Terminal Velocity “Stimulating Taper” suggested that the “Taper Talk” was an oxymoron. The consensus, held by the majority of observers, is that the “Taper” represents a tightening of monetary policy; or rather less easing. The “Stimulating Taper” explained the monetary stimulus effect; involving the repatriation of QE funds, which had leaked out of the American financial system into the global financial system.
The impact of the “Taper” is therefore the belated monetary stimulus from QE, four years after its inception. The first beneficiaries of this capital repatriation will be American financial assets. It was theorised that US Treasuries will be the first port of call; based on the flight to quality hypothesis out of global risk assets such as Emerging Markets. This will satisfy the Fed’s assertion that the back-up in US interest rates is higher than the economic fundamentals, especially inflation, currently justify.
The back-up in interest rates will also have ensured that the pace of economic growth will have slowed sufficiently to support the case for falling interest rates going forward. The slowdown of the housing market in particular is a visible sign that interest rates are currently too high. The Fed is judged to have “Tapered to Perfection”,i by creating the conditions precedent for further monetary easing. The Fed was however deemed to be walking a precarious line, in “Goldilocks Economy and the Three Bear Markets”;ii because QE to date has pulled forward economic growth from the future, so that the point has now been reached at which the lack of further growth has just arrived in real time.
To recap therefore, the Fed has now reached the point at which there is no further growth; which necessitates more QE. This next quantitative easing will involve the repatriation of the QE, which has leaked out of the American financial system hunting for yield and growth opportunities globally. The “Taper Talk” has arrested these global opportunities and caused the repatriation of said QE. Said QE is unlikely to find growth opportunities in America, because the “Taper Talk” has choked them off. Said QE can therefore create more bubbles in financial assets such as US Treasuries and US Equities. The risk is that said QE leaks into the real economy, where the supply of goods and services has been cut-back through recession, to create inflation. The Doves in the Fed would like to see the creation of some domestic inflation; and the Hawks see all this repatriated QE creating hyperinflation.
The August Import-Export Data evinced the first signals of this stimulatory “Taper” impact hitting the real economy. It did not move the inflation needle far enough to satisfy the Doves or to embolden the Hawks however.
August US Import-Export Price Data
It is clear that the terms of American trade have been reversed.iii
January US Import-Export Price Data
Pre-“Taper”, America was importing global deflation and re-exporting inflation in a virtuous circle, which strengthened the relative position of the American economy.iv The August data signals that these terms of trade have been reversed. America now imports global inflation (such as it is) and re-exports deflation. This can be explained in terms of repatriation of QE. The return of QE to America has created domestic liquidity conditions that support price increases.
The lack of QE in the global economy means that America has no global pricing power. Ultimately, global deflation will work its way back to American domestic prices. At this point the pricing power of foreign exporters into the American economy will also get hit. The iron hand of global deflation ultimately crushes all; and in doing so calls out for the creation of more US Dollars by fiat to restart the global trading system. The Emerging Markets, despite their previous militant rejection of US Dollar hegemony and America’s “undeserved” privilege of money printing, are now begging for some good old fashioned American liquidity and consumption.
For the Hawks, the current rise in American inflation is a cause for alarm that requires higher interest rates. Rising interest rates will however suck more capital back into America and create even more domestic inflation. The Hawks are following the Volcker model of inflation fighting; so that inflation and interest rates will rise together and destroy the American economy as they did in the late 1970’s and early 1980’s. Volcker was praised, but his tactics were crude and unenlightened. Rather than letting inflation run its course and slow economic activity, he made it worse by raising interest rates and sucking more liquidity into an American economy which was already decaying and therefore producing less goods and services. Volcker thus made the pricing power of the remaining domestic producers (along with the OPEC) stronger; which they exploited to maintain their margins in the face of dwindling output volumes.
No-one dares to challenge the tactics and legacy of Volcker for some reason; which is ironic since he contributed as much as any recession to the hollowing out of American industrial capacity. To be fair, one could say that he simply accelerated the eventual decline; and therefore speeded up the recovery. The cost, to American productive capacity, relegated the nation to one that flips hot assets, houses and burgers.
The Hawks are clearly wearing “Volcker Rims”; since they believe that the returning QE will create the inflation that necessitates his policies. This time around however, the returning QE has domestic capital markets alternatives to the real economy to flow into. The potential rise in domestic inflation is therefore much lower than it was in the Volcker days. The potential for bubbles in financial assets and the problems they create are however much larger. This is why the Fed intends to maintain an expanded balance sheet; as a reservoir to regulate the liquidity in various financial asset classes to avoid these bubble risks. The expanded balance sheet is also the liquidity reservoir where real price inflation can be stored up and leaked out into the economy over time.
The first order of business for the Fed is to get the returning QE locked up in financial assets, which it can regulate through its expanded balance sheet. This process involves the diversion of this QE from the real economy to the capital markets. Real economic growth will therefore be slow; creating the demands for more QE. At this point we suspect that the Fed may be entertaining the notions of controlled “Helicopter Money”, as suggested by Michael Woodford v and Adair Turner, directly injected into the bank accounts of targeted economic strata in the American polity which correspond to the Obama Administration’s taxonomy of the Middle Class.
The evolution of Fed actions depends greatly upon the behaviour of the dysfunctional elected officials. Partisanship and the lack of consensus growth policies are the greatest headwind now facing the domestic economy. In the continued absence of pro-growth policies, the only driving force is the Fed’s balance sheet. If the Congress fails again, the Fed will be forced into action. At this point the “Helicopter” may have its inaugural flight. At this point, it is also likely that the Fed will have a new Chairman in the cockpit.
The majority of the academic economics cohort, within North America, has voted for Janet Yellen and she has been nominated. Larry Summers was framed as all that is bad, in the nexus of Wall Street and the Executive, which led to the last crisis. Observers need to be a little more perspicacious and a little less “partisan” themselves. Going into the last crisis, Larry Summers’ hands were not on the wheel. He may have set out the cones and waypoints back in 1998, but the greatest of all crashes in 2008 did not occur on his executive watch.
It did however occur on Janet Yellen’s watch, although to be fair she was not Vice Chair at the time. She is however guilty by association. The pro-Summers camp just started to focus on the perspicacity of Larry during the crisis of 2008 before he withdrew from consideration. His prescriptive analysis at the time has been reprised recently; and found to be absolutely apposite.vi He was right on the money, because he was part of “The Team that Saved the World”; and created the system that led to the crisis of 2008. He may not have known when the music would stop; but he certainly knows what the new tune is, because he wrote the words for it back in 1998.
Yellen by comparison, did not become a serious convert to ultra-easy monetary policy until Jackson Hole 2012 at the earliest; when she jumped on the Michael Woodford bandwagon. It was not until a full year later in April 2013, when she finally vocally espoused the notion of Michael Woodford that guidance should be followed up with commitment to act.vii Yellen was therefore at least four years behind Summers in terms of response time; which is an eternity in policy making terms. Summers wins this game of “Musical Fed Chairs”; because he was not in a Fed chair when the music stopped last time. He also wins because Yellen is an anachronism in policy terms. Ben Bernanke’s “Deep Throat”, aka John Hilsenrath, also seemed to have jumped on the Summers’ bandwagon before the end; no doubt in order to maintain his journalistic edge on his peers. But Yellen now has the nomination.
“Uncle Paul now Rules!!!”
Mr Hilsenrath was busy building the legend of Chairman Summers; the “humble” scion of an illustrious economics dynasty led by the noted Keynesian Paul Samuelson (“Uncle Paul”) viii. No doubt Mr Hilsenrath chose his words and parables carefully; hoping to ingratiate himself and position for privileged access going forward. But Yellen now has been nominated.
Summers also had one other fundamental point going for him. The economic scenario developing right now in the global economy closely resembles that which existed when he, Greenspan and Rubin saved the World back in 1998. They may have created the Dot.com bubble in the process, but that’s another story. Right now, as Emerging Markets implode and threaten global growth again, cometh the hour cometh the man. But Yellen has the nomination.