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September 10, 2007

Waiting for the Witch Doctor

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Reprint Policy

And then the witch doctor, he told me what to do
He said that
ooh-ee, ooh-ah-ah
ting, tang, walla-walla bing-bang
ooh-ee, ooh-ah-ah
ting, tang, walla-walla bing-bang

Witch Doctor, Sha-Na-Na

Given Friday's substantially weak employment report, the universal and unrelenting topic on Wall Street is whether the Fed will ease monetary policy in its September meeting, and by how much. This is an amazing exercise in superstition. This is not to say that the Fed's actions will be unimportant. It's just that whatever the Fed does, the impact will be almost entirely psychological. I've written about superstition and the Fed before, but given the dominating focus on the Federal Reserve here, it's important to refresh those comments.

There's no question that interest rates – market determined interest rates – have a substantial role in economic activity, particularly on the durable goods and housing sectors of the economy. But if you look carefully at what the Fed does, and the instruments it uses, economists and even central bankers (both at the Fed and internationally) are at a loss to describe the “monetary transmission mechanism” in any detail – that is, why the tools of monetary policy should actually exert an effect on the real economy.

The problem, as I've noted before, is that since the early 1990's when reserve requirements were removed for all bank deposits except checking accounts, there is no longer any relationship between the volume of bank reserves and the volume of lending in the U.S. banking system (see Why the Fed is Irrelevant for a more complete review of the data).

Simply put, you can draw a clear connection between Federal Reserve operations and the monetary base. You can draw a connection between the monetary base and the overnight Fed Funds rate. You can draw connections between market interest rates, bank lending, and economic activity. But what you can't do in any specific, meaningful way is to complete the diagram by drawing a cause-and-effect connection between the monetary base and the Fed Funds rate on one hand, and market interest rates and bank lending on the other. Yes, in crises, you can – briefly. If there's a bank run, the Fed has a real and essential role to play in supplying emergency liquidity. Outside of that, the monetary transmission mechanism is hypothetical at best.

It's strange that Wall Street makes such strong assumptions about the link between monetary policy and economic outcomes when there's no agreement among economists and central bankers about how changes in the quantity of the monetary base should exert an effect on the real economy. Again, there's clear agreement that market interest rates matter. There's also clear agreement that the Fed has direct control over the monetary base, and approximate control over the overnight Federal Funds rate. But that's where the agreement about fact ends and the debate about theory starts.

Economists can easily write down models of why monetary policy should affect the economy. But you'll always find a “ghost in the machine” – some assumption that links the variable controlled by the Fed with the real economy, but with nothing but assumptions to enforce that link. It would be convincing to say that in fact, bank lending is proportional to reserves, or that the Fed directly controls the interest rates charged on loans, but neither is true. If the models don't capture reality, they are just intellectual curiosities. As I've said before, if you're around academia for any length of time, you learn that few academic economists actually study the economy. They study “economies” in a very abstract sense. As in “consider an economy in which there are two islands, a turnpike, and five guys named Jack, one of whom is the government but nobody knows it…”

Monetary policy is not an “independent policy tool”

Monetary policy, at bottom, is not independent of fiscal policy. While reckless fiscal policy invariably ends in attempts to “monetize” the government's debt by printing money instead of issuing bonds, inflation is ultimately always and everywhere a fiscal phenomenon. Money and bonds are essentially portfolio substitutes, and interest rates fluctuate in order to ensure that the existing quantities of both assets are held in equilibrium.

Inflation occurs when fiscal policy creates more government liabilities (either money or debt) than people are willing to hold at existing prices. If investors are scared about credit risks, they generally seek government liabilities as a safe haven, so you typically get deflationary pressure during credit crises. In contrast, if the government produces a lot of liabilities in an unproductive economy (as the Germans did in the 1920's, paying striking workers in the Ruhr even though they weren't producing anything), you get high inflation. It would not have mattered had Germany paid workers with bonds instead of money – bond prices would have declined, raising interest rates, lowering the willingness of people to hold non-interest-bearing currency, and causing a hyperinflation nonetheless. Inflation is first a fiscal phenomenon, tempered by economic activity and credit conditions, and affected only at the margin by “monetary policy.” The government budget constraint (spending = taxes + debt + money creation) ensures that monetary policy cannot be independent of fiscal policy. All monetary policy does is to vary the mix of debt and money within that equation.

If you are interested in inflation, it is much better to focus directly on fiscal policy than monetary policy.

Notice by the way that were it not for the high rate at which U.S. government liabilities have been absorbed by China and other countries in recent years (with half of the float in U.S. Treasuries now held by foreigners), inflation would likely be running at a substantially higher level. The most inflationary factor here would not be an easing by the Federal Reserve, but a reduction in the rate that foreigners are accumulating U.S. Treasury securities. The inflationary effect would of course, be reduced to the extent that there was a credit crisis here in the U.S. (which would create public demand for safe havens, absorbing some of the additional Treasuries not purchased by foreigners). In any event, U.S. fiscal policy has put the U.S. economy in a situation where we now rely on foreign accumulation of our government liabilities.

A small base of influence

Recall that the only thing that the Fed can do is to change the mix of government liabilities held by the public. When it “eases” monetary policy, it purchases Treasury securities, and recently, government backed mortgage securities, and replaces them with monetary base (currency and bank reserves).

As it happens, the vast majority of the base money created by the Fed is drawn off as currency in circulation – very little is actually retained as bank reserves. Indeed, of the $15.9 billion in monetary base the Federal Reserve has created over the past year, all of it has been drawn off as currency, leaving bank reserves about $2 billion lower than last year. That's not unusual. Total bank reserves have been gradually declining since the early 1990's. Since then, in contrast to what I used to teach my undergraduates about “money multipliers” and such, there no longer any link between the quantity of bank reserves and the volume of bank lending.

Moreover, it's unclear exactly how changes in the Federal Funds rate presumably cause changes in market interest rates – statistically, market rates lead and Fed Funds typically follow. We can of course argue that, well, the markets are anticipating the Fed. But why do we really need so badly to believe that a government entity that influences an overnight interest rate on a $41 billion pool of money (this is the entire amount of U.S bank reserves) is actually in tight control of a $13.8 trillion economy?

Think about it. The full range of variation in the U.S. monetary base (including both bank reserves and currency in circulation) typically amounts to only about $50 billion annually. Over the past year, foreign holdings of U.S. government debt have increased by $300 billion – more than six times the fluctuation in the monetary base, and over a hundred times the amount by which U.S. bank reserves have changed.

It might seem that Fed must have an effect because periods of easing are typically followed by subsequent economic recovery, and periods of tightening are typically followed by economic softness, albeit with a “long and variable lag.” But that's a lot like saying the sun comes up because the rooster crows. The Fed generally only raises the Fed Funds rate when the economy is near full capacity and continues until the economy softens. It lowers the Fed Funds rate when the economy is already weakening and continues until the economy recovers. The Fed is “effective” as surely as economic softness follows strength and strength follows softness.

Even if a round of Fed easing will eventually be followed by economic strength, we should not prefer it. By that sort of logic, a major spike in unemployment would be a great thing, because as we know, such spikes are also typically followed by economic recoveries, though with a long and variable lag.

Ultimately, what's really going on is that we in free market economies are very uncomfortable with the idea that there's nobody in control. As Voltaire said, “If there were no God, it would be necessary to create him.” And since we can be pretty sure that God's first priority isn't bailing out the mortgage market, we look to the Fed. When things are going smoothly, we understand that the economy is complex, and diffuse, and driven by millions of individual decisions. But when trouble strikes, we want to believe that there's somebody up at headquarters with their hands firmly on the controls of the entire operation.

Still, just as Pavlov's dog salivated when he rang the bell, investors have been conditioned to believe that the Fed matters. And so it does. But it's important to recognize that this effect is primarily psychological. Unfortunately, the belief that the Fed somehow has our back creates a “moral hazard” by encouraging speculative risk. One might recall that the Fed did not prevent the U.S. stock market from losing more than half its value several years ago, despite fourteen consecutive rate cuts.

What the Fed does next week will certainly have an effect on short-term market psychology. The Fed can also have an impact by maintaining liquidity in the banking system in response to short-term demands for withdrawals. But managing the day-to-day demand fluctuations in a $41 billion pool of funds will not cure the much deeper solvency issues in the trillion dollar mortgage and commercial paper markets. To believe otherwise is plain and dangerous superstition.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. As the S&P 500 approached 1500 last week, it was clear that market internals were not improving enough to make a favorable shift in the Market Climate likely. The Strategic Growth Fund remains fully hedged, with part of its hedge back in a staggered strike position that provides somewhat better downside protection at the cost of somewhat lower interest from the hedge. As usual, this can produce a bit of “give-back” for a day or two if the market declines below our put option strikes and then advances sharply before we have a good opportunity to reset those strikes. However, all of that is “local” behavior – overall, I don't expect market fluctuations to exert much direct positive or negative impact on the Fund. The primary driver of Fund returns continues to be the performance of our stocks relative to the indices, which can be positive or negative. The Fund also accrues “implied interest” on our hedge – roughly the Treasury bill rate, but less when we have a staggered strike position as we currently hold.

As noted in the Fund's Annual Report, the stocks held by the Fund (excluding the impact of hedges) have appreciated at an average annual rate of 11.39% from inception to June 30, 2007, compared with an annual total return of 2.08% in the S&P 500 Index. The Funds hedges have produced additional returns since inception, and have substantially reduced volatility and drawdown risk. After a long dalliance among investors with what I've called “garbage stocks,” the more balanced focus of investors on stability, balance sheet quality, and other factors has produced more characteristic performance in the stocks we hold, and the Strategic Growth Fund registered a fresh high last week.

As always, I have no particular forecast about near-term market action. If market internals improve sufficiently, I would expect to remove a portion of our hedges on the basis of a renewed willingness of investors to speculate (despite valuations that are unlikely to produce strong long-term returns). No such evidence is apparent here, so we presently have no reason to accept market risk on the basis of investment merit (valuations), or on the basis of speculative merit (market action).

In bonds, Treasury yields have declined further, as have the yields on inflation protected securities. Precious metals shares have also performed quite well, all of which brought the Strategic Total Return to a fresh high last week. In bonds, it is important to recognize that while credit concerns and widening risk spreads tend to be quite good for the Treasury market (as investors seek safe havens), it is also important to recognize that, say, 10-year Treasuries are priced to deliver long-term returns of, well, their yield to maturity of about 4.38%. At that level of yields, with a relatively flat yield curve and still moderate inflation, speculation at the long end of the maturity spectrum can be quite dangerous, and gains can be abruptly reversed. Yes, recessions tend to be good for long-term bonds, but bond yields typically start at much higher levels at the beginning of weak economic periods. Recessions tend to produce a steepening in the yield curve, so it's not at all clear that even lower short-term yields will produce much “give” at the long-end. Overall, long-term bonds may still perform well in a credit implosion, but with a good bit of volatility. I believe that it is more appropriate to nibble on longer durations during periodic selloffs (yield surges) rather than chasing low yields when bonds are already quite overbought.

In precious metals, the Market Climate remains favorable, but with precious metals shares overbought and quite volatile, any relaxation of immediate pressures on the U.S. dollar may produce some rapid giveback of recent gains. We clipped off a portion of our precious metals position on Friday's strength. Those holdings are still in the range of 10% of assets in the Strategic Total Return Fund, so again, the Market Climate is still generally favorable, but those stocks have run some distance, and again, it's not typically a good idea to chase a volatile and overbought market when the near-term drivers (such as potential Fed easing) have already been largely priced in by investors.

On the subject of possible Fed easing, the historical spread between the Federal Funds rate and the 3-month Treasury bill yield has had a historical median of about 25 basis points and an average of about 35 basis points. The current Fed Funds target is 5.25%, while the 3-month Treasury bill yield is just over 4%. Martin Feldstein presented a very gloomy economic outlook related to housing weakness, and suggested at the recent monetary policy conference that the Fed should cut the rate by a full percent. That, however, would completely tap out the Fed's psychological ammunition. Indeed, any cut of more than 50 basis points would likely panic the markets more than mollifying them. Combined with the recent employment report, the Fed has easy “cover” to cut by 25 basis points. A 50 point move would essentially reflect a desire to Fed governors to avoid any blame for whatever economic weakness lies ahead, and to prevent criticism about falling “behind the curve.” There's a slight chance the Fed will do nothing in order to prove its “credibility” and send a strong signal that it is not interested in bailing out financial markets, but that would be ill-advised because it would prompt a loss of confidence and an image of Nero playing the fiddle as Rome burned.

In the same conditions, Greenspan would probably move 50 basis points. He seemed to enjoy the whole “Maestro” bit, and didn't have much willingness to avoid moral hazard problems or the perception of a “Greenspan put.” Bernanke seems more concerned with not sending a “bailout” signal to the market, but the employment report and the wide spread between Fed Funds and 3-month bills creates a gray area that would allow moving 50 rather than 25, in the hope of avoiding blame. And of course, the next week will provide some additional data. Again, I don't think what the Fed does will actually matter to the real economy, except for short-term psychological effects because investors believe the Fed is important. Meanwhile, as usual, the Funds are aligned with the prevailing Market Climate. We presently have no evidence to accept market risk, and will shift our position as the evidence changes.

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