MONETARY POLICY & OUTLOOK
The Federal Reserve recently made a formal announcement that it intended to hold short term interest rates at their current low levels until late 2014. Investors should treat that forecast with suspicion. Interest rate policy by the Federal Reserve has historically been reactive, not proactive. The Fed Funds rate, which is the overnight inter-bank lending rate targeted by the Fed, has tended to follow changes in nominal GDP growth (see Chart 1). Nominal GDP is actual, unadjusted, current dollar spending. After turning negative during recent recession, nominal GDP growth in recent quarters has been moderately positive. If it remains similarly positive through the end of this year, or especially if it accelerates, we would expect the Fed to start gradually raising interest rates well before 2014. However, this is not a sure thing and some review of the history can be helpful.
In the 1960’s and 1970’s, nominal spending growth and inflation both trended upward as a result of a Fed policy to keep interest rates low. Because interest rates were kept below growth rates, it made sense for people to borrow money since the cost of money was less than the nominal returns which were used to pay the loans back. But because real growth is linked to real factors like population growth, entrepreneurial activity and changes in technology, increases in nominal spending translated into inflation rather than increased real production. The upward spiral in spending and inflation eventually got to the point where policy makers were willing to accept the monetary medicine needed to control inflation. Fed Chairman Paul Volker took the Fed Funds rate up to a peak of more than 19% in mid-1981, which was well above the 14% yearover- year growth rate of nominal spending. By inverting the relationship between spending growth and interest rates, with interest rates now on top, Volker began the long multi-decade period of declining rates of spending growth and disinflation—the opposite trend of the 1960s and 1970s.
In 2009 the disinflationary trend that began in 1980 reached a climax when nominal spending growth turned negative (again see Chart 1) and the consumer price index reached a low of negative 2.0% on a year-over-year basis. After that short experience with contraction and deflation, Bernanke’s Fed, reversed Paul Volker’s actions by now holding the Fed Funds rate below the rate of nominal spending growth. The Fed Funds rate is now targeted at approximately zero while nominal GDP recently has grown at a positive 3.7% rate. Bernanke is not the first Fed Chairman to reverse Volker. The Fed under former Chairman Greenspan reacted to the bursting of the tech bubble in 2000 with a similarly loose monetary policy. We can see this by subtracting the Fed Funds rate from the growth rate of nominal GDP (see Chart 2). This gives us a measure of whether monetary policy is expansionary (a positive number), as it was in most of the 1960s and 1970s, or contractionary (a negative number), as it was during much of the time since Volker.
Bernanke is keeping the Fed Funds rate at zero, despite the recent growth in spending, because of concern that an exogenous event, like the default on debt of a sovereign nation, could cause people to react in fear and that spending would decline again. However, as we pointed out at the start, the Fed ultimately is reactive, and sometimes only adjusts interest rates after a couple years of signals from the spending side. Nominal growth has been positive for two years already. Furthermore, it seems unlikely to us that we will see spending decline again as it did in 2009. More likely, spending will move along at a moderate pace of 2% - 5%. And the longer such moderate growth goes on, more pressure will build on the Fed to normalize rates by increasing the Fed Funds rate to a level closer to spending growth.
We expect spending to stay positive because of all the money now out there. Nominal spending is determined by the supply of money as well as how much money people want to hold (demand) for cautionary purposes. In that context, please note that the M2 money supply was up 9.6% year-over-year as of the end of 2011. Secondly, note in Chart 3 that M2 has risen to the highest level as a percent of GDP that we have seen from our dataset. In the 1990s, money demanded fell sharply after the fall of the Soviet Union and the advent of the Internet. People felt good and didn’t worry about building cash balances. Today, it’s the opposite. It’s always possible that people will want to accumulate even larger cash balances, but we are already reaching extreme levels of money accumulation. Also, the Fed is clearly willing to accommodate rising money demand, as evidenced by the fast growth in M2. So the best bet, we think, is that money accumulation is coming to an end and that it will increasingly begin to circulate: spending growth should stay positive and interest rates are likely rise sooner than 2014.
The current Fed policy is very positive for equities—at least in the medium term. The economy is growing--albeit at a moderate 2.8% annualize pace in the last quarter, and inflation is low. With interest rates near zero, the Fed is giving investors very little reason to hold bank balances or fixed income securities. The only thing holding money back from flowing heavily into equities is the fear of losses. People are still in shock from 2008-9. But as the money supply grows as it has, some of it is bound to splash over the edges of the banks into the stock market. Higher stock prices, in turn, make people feel wealthier, more confident and willing to spend. We think this mechanism is in play now. We are maintaining a healthy cash balance ourselves, thanks to the continued risk of that exogenous shock, but we would use any significant declines in stock prices as a buying opportunity. And in the meantime, we look to gradually accumulate good companies with beaten down valuations. A few years out, it will be important for the Fed to reduce liquidity to prevent inflation from returning, but that problem is likely out past the horizon. For now, Fed policy is good for equities.
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