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June 14, 2004

The Fed Bone's Connected to the Tax and Spend Bones

John P. Hussman, Ph.D.
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Just a note. For investment advisors attending the Morningstar Advisor's Conference, we will be hosting a presentation on Thursday June 24 th from 5:30-6:30 in the Truffles Room (Hyatt Regency Chicago, 151 E. Wacker Drive, 2nd floor of the West Tower). Though no truffles will be served, there will be other refreshments. The event is intended for advisors at the conference, but it is hosted by the Hussman Funds, so we can also accommodate shareholders who find themselves in the area on that date. We've initially planned for about 50-70 guests. Please send a note to surveys@hussmanfunds.com if you plan to attend.

One of the reliable sources of expected return in this business is the perennial optimism of investors that two plus two can equal something other than four, and that tightly linked concepts are actually independent. A good example of this is that notion that monetary policy is somehow independent of fiscal policy. That fantasy shatters quickly if you look at the government's budget constraint.

Whatever the government spends must be financed by taxes or the sale of government debt. The public can buy that debt directly, or the Fed can buy it and create monetary base - currency and bank reserves - to pay for it (a method of printing money that is only slightly less direct than used in the typical banana republic).

So the basic government budget constraint is:

Government Spending = Tax Revenues + Change in government debt held by public + Change in monetary base held by the public

Stare at that. All spending must be financed by taxes, public debt, or money creation. Given any fiscal policy stance (spending and taxes), monetary policy can do nothing but change the mix of government liabilities that are held by the public.

When the Fed “eases” monetary policy, it simply buys more government debt and creates more monetary base. The public ends up holding fewer Treasuries and more money. The Fed's greater demand for short-term Treasuries helps short-term interest rates to decline, as does the greater availability of bank reserves.

When the Fed “tightens” monetary policy, it simply buys less government debt, and creates less monetary base as a result. The public ends up holding more Treasuries and less money. The Fed's reduced demand for short-term Treasuries pressures short-term interest rates to increase, as does the smaller availability of bank reserves.

Notice something. The Fed has absolutely no control over the total quantity of government liabilities that must be held by the public. Only Congress controls that. The Fed only determines the mix.

Inflation and its Causes

This leads directly to the “unpleasant monetarist arithmetic,” as it's been called, that monetary policy is always and everywhere subordinate to fiscal policy. It is patent superstition to believe that the Federal Reserve can control inflation if fiscal policy is out of control.

It has always been thus. It is impossible to explain historical U.S. inflation by referencing monetary growth per se. Inflation is primarily linked to the expansion of “unproductive” forms of government spending (socially valid in many cases, but not serving to expand capital or draw new output into existence). It was the expansion of war and entitlement spending beginning in the late 1960's that drove the federal budget and U.S. current account into deficit, demanded a monetary expansion, and forced the U.S. dollar off of the gold standard and eventually off of the Bretton Woods system of managed exchange rates as well. That, combined with energy price pressures, is what created the high inflation and profound dollar weakness of the 1970's.

Paul Volcker succeeded as a Fed governor in the 1980's not simply because he tightened monetary policy, but because his refusal to expand the monetary base forced the government's spending to appear directly as deficit spending, and this spending was successfully managed over the following decade (note that the bulk of the “Reagan deficit” represented a recessionary tax shortfall in the early 1980's, not a rapid expansion of spending relative to GDP). Spending was brought down further in the 1990's - relative to GDP - with additional disinflationary benefits. Volcker also had the serendipity of starting the process at a period when economic slack was great and new industries such as personal computers and biotech were emerging, which allowed expansion in output to mitigate price pressures (see the May 24th comment for an explanation of why GDP growth is disinflationary).

Look at the German hyperinflation in the 1920's. Would it have made any difference if the German government had paid striking workers in the Ruhr using government securities? Germany would have still had an excessive expansion in government liabilities at a time that output growth could not absorb them. The government securities would still have lost their value, causing interest rates to soar, and the direct competition between negotiable interest-bearing assets and currency would have ensured a hyperinflation just the same. Once the total quantity of government liabilities is out of control, the inflation fight is lost.

The Fed's Problem

At present, we don't really see many of the output constraints that would normally lead the Fed to tighten monetary policy. Normally, the point of a tightening is not to slow economic growth per se, but to slow down the rate of demand growth when the economy has little capacity to expand supply.

So from a capacity standpoint, the Fed is exactly right to target a “dampened trajectory” for coming rate hikes, since those hikes are intended to normalize short-term interest rates to be consistent with current rates of inflation and economic growth, not to slow demand growth.

Unfortunately, there are at least three problems. First, as I've noted before, Fed hikes have a very strong tendency to increase “monetary velocity,” which means that the short-term result of Fed tightenings has historically been higher, not lower inflation. Combined with recent energy price hikes, the risk is that inflation rates will rise enough to make the Fed seem “behind the curve.” Indeed, the latest string of Fed pronouncements seems to recognize that the Fed may be forced into a more aggressive stance if inflation rates continue to surprise on the upside.

Second, fiscal policy is undisciplined here. If fiscal policy was balanced, and bank lending still had any tie at all to reserve requirements (which it does not – see Why the Federal Reserve is Irrelevant), then monetary tightening might have a chance to reduce inflation. At present, monetary tightening will surely have the effect of normalizing short-term interest rates (perhaps too quickly if the Fed comes to believe it's behind the curve), but those policies are unlikely to have much favorable effect on inflation rates in the near term.

Finally, looking out somewhat longer term, the U.S. continues to carry weak balance sheets at the national, corporate and personal levels. Yes, economic expansion has been reasonably good in recent quarters, which was largely expected from helicopter-money fiscal policy and a peak in the refinancing boom. But in order to determine whether a given level of spending is sustainable, you don't look at the recent pile of store receipts – you look at the balance sheet. Given the overhang of debt that was never worked off in the past recession, and the unfortunate fact that much of this debt is now tied to short-term floating interest rates (see Freight Trains and Steep Curves), higher interest rates and inflation in the near term could very well contribute to defaults and credit instability over the longer term.

Unlike Paul Volcker, who was willing to endure harsh criticism in order to force the government and public to make hard choices, Alan Greenspan has been continuously eager to shield the government, corporations and investors from the economic impact of reckless spending, overinvestment, leverage and speculation. The Fed has a lot of potential problems to manage, but it doesn't even have an independent policy lever.

As we approach the June 30th Fed meeting, everyone is watching to see what the Fed does at the wheel. The problem is that the wheel is connected to the gas pedal, which is connected to the transmission, which is connected to the brake system, which is connected to the power windows. In short, regardless of what direction the Fed decides to turn, the car just might land upside-down in the river anyway.

Market Climate

The Market Climate for stocks continues to reflect unusually unfavorable valuations and unfavorable market action. The Strategic Growth Fund remains fully invested in stocks that we believe have some combination of favorable valuation and market action, but that diversified portfolio is hedged against the impact of market fluctuations using an offsetting short sale in the S&P 100 and Russell 2000 indices. As such, the day-to-day returns of the Strategic Growth Fund are largely driven by the difference in performance between the stocks that we hold long and the indices that we are short. This is not a “call” on market direction, but rather a statement that we can find merit in a large number of individual stocks, provided that we can hedge away their sensitivity to overall market fluctuations. That “relative” comparison between our stock holdings and the overall market was precisely what drove the Fund's returns from 2000 through early 2003. I continue to believe that this “active risk,” while still a form of risk, has a higher expected return than the alternative of holding cash balances during unfavorable Market Climates as we have now.

In bonds, the Market Climate continues to reflect neutral valuations and unfavorable market action, holding the Strategic Total Return Fund to a short-duration stance (about 3.25 years, meaning that a 100 basis point change in interest rates would be expected to impact the Fund by about 3.25% as a result of bond price fluctuations). All of that duration is in the form of Treasury Inflation Protected Securities, which I expect to be reasonably independent of interest rate fluctuations that result from shifts in inflation expectations. The Market Climate for precious metals continues to be favorable, so the Fund also has about 12% of assets in precious metals shares. This remains a smaller allocation than I would choose if movements in the U.S. dollar and U.S. bonds were not as tightly linked as they have been recently, but I do view it as appropriate in terms of overall return/risk considerations.

A note on hedging versus cash. In the Strategic Growth Fund, we can always find a wide range of securities that have characteristics that are “independent” of the market – valuation, products, management, balance sheets, and so forth. For that reason, negative Market Climates in stocks are always periods where we continue to hold a fully invested position in stocks, and simply hedge the market risk as much as possible. In contrast, the amount of “dispersion” in the bond market is much lower, particularly for investors who don't use credit risk as a source of return. For that reason, negative Market Climates in bonds generally lead us directly to lower duration securities or Treasury bills.

While we have the flexibility to use Treasury futures or options to hedge in the Strategic Total Return Fund, in practice we would only do so if we rapidly needed to hedge bonds having limited liquidity (which we currently do not hold), or if there were compelling yield curve or agency spread trades that seemed attractive, independent of the Market Climate. At present, there isn't much opportunity for that sort of “dispersion trade,” so the Strategic Total Return Fund has focused its holdings largely on Treasury Inflation Protected Securities using a reasonably short overall duration, precious metals holdings, select utilities, and very small allocations to government agency notes. The balance remains in Treasury bills and other short-term money-market securities. That's not a “standard” or long-term position for the Fund, but I do believe that it appropriately reflects current risks and opportunities in the bond and related markets.


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