Monday, July 1, 2013

Hussman Weekly Market Comment: All of the Above

The prospect of continued tepid economic growth, if not recession, might be taken as evidence that the Fed will not taper its program of quantitative easing anytime soon. I actually think this inference is incorrect. It’s important to distinguish between two policy responses – one being a reduction in the pace of new purchases of Treasury and agency securities by the Fed, and the other being actual sales to reduce the size of the Fed’s balance sheet. Based on the tight historical relationship between the monetary base (per dollar of nominal GDP) and short-term interest rates, we estimate that the Fed would have to actually reduce its balance sheet by over $400 billion simply to nudge short term interest rates up by 0.25%. This is nowhere in the Fed’s plans, and numerous statements from Fed governors have made that clear. The Fed has no plans – zero – to raise its policy rates in the foreseeable future. Accordingly, material reductions in the size of the Fed’s balance sheet are highly unlikely. Any economic weakness will push off the date of even the first tiny hike in short-term interest rates even further.

On the inflation front, we’ve always argued that the price level is the ratio of two marginal utilities – the extra benefit people get from an additional unit of goods, divided by the extra benefit that people get from an additional unit of money. A unit of money throws off benefits by providing a store of value and a means of payment, and each successive holder gets a tiny bit of that benefit. The marginal utility of an additional unit of money is just the appropriately discounted sum of all of those tiny bits. Inflation actually reflects an increase in the marginal value of goods at a faster rate than the marginal value of money. Creating huge quantities of money when interest rates are near zero and where there is a great deal of economic slack is far less inflationary than creating the same quantity of money when interest rates are high and the economy faces supply constraints.

“Originally forged as a description of central bank actions to prevent financial collapse, the phrase ‘whatever it takes’ has become a rallying cry for central banks to continue their extraordinary actions. But we are past the height of the crisis, and the goal of policy has changed – to return still-sluggish economies to strong and sustainable growth. Can central banks now really do ‘whatever it takes’ to achieve that goal? As each day goes by, it seems less and less likely. Central banks cannot repair the balance sheets of households and financial institutions. Central banks cannot ensure the sustainability of fiscal finances. And, most of all, central banks cannot enact the structural economic and financial reforms needed to return economies to the real growth paths authorities and their publics both want and expect.