same postulate applies to my financial behavior. Hardly Keynesian friendly, I know.
Currency.- The Riksbank is nearing its day of reckoning. We should be reasonably close to cashing in on our SEK longs. Unless they want to go over the cliff with Thelma and Louise. Look at their Real Estate Market. Lower for much longer? More QE? They are getting closer to their Jordan-Danthine moment.
Whatever you do, don’t go short the USD -unless they print seriously. I will not elaborate further. This post is too long. The next chart should speak for itself. It follows the line of reasoning of previous posts.
Rates and Bonds.- Default risk is growing, step by step. If we do not reignite growth, or reliquify the financial system, credit risk spreads will have to widen. More on this next month. Duration spreads should continue to shrink. An inverted yield curve is almost impossible with ZIRP and NIRP, but we will get very close. Therefore, I expect wider credit spreads, and flatter yield curves.
Thank you very much for putting up with me for such a long post. And if you read this sentence, you did. Will be back next month -God willing (any God, be it Christian, Hindu, Greek, Muslim or Buddist -but please not a Central Banker).
Keep your spirits up. If we educate our children correctly we have to be firm believers in the future of the species (after we clean up this mess). We need teachers like Monsieur Mathieu. Our children will do the rest.