Easy Money

Earlier this week, after hearing and reading a variety of pundits opine about when the Fed will raise rates, I wrote a draft of a piece that remarked that (IMHO) long before the Fed decides to raise the much-watched and oft-discussed Fed Funds Rate they will likely begin shrinking their balance sheet, which exploded last fall from $900 billion or so (which had been remarkably steady for many many months) to over $2.2 trillion in a matter of two months. While I still think that will be the case, the Fed’s statement yesterday makes it very clear that the Fed has no intention of doing any of this any time soon. They plan to keep buying securities (mainly debt securities such as Agency bonds) and keep interest rates low, low, low.

Also yesterday there was an article in the WSJ titled “Fears of a New Bubble as Cash Pours In.” The title pretty much tells it all, but here is one example: “Asian stock prices are shooting up, in part due to low interest rates in the U.S. Investors looking for higher yields are borrowing in U.S. dollars and then pouring that money ‘into countries that are growing more rapidly,’ said Stephen Cecchetti, chief economist at the Bank for International Settlements, the central banks' central bank, which warned early of the last asset bubble and is beginning to do so again.”

Judging from both the WSJ article and the Fed’s policy statement it appears that policy makers can’t connect these dots, so I will state the obvious. Since the mid-1990’s, central banks around the world (led by our own Federal Reserve) have followed the decades-old dogma that as long as inflation is subdued they can keep interest rates very low to drive economic growth. The problem is that they look at CPI and PPI as the only measures of inflation. Modern economic theory was developed during a time when excess liquidity flowed into the hands of producers and consumers who bought intermediate and consumer goods with the excess money and drove up prices, creating inflation in the PPI and CPI. When the central banks saw this inflation, they knew it was time to tighten monetary policy. But it doesn’t work that way any more.

Since the mid-1990’s, the excess liquidity still flowed into the hands of producers and consumers, but they no longer used it to buy products as measured in the PPI and the CPI. Instead, they invested in assets – stocks (late 90’s), real estate (early-mid 2000’s), oil and gas (mid-late 2000’s), treasury bonds (last year), or gold (now) – or they just leave cash on the corporate balance sheet. Part of the switch from products to assets has been due to the baby boomers planning for their upcoming retirement, while part has been due to competition from low-cost foreign producers (China) keeping product prices so low that it both prohibits domestic producers from raising prices and also disincents them from making more products. As a result, there has been massive investment in and inflation of assets, but the Fed doesn’t consider that “inflation” because the CPI and PPI only reflect product inflation, not asset inflation. Therefore, the Fed and the other central banks around the world will continue to keep rates low and monetary policy loose for the foreseeable future.

But eventually that will change, and one of two things will happen. One possibility is that the Fed and other central banks wise-up at some point and tighten monetary policy. This would likely deflate all sorts of bubbles, from gold to Asian real estate, and would also adversely affect less “bubbly” assets like stocks and domestic real estate. In the long run this would be healthy, because it would finally ring the excess leverage out of the system (that almost happened a year ago, but the Fed was so effective at reflating that it never really happened).

The other possibility is that the Fed continues to let excess liquidity feed these various asset bubbles. Many people predict that this will lead to horrible inflation, and that is probably true for a while at least, but asset bubbles typically eventually end differently. Usually they end by deflating quickly and violently in a somewhat deflationary manner. Perhaps the bond market will (finally) start demanding higher yields, forcing interest rates up in spite of the Fed’s free-money policy, or perhaps some other event will have the effect of yelling “fire” in the crowded theater. But I would expect that one way or another, after perhaps a period of bad inflation, we will still end up (eventually) back with a deflationary contraction that sends almost all asset prices downward.

This makes for an incredibly difficult investment environment. On the one hand, we could see another “bust” next year, while on the other we could have an inflationary easy-money party for many years before the bust. When the inevitable deflationary contraction finally comes then the clear winner for investment portfolios will be Treasuries, but if you buy them today you risk getting killed by several years of easy-money inflation that erodes their value. If instead you plan for inflation by buying risk assets set to capitalize on easy money, then that will backfire badly if the Fed wakes up and tightens any time soon. And if you are looking to me (or anyone else) for the magic answer then you will be disappointed. As I have said before, the best we can do is to know that we don’t know, which in this case means try and plan for both.