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May 24, 2004

Breaking Monetary Policy into Pieces

John P. Hussman, Ph.D.
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Among the more useful items in our bag of tools is something called “decomposition analysis,” which basically involves breaking something complex into well-behaved pieces that describe it as a mathematical identity (true by definition), and then analyzing the pieces individually. For example, we got great mileage during the bubble by analyzing prices as simply:

Price = Price/Earnings x Earnings/Revenue x Revenue

In effect, all stock price fluctuations can be described as the product of valuation (P/E) changes, profit margin (Earnings/Revenue) changes, and revenue growth. Since we know a lot about how these behave as economic conditions change, we could make fairly strong assertions in April 2000 that the Nasdaq was likely to lose between 65 and 83 percent of its value (see Bear Market Insights).

Similarly, with many investors evidently believing that the economy is in the beginning of a normal and sustained economic expansion, I've made a lot of noise about the savings-investment identity (Gross domestic investment = private savings + government savings + foreign savings), arguing that normal investment booms have historically relied on sources of savings inflow that are not presently available, so that any expansion in capital spending will probably come at the expense of housing investment, with fairly flat overall growth in U.S. gross domestic investment.

The Exchange Equation

As we look to understand the probable impact of coming Federal Reserve tightenings (which I continue to expect to be on a “dampened trajectory” – as confirmed by recent comments of Fed governors), the appropriate identity is something called the “monetary exchange equation.”

The exchange equation is usually written PY = MV. Basically, the amount of nominal output purchased during any period (the price level P times real output Y) is equal to nominal money spent (the money stock M times the rate of turnover or “velocity” of money V). Since the monetary base (currency plus bank reserves) is the only aggregate that the Federal Reserve can directly control, I usually analyze the exchange equation using the monetary base as M. Velocity can't be observed directly (so you calculate it as nominal GDP / monetary base).

Velocity is basically a measure of people's willingness to hold cold, hard cash (currency and bank reserves – the stuff in your wallet and the stuff in the bank vault). Lower velocity means that people are hoarding cash, which usually happens when the economy gets weak, credit concerns and bankruptcies increase, or generally anytime there is a banking scare. In contrast, higher velocity means that cash is a hot potato, which usually happens as interest rates rise, since it becomes expensive to hold cash in your wallet when it could be earning interest.

Let's take a look at the exchange equation in terms of percentage changes (I'll use %X to mean the percent change in some variable X – to a small approximation, the percentage change in a product, say XY is equal to the sum of the percentage changes %X + %Y). So:

%P + %Y = %M + %V

Rearranging, we get the basic inflation identity:

%P = %M + %V - %Y

Stare at that. It says that inflation (%P) is equal to the rate of money growth, plus the change in velocity, MINUS the rate of output growth. This is something that people don't seem to understand, but is exact in the data. Output growth in and of itself has the effect of REDUCING, not increasing inflation. If it helps, remember that if inflation is too much money chasing too few goods, then an increase in the quantity of goods is disinflationary.

For example, if money growth is 9% in a given year, velocity declines by 2%, and real output growth is 4%, the rate of inflation will be 9% - 2% - 4% = 3%. Again, that's not a theory, it's an identity.

As another example, the deflation of the Great Depression did NOT occur because output fell. It occurred because bankruptcies created an environment where monetary base (cold, hard cash) was in frantic demand, and the Fed did not adequately accommodate that demand, so banks toppled one-by-one like dominos. (Think George Bailey: "“No, but you're thinking of this place all wrong. As if I had the money back in a safe. The ... the money's not here. Your money's in Joe's house, that's right next to yours, and in the Kennedy house and Mrs. Macklin's house and a hundred others..."). From the standpoint of the exchange equation, the drop in monetary velocity was so profound that deflation took hold despite more money chasing fewer goods.

Why the Fed tightens policy

The Fed does not tighten monetary policy because output is growing too fast. It tightens monetary policy because the economy (capacity use, employment, potential GDP) has reached such tight constraints that output is no longer capable of growing fast. If that happens, and the Fed fails to reduce money growth (%M), you get inflation. So the point of a Fed tightening is not to cause slower economic growth, but to anticipate slower economic growth.

If you could hold velocity constant, the non-inflationary policy rule for the Fed would be to set the rate of money growth to the rate that the economy is capable of growing over the long term (Friedman's rule). Greenspan modifies this to an active strategy by aligning policy with the potential for near-term growth: if there is a lot of slack in the economy, a loose monetary policy is seen as appropriate. If there is so little slack that supply cannot meet demand, a tight monetary policy is desirable.

Unfortunately for the Fed, velocity cannot be controlled directly. For the most part, it is driven by two things: 1) the level of interest rates – velocity increases when higher interest rates make it costly to hold currency, and; 2) the desirability of holding the currency itself – velocity falls when cash is pursued as a safe haven.

For the past few years, despite sluggish economic growth, the Fed has been able to run very rapid monetary growth with impunity because velocity has been plunging. Part of this is attributable to falling interest rates, and part is attributable to the willingness of China, Japan, and dollarized economies to accumulate U.S. currency.

And here is the problem. Historically, Fed tightenings have led to abrupt increases in monetary velocity regardless of the prevailing level of inflation or capacity use. Add to that the growing pressure on China to revalue the yuan (which would correspondingly reduce its accumulation of U.S. dollars, thereby raising velocity), and you've got a great recipe for a strong surprise in U.S. inflation over the coming quarters.

All of which explains why the Strategic Total Return Fund has a significant allocation to Treasury Inflation Protected Securities, as well as about 12% of assets in precious metals shares, and very little in straight Treasuries. While Treasuries are so oversold that some amount of strength is apt to occur, we believe that such strength should now be viewed as a selling opportunity.

In short, following several years of very restrained behavior even in the face of weakening fiscal discipline, velocity appears likely to break higher. Absent a new round of credit defaults and bank problems (which we'll address when credit spreads indicate a concern) it's just difficult to see the factors that have kept velocity down continuing much longer. In general, Fed tightenings are followed in the near term by higher, not lower inflation.

The bond market's recent thesis of rapid, noninflationary growth continues to strike me as incorrect. The past few weeks have partially reversed that thesis, which has restored my faith in critical analysis. Still, we never take positions that rely too heavily on clear thinking by the consensus, or on particular scenarios or outcomes. In any case, I believe that slower economic growth and higher inflation pressures remain the most likely result of current conditions.

Market Climate

The Market Climate for stocks continues to be characterized by unusually unfavorable valuations and unfavorable market action. This combination places the Strategic Growth Fund in a fully hedged position – fully invested in a broadly diversified portfolio of stocks, with an offsetting short sale in the S&P 100 and Russell 2000 intended to remove the impact of market fluctuations from the portfolio. This position should not be taken as a forecast of a market decline, but rather as a statement that market risk has historically not been rewarded in this Climate. That may seem like a subtle distinction, but the lack of forecasting and willingness to align ourselves with the prevailing Climate is an essential feature of our approach.

The Strategic Total Return Fund holds a portfolio duration of about 3.5 years, primarily in Treasury Inflation Protected Securities. The Fund also holds about 12% of assets in precious metals shares, about 6% in utility shares, and very small positions in U.S. agency notes and foreign currency denominated notes. The Fund would be expected to benefit most from factors that place downward pressure on real interest rates and the U.S. dollar, or upward pressure on inflation. In contrast, rapid non-inflationary growth would tend to place upward pressure on real interest rates with little benefit to precious metals shares. As noted, however, the overall portfolio duration of the Fund is about 3.5 years, meaning that the Fund would be expected to fluctuate about 3.5% in the event of a substantial, 100 basis point change in real interest rates. On a day-to-day basis, most of the fluctuation in the Fund is likely to be linked to that 12% exposure to precious metals shares, which remain relatively depressed in a Market Climate that I continue to view as favorable toward that group. Though we ordinarily might take a larger position in precious metals shares, the unusually strong correlation between bonds and the U.S. dollar has not abated. The reduction in diversification benefits between bonds and precious metals holds us to a more conservative stance than we might otherwise take.


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