The Fed and Goodhart's Law

Goodhart's law is:  When a measure becomes a target, it ceases to be a good measure.

The most common measure of when a recession is coming is the inverted yield curve.  I believe the Fed is now targeting this measure.

In the past when inflation got too high and the Fed needed to tighten monetary policy it would raise the Fed Funds rate.  This increases short term interest rates.  If short term rates were higher than long term (the dreaded "inverted yield curve"), it meant the Fed was tightening monetary policy and a recession would soon come.

So the Fed thinks that "inverted yield curve" is the cause of recessions.  So the plan now is to tighten monetary policy without inverting the yield curve, which they think will avoid the recession that usually comes from tightening.  The way they will do this is by leaving short term rates low and selling off bonds they bought during Quantitative Easing (QE).   This is being called Quantitative Tightening (QT).   When they sell bonds they will raise longer term interest rates.   If the Fed Funds and short term rates stay low, then the yield curve will not invert.  

Again, they think as long as they don't invert the yield curve they can get the mythical "soft landing" and avoid a recession.   They are wrong.   It is the monetary tightening that causes the recession, not the "inverted yield curve".

When rates are lowered it makes monthly payments on loans smaller so people and companies can buy things sooner.  We say "it brings demand forward".  Imagine someone can buy the $40,000 car of their dreams sooner if the Fed drops rates from 10% to 2% and so reduces the monthly payments.  The problem is that eventually this makes too much inflation and they have to let rates go back up.   This pushes demand backward.  Someone who was about to buy their dream car with a 2% loan now has to wait much longer when loans are at 10%.  The demand being pushed backward is the recession.   It is the rates going up that causes demand to be pushed backward, not the inverted yield curve.

Of course, if they don't tighten monetary policy they will get "run away inflation" and then hyperinflation.   So the Fed does need to tighten.  But doing it in a way that avoids the inverted yield curve will not avoid the pain of the tightening or result in a "soft landing". 

There is also a real risk that once people understand that bond prices will be falling as the Fed tries to dump bonds that everyone will "not fight the Fed" or "front run the Fed" and try to sell bonds before the Fed does.   For the last 40 years bond prices have generally gone up as interest rates went down.  Now with rates going up and bond prices going down we could see a rush to sell and indeed panic selling.   The saying is "the market takes the stairs up and the elevator down".  This is probably true for the bond market as well.  One should not expect bond holders to keep holding as bonds go down for years and years.  A bond crash makes more sense. 

So far the Fed has just recently stopped buying bonds and only raised Fed Funds by 0.25%.   But the markets anticipate the future and so have gone up significantly already.   The 30 year mortgage rate has gone from a low last year of 2.65% to 4.16%.

The 0.25% fed funds hike makes it seem like the Fed is not serious about fighting inflation.   But really it is probably just that they don't want to make the dreaded inverted yield curve.   We will see how serious they are when they start selling bonds.   If they let bond interest rates go way up, they are serious.  There is still some chance.

We will soon get the first recession without an inverted yield curve, because the Fed targeted this measure.  So the measure will cease to be a good measure.

 

 

Crashing Without a Net

 

"It ain’t what you don’t know that gets you into trouble, it’s what you know for sure that just ain’t so."

    The Big Short

 

Today people "know for sure" that the more money the Fed prints the more the stock market goes up.   Using Fred Graph we can make the following: 

 

With this view people may think that the Fed can always print money and always make the stock market go up, but this just ain't so and will get them in trouble. 

A more accurate way to think about it is that stocks are correlated to long term bonds but a bit more volatile (here we use 1.5 factor).   This Fred Graph shows this:

 The Fed can often manipulate the bond market by buying/selling bonds and adjusting the Fed Funds rate.   As the Fed buys bonds they are printing money and driving up the price of bonds (and lowering interest rates).   The stocks go up as the bonds go up.   So often the Fed printing money does make the stock market go up, but again that is too simple a way of thinking about it and will get you in trouble.

The trouble comes when inflation comes, as it has now.   By law the Fed has to fight inflation.   The way to fight inflation is by not printing so much money.  If they are not printing so much money then they are not buying so many bonds, so bond prices will come down.   As bond prices come down, stock prices will also come down.

The famous Fed Put is where the Fed steps in and stabilizes markets.  This does not work when there is high inflation and interest rates are already at 0%.    In previous market crashes the Fed could lower interest rates and so make bond prices and stock prices go up.  However, with interest rates already at 0%, the Fed can not lower them any more.   Bonds are already at historic highs, so they can not be driven up any higher.  High inflation tends to push bond interest rates up and so make bond prices go down.  In previous market crashes inflation was low so the Fed was cleared to print money.   Today we have high inflation, so the Fed's hands are tied.   The Fed Put has expired.

In previous crashes the Fed was able to step in and halt a crash, making for a quick bounce back.   Current investors believe the "Fed has their back", but this just ain't so.   Today we are crashing without a net.  This crash will probably be worse than anything in recent memory.

PS.   Powell understood the danger of low interest rates making the current bubble and yet did it anyway.  Here is Powell from 2016:

 "... it’s plausible to me that rates will have to remain very low for a very long time to achieve stable prices and full employment, but that such low rates will drive excessive credit growth and create irresistible upward pressure on asset prices, including real estate prices. I’m thinking of a situation in which a broad range of asset prices are moving up well beyond what fundamentals would justify; where the other tools we have don’t seem to be addressing the problem or have failed to do so; and where low interest rates are pushing up asset prices and driving credit to excessive levels, probably over many years, and thus are a principal cause of the threat. Recalling that we have had two major real estate blowups in the past 25 years, ..."

Deep Reasons for Current Trouble

 

There are a few deep reasons for the trouble coming to the USA which I will go over here.

At Best a Necessary Evil

There is some minimal government with police, courts, and defense that is sort of a necessary evil.  While such a government is a cost to the economy, it is better to pay this much cost than to suffer anarchy.   After this, the more government the less real economic growth.   The USA devotes too much of the economy to government and so not enough to real growth.   At this point, the size of the US government is far beyond optimal.

Dutch Disease and Resource Curse

There are the related concepts of Dutch Disease and Resource Curse.  Countries that have some valuable natural resource tend to suffer worse governance and to suffer in other areas of their economy.   Back in 1711 the Spectator wrote, "It is generally observed, that in countries of the greatest plenty there is the poorest living."   It is easier for a bad government to get control of some natural resource and then stay in power.  If they have to tax the general economy there will be some resistance to government excess.   So when there is a valuable natural resource, the odds of having a bad government go up.  

The US ability to print the world reserve currency is like having a valuable natural resource.

Triffin Dilemma

The Triffin Dilemma is the problem of a country with a world reserve currency.  For the country's own benefit (say when there is a Pandemic) there is a huge advantage to printing lots of money.  But if done too much this harms the rest of the world and makes them not want to keep using that currency as the world reserve currency.   You can view inflation as a tax.  The country with the world reserve currency can impose an inflation tax on the whole world.  However, if the inflation tax gets too high, the world can rebel and stop using that currency.   Taxes always cause modifications in behavior.  

The current inflation is reported as a CPI of 7%, but really the inflation is over 10% (the owners equivalent rent component of the CPI is a cheat) and going up fast.  This is an intolerably high inflation rate for a world reserve currency. 

Alternatives to the Dollar

If countries don't want to keep paying the inflation tax to the US they have to reduce their usage of dollars.  Many people can not conceive of any alternative to the US dollar but there are some.   

Central banks in other countries could use gold as reserves instead of dollars. Before Bretton Woods central banks each kept their own gold reserves.   Imagine that country X has 75% dollar reserves and 25% gold reserves.  In this case, if the dollar were to get hyperinflation and go to near zero, their currency would drop by a factor of 4 and then stabilize.  They would have suddenly moved to a gold standard.   So countries may end up moving to a gold standard without planning to do so.   At this point, it would be wise for central banks to have some gold just in case.  It seems central banks around the world are increasing their gold holdings.  If central banks only have dollars then if the dollar gets hyperinflation their currency will also get hyperinflation.

If people live in a country where the central bank is still only using dollars as reserves, they could save in Bitcoin instead of the local currency.

Spain and New World Gold

Spain took huge amounts of gold and silver from the New World.  Since gold was the world reserve currency then, getting all this gold was a bit similar to the US ability to print the world reserve currency.   This did cause prices, measured in gold, to go up by about a factor of 6 in 150 years, but this is only 1–1.5% per year.  While Spain was bringing in the gold and silver they had significant power but after the flow stopped they were a shadow of their former selves.  Similar to the resource curse, the rest of their economy was sort of hollowed out.

Dollar Losing World Reserve Status

It is in the interest of other countries to move away from the dollar, and so not pay the dollar inflation tax.  As countries do this the dollar will be less and less used.  China and Russia have worked to de-dollarize their economies.    The same amount of dollar creation will create more inflation when there are fewer countries using it.  But more inflation will push countries to flee the dollar even faster.   So there will be a positive feedback loop and leaving the dollar could happen very fast.

USA Just Another Banana Republic

If the dollar is not the world reserve currency, then the USA becomes just another Banana Republic that is printing way too much money.  Half their spending power comes from printing money.  The US will effectively lose a huge amount of its power, similar to when Spain could no longer bring gold from the New World.  The USA will be a much weaker country.  

The US manufacturing in 2021 was $2.3 trillion.    The Fed's balance sheet has on average increased by more than this per year in the last 2 years.  I think it is fair to say that money printing contributes more to the US economy than all of manufacturing.  

Without reserve currency status, it is nearly impossible to keep spending  twice what comes in as taxes without getting high inflation.    However, it is probably not possible for the USA to cut spending back to the level of taxes they will be collecting once things go bad.  Also, much of their spending is indexed to inflation and some of the bond payments as well.    Sadly, the USA is probably headed for hyperinflation.

Another Fine Mess The Fed Has Gotten Us Into

 Laurel and Hardy had a catch phrase with variations on "well here is another fine mess you have gotten me into".  The Fed has blown many bubbles since it was created over 100 years ago but this is the first "everything bubble" and a really fine mess.

The core problem is that the bubble economy and government are now dependent on interest rates that are near zero but these low interest rates are causing inflation.   The Fed's duel mandate of high employment and stable prices requires that they raise interest rates to fight inflation.   But this is likely to pop the everything bubble.

The Fed is targeting 2% inflation.  The latest CPI reading was 6.8%.  It has been going up very quickly.   The current CPI uses owners equivalent rent, where they go around asking non-renters what they think their house could rent for.  This is just just aggregating made up numbers and not collecting real housing price data.  People experience real inflation and not the made up numbers.  If you use real housing data, like they used to, the CPI comes out to 11%.  There are other tricks in the CPI that cause it to understate inflation.  Really inflation is at least 9% above the Fed's target.  

There is a Taylor Rule for figuring out what interest rate the Fed should use to get inflation back to its target rate.  It is easy to try out the Atlanta Fed Taylor Rule Calculator  to see what rate should be used.   But really you should have 2 or 3% more than the current inflation rate.   The only way Paul Volker could control inflation was by raising interest rates above the inflation rate.  We really need something like 13% interest rates to control this inflation.  Staying near 0% will encourage more inflation.

Some people ask, "how could increasing interest rates fix supply chain problems?".   The wrong idea here is that the current inflation is just caused by supply chain issues and these are not things the Fed can fix.   Let me try to explain.   Imagine each businessman is seeing various costs for his input supplies going up at  numbers like 10%, 15%,  25%, 50%.  Also imagine that banks pays him 0% if he leaves the money in the bank and charges him only 2% if he borrows money.  The rational thing for him to do is order extra of his input supplies, either with cash on hand or by borrowing.   In these conditions he is better off using these input supplies as a store of value.   With 0% interest and these inflation rates, the dollar is not a "good store of value".   The dollar has lost one of the key attributes of good money.   But the supply chains were designed for normal monthly supply quantities and not for businesses also using supplies as a store of value.  This additional usage is too much.    If interest rates were at 13% many more businessmen would use money as a store of value instead of input supplies.  If the Fed raised rates to 13% the supply chain would be fixed right away.  Really. 

When the local money fails as a store of value, you always see laws against "hoarding" as if that was the core problem.  Hoarding is a symptom of bad money, not a core problem.

It is also not clear to many people how the Fed has caused the labor shortage, so let me try to explain that as well.  By dropping interest rates to zero the Fed has about doubled the stock market since the 2020 low.  This has made many people feel rich enough that they think they don't need to work, so they quit.   If the Fed were to increase interest rates, probably the stock market would crash, and many of these people would be looking for work again.

The US Federal Government has over $29 trillion in debt.    These days much of it is short term T-bills and not long term Treasuries.  If interest rates went to 13% the interest could be more than the total taxes collected.   Many companies and individuals have also taken on lots of debt to take advantage of the low interest rates.   If rates go up they will have a very hard time.

The market is only expecting two rate hikes of 0.25% each in 2022.  The market is thinking we will be at 0.5% interest 12 months from now.   This is nowhere near high enough rate to fight inflation.  Inflation has been going up 0.5% per month many times recently.  Without some serious effort to fight inflation soon, we will see far higher inflation by the end of 2022.     On the other hand, even 2% rates now would no doubt crash the stock market and slow the economy way down.   It is another fine mess the Fed has gotten us into.

Inflation Going Higher

The Nov 2021 CPI report comes out Dec 10th.   The Oct CPI was 6.2%.   Here are three different estimates for Friday's number:

1. Cleveland Fed estimates 6.6%
2. Lyn Alden says  economists are estimating 6.7%
3. Trading Economics forecasts 6.9%

As Edward Garbarino commented in response to Lyn's tweet, "If Powell did not have information indicating significant worsening inflationary pressure on the horizon, he would not have jettisoned the "transitory inflation" narrative, IMHO."

This year the real CPI numbers have surprised to the upside many times.  We may be at 7% or more on Friday. 

People are expecting that about a 0.5% increase in the Fed Funds rate in 2022 will tame inflation.   This is naive.   Given how fast inflation has been going up (frequently 0.5% per month) that is far too slow a pace of increasing interest rates to ever get ahead of the inflation rate.   If interest rates stay far below the inflation rate, inflation will continue to go up.  Interest rates need to be well above the inflation rate to be "fighting inflation".

Historically when inflation starts going up the Fed tightens and the market goes down.  It really seems that this is likely soon.

However, if we have 7% inflation then it would take something like 10% interest rates to get control of it.  If we had such rates the economy would be dead and the government bankrupt.   But if interest rates stay low, inflation can get out of control.  It really could go to hyperinflation.  Either choice the Fed makes has a really bad result.   There does not seem to be any nice way out at this point.

Private Economy is the Real Economy

 

Government economists define GNP to include government spending.   This way the more government spending, the higher the GNP.   So if they need to "grow the economy" all they have to do is increase government spending.  The more the government is spending, the more power they have. 

The reality is that government is a leach on the real productive economy.  They are taking resources from the productive parts by taxation and money creation (inflation).   Government does not add to the economy, it sucks life out of the economy.   

If we subtract government spending from the official GNP and scale for inflation, we get the following graph which gives a better idea of the Real Economy.

First, looking at this graph it is crazy for the stock market to be up by about a factor of 7 in the last 12 years.   The real economy is not doing anything close to that kind of growth.

Next, the idea that government spending fixed the recession last year so it was only 2 months is silly.   Sure they got the "official GNP" back up, but the real economy is still way down.

Graveyard of Empires

 

Biden and others have called Afghanistan the Graveyard of Empires.  There are a number of definitions of "empire" but here we will use:

   Empire:  A government that collects taxes from other countries.

By this definition I believe the USA is an empire, though using a tax very few recognize.   As Keynes put it:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.

After world war 2 the US dollar became the world reserve currency.   Since then Central Banks, businesses, and people all over the world have been using the US dollar and holding US bonds.   As the US prints more dollars, they are really collecting a hidden tax on dollar holders all over the world.   This is a most diabolical tax, as it is so secret and unobserved.   This "inflation tax" has gone on for more than 70 years.

Recently the pace of money printing has increased to trillions per year.   This may be getting to the "evil empire" stage, where there is a tax revolt. 

The fraction of US debt held by foreigners has been dropping recently:

Source:  Fred

If enough people realize that holding dollars makes them subject to this tax, and so decide to no longer use the dollar, we could easily get hyperinflation.

The rest of the world could leave the dollar for something else.  For example, other central banks could use gold as reserves to back their own currencies.  Gold is what was used before the dollar and could work again.  A number of central banks do seem to be buying gold faster recently.   For international settlement, Bitcoin could work.    No doubt such a major change will be chaotic for awhile.  After the change most of the world could be better off, as they would no longer pay the US dollar inflation tax.   However, the USA will be much worse off, as they will no longer collect this huge inflation tax from the rest of the world.

Like other empires that failed after failing in Afghanistan, probably the American Empire is coming to an end.  

 

Devil in the Details

 The low on the S&P 500 in 2009 crash was 666.   If we multiply that by 6.66 and round off just a bit we get 4444.    A factor of 6.66 in 11 years should qualify as "frothy".  Seems like 4444 is a good number for a high. 

Extreme Valuation and Crash Warning Charts

 

They say "no one rings a bell at the market top".   But there are signs that things are higher than normal or getting shaky.  I am collecting links that show charts indicating extreme stock, bond, or real estate valuations or things that often come before crashes.  If you know of other such links that you like, please comment and I will add them to the original post.  Thanks.

1. How to Spot a Bubble, March 2021, Hussman
2. Crescat Capital March Research Letter
3. Shiller PE, gurufocus
4. Buffett Indicator, gurufocus
5. Goldmen Sachs Non-Profitable Technology Index, Robeco 
6. Is the Market Still Overvalued?, Advisor Perspectives, 8/21 
7. CurrentMarketValuation.com 
8. P/E and inflation, Advisor Perspectives, 8/21 
9. 14 Warning Signs That a Stock Market Crash Is Coming, moneycrashers.com 
10. Stock Market Crash, Fragility And Silence, seekingalpha.com 
11. This one signal says a stock market correction may be on the way, marketwatch.com
12. Whole Lotta Love: Sentiment’s Potential Warning, schwab.com 
13.  What Triggered the Crash?, John Hussman, 7/20/21 
14. Alice’s Adventures in Equilibrium, John Hussman, 6/21
15. Grantham:  This is a bubble, this is serious 
16. Warnings about a stock market crash are growing louder, timesnewsexpress.com 
17. These 23 Charts Prove That Stocks Are Heading For A Devastating Crash,  July 2014
18. The Folly of Ruling Out a Collapse, Hussman Aug, 2021
19. Recession Alert! Morgan Stanley, Rabobank, Normura, & BofA Warn Investors a Crash is Coming Aug 25, 2021
20. Four Reasons the Next Recession Will Be Worse Than the Last One 9/10/21 
21. Technically Speaking: The Markets Next “Minsky Moment” 7/27/21 
22. The Beginning Of The End -Alasdair MacLeod 10/11/21
23. When Bubble Meets Trouble - Hussman 11/9/21
    

From the above, I think one of the most important charts is:

 

At the current inflation level we have never had such a high P/E before (yellow box).   If inflation gets higher this P/E will be even more extreme.

Inflation Expectations are Never "Well Anchored"

 

Jerome Powell keeps saying, "inflation expectations are well anchored".   This "well anchored" makes it sound like they can't easily change.

 The reality is people expect inflation about like the current inflation.  As seen in the graph below, if the CPI (green line) goes up, as it has the last 4 months, people's expectations goes up too (blue line).   For Powell to think it it safe to print money because people are not expecting much inflation at this moment is foolish.   People's expectations can change in a month but the "long and variable delays" from policy change to inflation change  can take years.

Inflation can get into positive feedback loops that are very hard or impossible to control.  The central banker needs to take a long term view, because inflation responds so slowly to their policy changes.   It is irresponsible to make decisions about money creation based on a short term and fickle measure like people's expectations.  

The reality is that people's expectations are never "well anchored".  If we get CPI numbers of 6% or 7% then inflation expectations will move to that range also.   Maybe then Powell will stop saying, "inflation expectations are well anchored".