Hoisington Quarterly
Review and Outlook, Second Quarter 2017
I have often written about the
Fed’s abysmal track record in managing the economy. In today’s Outside the Box, Lacy Hunt
and Van Hoisington of Hoisington Investment Management give us an in-depth
tutorial on the reasons for the Fed’s consistently poor record.
They start by considering the Fed’s
“dual mandate,” which sets “the goals of maximum employment, stable prices and
moderate long-term interest rates.” (And yes, that is actually three goals, not
two.) But a problem arises, the authors note, “because considerable time
elapses between the implementation of the monetary actions designed to follow
the mandate and when the impact of those actions take effect on broader
business conditions.” The time lag can easily be three years or longer, with
the result that policy changes often end up being pro- rather than
countercyclical. To make matters even worse, “the economic risks from adherence
to this dual mandate are now much greater than historically due to the
economy’s extreme over-indebtedness, poor demographics and a fragile global
economy.”
In the real world, the dual mandate
can break down. Now, the Fed is tightening over concerns about wage pressure
from a low level of unemployment, yet inflation has run consistently below the
Fed’s 2% target for the past year or more. Enter the Phillips curve.
The Phillips curve represents the
relationship between the rate of wage inflation and the unemployment rate.
Proponents of the curve see an inverse relationship between the two, but that,
say Lacy and Van, is a simplistic conclusion. Under both Bernanke and Yellen,
the Fed has come to rely greatly on the Phillips curve – in spite of the fact
that both Volcker and Greenspan panned it. Alan Meltzer, whose multi-volume
series A History of the
Federal Reserve is widely considered to be the definitive study of
the Fed’s operations, said “The Fed’s error was to rely on less reliable models
like the Phillips Curve ... that ignore or severely limit the role of money,
credit, and relative prices.” Meltzer adds, “Year after year, growth and
employment are below forecast. One might hope that repeated forecast errors all
in the same direction would raise doubts about the usefulness of the model or
models and initiate search for a better model. This does not appear to have
happened.”
Over the past few weeks I have
identified a Fed policy error as one of the major potential triggers for the
next recession/bear market. In my conversations with Lacy we talk a lot about
the (oft-realized!) potential for Fed policy mistakes – and I am sure it will
be a hot topic again this year at the annual economics, fishing, and tippling
fest in Maine, coming up in just a few weeks. I simply do not get this fetish
for “quantitative tightening.”
Shane and I will be on yet another
plane tomorrow and then back late Sunday night. Then, after a few days of
meetings, I will begin to make my way to Maine via Philadelphia, where I will
pick up fishing partner Steve Blumenthal of CMG. There are so many old friends
at “Camp Kotok” – I have shared the experience with them for over a decade now.
I normally go with my son Trey, but he can’t get off work, which is responsible
of him but disappointing. Have a great week!
Your wondering how the Fed can keep
using the same models that clearly don’t work analyst,
John Mauldin, Editor
Outside the Box
Hoisington Quarterly
Review and Outlook, Second Quarter 2017
By Dr. Lacy Hunt and Van
Hoisington
The Fed’s Dual Mandate
“Dual mandate” is one of the most
commonly used phrases in U.S. central banking. The current Chair of the Federal
Reserve often mentions it in both speeches and testimony to Congress. Not
surprisingly, this is an extremely hot topic in monetary economics, and
execution of this mandate has profound significance.
The mandate originated in The
Federal Reserve Reform Act of 1977. This legislation identified “the goals of
maximum employment, stable prices and moderate long-term interest rates.”
Ironically, these goals have come to be known as the Fed’s “dual mandate”, even
though there are actually three goals. The manner in which the Fed operates in
following these goals has had and will have dramatic effects on economic
activity. In this report we consider:
- What is the causal link between
the mandate and the Fed’s capacity to act in a counter-cyclical fashion?
- How has the dual mandate
morphed into the Phillips Curve?
- What are the arguments for and
against a Phillips Curve based approach for conducting monetary policy?
- What does empirical research
reveal?
In view of the extreme
over-indebtedness and other adverse initial conditions, what are the immediate
consequences of using a Phillips Curve based dual mandate for the economy, the
Fed and fixed income investors?
Causality
To achieve the goals of this
mandate (maximum employment, stable prices and moderate long-term rates), the
Fed will inevitably tighten for too long and by too much. This occurs because
considerable time elapses between the implementation of the monetary actions
designed to follow the mandate and when the impact of those actions take effect
on broader business conditions. By waiting to recognize a definitive change in
inflation and unemployment, monetary policy changes will be pro-, not
counter-cyclical. The time difference between leading or causative measures
like the money and reserve aggregates, on the one hand, and the economically
lagging series of the unemployment rate and inflation, on the other hand, can
easily be three years or longer.
This difference between the actions
of the Fed and the reactions within the economy explains why the Fed
historically has not begun easing cycles until the economy was either in, or on
the cusp of, a recession. When the Fed takes action, relief is painfully slow
in arriving. Importantly, the economic risks from adherence to this dual
mandate are now much greater than historically due to the economy’s extreme
over-indebtedness, poor demographics and a fragile global economy.
To demonstrate, suppose that in the
fourth quarter of this year, unemployment turns significantly higher while the
inflation rate decelerates from its already subdued pace. The downturn that the
Fed would be witnessing in the fourth quarter could be reflecting policy
actions all the way back to the fourth quarter of 2015 when they initiated the
current tightening cycle. This cumulative evidence is reflected in the monetary
and credit aggregates (Charts 1 and 2). This change in economic fortunes might
cause the Fed to accelerate the rate of growth in the monetary base and lower
the policy rate in order to stimulate money and credit growth. However, the
monetary and credit aggregates might not respond to these first steps until
2019 or even 2020, thus putting the Fed three years or more out of sync with
the needs of the economy, suggesting a prolonged period of severe
underperformance.
Being out of step with the goals of
a counter-cyclical monetary policy will arise as long as the Fed keys its
decision-making on unemployment and inflation, rather than on maintaining
financial stability, which focuses on the reserve, monetary and credit
aggregates. Achieving such stability, however, is now much more difficult for
the Fed than in the past. Until the economy became so heavily indebted, M2 was
a consistent leading economic variable. Now M2 only leads recessions. Until the
debt overhang is corrected (which does not appear to be in the immediate
future), the velocity of money is likely to continue declining. Thus, when the
Fed eases in the future, the strong leading relationship between M2 and the
economy will no longer prevail.
There have always been lags between
the time of a policy shift and evidence of that shift in the broader economy.
However, in a heavily indebted economy, with the velocity of money likely
falling further, and policy rates close to the zero bound, the Fed’s current
capabilities are decidedly asymmetric. Any easing actions taken now would be
far less powerful than the steps taken in the prior tightening cycle. Thus, by
keying off the dual mandate in an economy with a severe debt overhang, the Fed
would be more disadvantaged than normal in trying to come to the quick aid of a
faltering economy.
From the Dual Mandate to
the Phillips Curve
The Federal Reserve Reform Act of
1977 does not spell out the nature of the trade-off between the unemployment
rate and the inflation rate, nor does it say how the Fed should act if the
mandates are at odds in terms of the policy approach.
The potential problems that arise
from this lack of clarity are clearly illustrated by the current situation. The
Fed has extended the current tightening cycle twice this year, with the latest
move on June 14. At the time of the latest decision, headline and core CPI had
year-to-date price increases of 1% and 1.3%, respectively, substantially below
their 2% target. Additionally, the latest twelve-month increases in both of
these inflation gauges were below the 2% target. Only the unemployment rate
warranted more restraint. This means that inflation and unemployment are at
odds, thus the dual mandate is dead. It now boils down to the Fed’s
interpretation of the Phillips Curve.
The most definitive study of the
Fed’s operations is widely considered to be the multi-volume series, A History of the Federal Reserve written
by the late Carnegie Mellon economist Alan Meltzer (1928-2017). Volume I examines the span
from the creation of the Fed in 1913 until the accord with the Treasury in 1951.
Volume II, Book 1 covers
the years from the accord in 1951 until 1969, while Volume II, Book 2 discusses the period from
1970 until the end of the great inflation period in the mid-1980s. In this
scholarly historical examination, Meltzer, on the basis of price and financial
stability, gave the Fed high marks in only one-fourth of its years of
operation. Meltzer made many seminal contributions to economics, including
identifying the algebraic determinants of the money multiplier and outlining
the transmission of monetary policy actions to the real economy.
In his 2014 paper, “Recent Major
Fed Errors and Better Alternatives,” Meltzer summarized the root cause of the
Fed’s policy errors and long record of failed forecasts as follows: “The Fed’s
error was to rely on less reliable models like the Phillips Curve ... that
ignore or severely limit the role of money, credit, and relative prices.” By
focusing on the Phillips Curve, Meltzer contends that the Federal Open Market
Committee (FOMC) overemphasizes information in monthly and quarterly data
periods while giving insufficient attention to persistent trends in money and
credit, which are the very aggregates that the Fed supplies. To paraphrase
Meltzer, by relying on the Phillips Curve, the FOMC avoids developing a
strategic view of their role and the complex world in which they operate. As
the massive credit buildup leading up to 2007 illustrates, the Phillips Curve
mandate also diverts the Fed’s attention from important regulatory matters that
can have extremely consequential and long lasting macro implications.
The key passage that Meltzer writes
to describe the inadequacies of the Phillips Curve/ dual mandate within the Fed
is as follows:
No less an
authority than Paul Volcker explained publicly and to the staff that the
Phillips Curve was unreliable and not useful. As Chair, he gave many talks
about what I have called the anti-Phillips Curve. Volcker claimed repeatedly
that the best way to reduce unemployment was to reduce expected inflation. He
did not use Phillips Curve forecasts. He ran a very successful policy. Alan
Greenspan was less outspoken, but he also rejected Phillips Curve forecasts as
unreliable. Instead of finding a better model, the staff resumed use of
Phillips Curve forecasts. They were again unreliable as should be evident from
the repeated prediction errors ... Year after year, growth and employment are
below forecast. One might hope that repeated forecast errors all in the same
direction would raise doubts about the usefulness of the model or models and
initiate search for a better model. This does not appear to have happened.
In the three years since this
prophetic passage, the string of unbroken economic forecasts continued
unabated.
The Phillips Curve
The Phillips Curve represents the
relationship between the rate of wage inflation and the unemployment rate. In a
1958 study, New Zealand economist A. W. H. (Bill) Phillips (1914-1975) found an
inverse relationship between wage inflation and the unemployment rate in the
United Kingdom from 1861 to 1957. A high unemployment rate correlated with
slowly increasing wages, while a lower unemployment rate correlated with
rapidly rising wages.
According to Phillips, the
reasoning for this finding was that the lower the unemployment rate, the
tighter the labor market, thus firms would raise wages to attract scarce
workers. Conversely, at higher rates of unemployment the pressure on wages
abated. Thus, this curve attempts to capture a cyclical process that can be
used for evaluating the business cycle. This curve presumes the average
relationship between wage demands and the unemployment rate is stable, thus
there is a rate of wage inflation that results if a particular level of
unemployment persists over time. As time has passed, Phillips Curve proponents
have also asserted that a stable relationship exists between the unemployment
rate and the overall rate of inflation, not just that for wages. The original
Phillips Curve shows a downward sloping line on a graph, with wage inflation on
the vertical axis and the unemployment rate on the horizontal axis.
In a 1967 peer-reviewed paper,
Edmund Phelps challenged the theoretical structure of the Philips Curve.
Independently of Phelps, Milton Friedman (1912-2006) in his Presidential
address to the American Economic Association in 1967 (published in 1968) came
to similar conclusions. They reasoned that well-informed rational employers and
workers would pay attention only to real wages (i.e. the inflation adjusted
level of wages). In the view of Friedman and Phelps, real wages would adjust to
make the supply of labor equal to the demand for labor, and the unemployment
rate would then stand at a level uniquely associated with the real wage rate.
In time this uniquely associated real wage rate has come to be called the
“natural rate of unemployment.”
Friedman and Phelps argued that the
government could not permanently trade higher inflation for lower unemployment.
When the natural rate of unemployment prevails, the real wage is constant.
Workers who expect a given rate of inflation insist that wages increase at the
same rate to prevent the erosion of their purchasing power.
Consistent with Friedman and
Phelps, consider the effects of a monetary policy designed to expand economic
activity in an attempt to lower the unemployment rate below its natural rate.
The resulting increase in demand (pricing power) encourages firms to raise
prices faster than workers anticipate. With higher revenues, firms are willing
to employ more workers at the old wage rates and in some cases are willing to
somewhat boost them. With rising wages, workers willingly supply more labor,
which leads to a drop in the unemployment rate. Initially, they do not realize
that their purchasing power has eroded since prices have advanced more rapidly
than expected. In this initial period workers suffer from what is known as a
“money illusion” – the rise in nominal wages is not equal to the rise in real
wages. As workers come to anticipate higher rates of price inflation over time,
they see through the money illusion, and less labor is supplied and demanded.
The real wage is restored to its old level, and the unemployment rate returns
to its natural rate. Today, the opposite case is present. Monetary restraint is
limiting demand and eroding pricing power, causing employers to restrain wages.
Once workers realize this restraint is not a cut in real wages, they will
continue to supply the same amount of labor. The Phillips Curve trade-off does
not exist in either of the two alternative situations.
Phelps and Friedman also
distinguish between these effects over the “short run” and the “long run”.
Phillips Curves only prevail so long as the average rate of wage inflation
remains fairly constant. Only in such a limited time frame will wage inflation
and unemployment be significantly inversely related. Once the higher inflation
is fully incorporated into expectations, unemployment returns to the natural
rate, with the result that the natural rate of unemployment is compatible with
any rate of inflation. These long and short run relationships can be combined
in an “expectations augmented” Phillips Curve. The quicker workers adjust price
expectations to changes in the actual rate of inflation, the quicker the
unemployment rate will return to the natural rate and the less successful the
government will be in reducing unemployment through monetary and fiscal
policies. The expectations augmented Phillips Curve approach is used in and
appears to play a major role in the Federal Reserve’s large-scale econometric
model.
Empirical Evidence
We examined the relationship
between percent changes in real average hourly earnings and the unemployment
rate from 1965 through 2016 – the entire historical record for wages. This
sample is comprised of over 600 monthly observations (Chart 3). The trendline
fitted through the observations does have a slightly negative tilt, but the
line is not statistically different from a straight horizontal line, which
signifies a total lack of responsiveness of real wage changes to the
unemployment rate. The adjusted R2 is 0.04, which is not statistically
significant. Thus, our empirical findings are consistent with the causality
outlined – that the Phillips Curve assumption is not valid. Cherry picking
through the data points can identify limited time periods when a greater
inverse relationship exists between wage increases and the unemployment rate.
As many researchers have pointed out this was true of the 1960s. From the first
half to the second half of the 1960s, nonfarm business sector compensation per
hour (a widely followed measure of labor compensation) increased from 3.6% per
annum to 5.9% as the unemployment rate fell from 5.7% to 3.8%. The critical
point is that these individual episodes of an apparent Phillips Curve trade-off
are too weak and too infrequent to establish an enduring relationship over
time.
The adherents to the Phillips Curve
do not accept these various empirical criticisms. For many decades, they insist
that the poor results are due to the fact that the basic relationship has not
been properly quantified. They point to the problems capturing leads and lags
between the unemployment rate and wage changes as well as difficulties that arise
from measuring expectations and working with aggregate data. For followers of
the Phillips Curve, it is just a matter of time before these issues of
statistical quantification are resolved.
These arguments are not compelling,
yet they have been used repeatedly for at least a half a century. As the years
have passed, the constantly restated Phillips Curve formulations have regularly
missed major business cycle developments, a pattern which has been evident in
the Fed’s record. The Fed presided over the worst U.S. peacetime inflation from
1977 to 1981, and tightened before all of the recessions after 1977. The Fed
did contain the Panic of 2008 with excellent lender of last resort tools, but a
far better result might have been achieved if the Fed had learned the lesson of
the 1920s and prevented the massive buildup of debt prior to 2008 that the
regulatory powers of the Fed were designed to prevent.
For most of the past eight years,
the frequently restated Phillips Curve models have pointed to a sustained acceleration
in wage and price inflation that has failed to materialize. These failures not
only impair monetary policy but also portfolio decisions based on the presumed
efficacy of the Phillips Curve and the reliability of the dual mandate. Based
on the slowdown in the monetary and credit aggregates, and the continuing fall
in the velocity of money, the rate of inflation is more likely to moderate
rather than accelerate, even as the unemployment rate in May 2017 stood at a
sixteen year low. Thus, inflation, on average, moved lower during this current
expansion, contradicting the forecasts for higher inflation based on the
Phillips Curve concept. the velocity of money, the rate of inflation is more
likely to moderate rather than accelerate, even as the unemployment rate in May
2017 stood at a sixteen year low. Thus, inflation, on average, moved lower
during this current expansion, contradicting the forecasts for higher inflation
based on the Phillips Curve concept.
Implications
For the Fed, the more advisable approach
would be to pull the Phillips Curve relationships from their model and their
policy decisions. Instead, they should rely on capturing the strategic role of
the monetary transmission mechanism and its potentiality for moving through the
reserve, monetary and credit aggregates in a highly leveraged economy. If the
Phillips Curve proponents are right, and the quantification efforts are
eventually proved to be valid, then at that point they can be inserted into the
Fed’s model as well as into their subjective decision-making process.
This is relevant to investors as
well. If adherence to the dual mandate induces financial insatiability, then
investor performance, like overall economic activity, will be directly
influenced. If the Fed’s mandate consistently leads them in the wrong
direction, then long-term investors may often be forced to construct portfolios
that are contradictory to the error-prone words, forecasts and policy actions
of the FOMC. Moreover, investors should expect that the Fed’s actions will
create substantially more volatility in the financial markets and particularly
so over the short-term. Operating with strategic views and multi-year trends,
rather than trying to focus on the Fed-generated noise in many monthly and
quarterly indicators, may be a preferred method of generating investor returns.
Our economic view for 2017 is
unchanged and continues to suggest that long-term Treasury bond yields will
work irregularly lower. The latest trends in the reserve, monetary and credit
aggregates along with the velocity of money point to 2% nominal GDP growth for
the full year, down from 3% in 2016. This would be the third consecutive year
of decelerating nominal GDP growth and the lowest since the Great Recession.
This suggests that the secular low in bond yields remains well in the future.
Van R. Hoisington
Lacy H. Hunt, Ph.D.
Lacy H. Hunt, Ph.D.
0 comments:
Publicar un comentario