Federal Reserve On Road to Vanishing Point?

Vanishing Point - In art, the point on the horizon line at which 

any two or more parallel lines seem to meet.

For this article, the space between the two lines represents the road of Quantitative Easing with price stability, the space to the left - deflation, and the space to the right - inflation. The longer the Federal reserve extends QE into the future, the harder it becomes to maintain price stability, ultimately proving unsustainable at the vanishing point. Our position remains fixed as we watch the Fed drive down the road.

In summary, price stability appears right in the middle of the road, and thus a primary reason why the stock markets have performed well, in my view. The risk is that the road is narrowing and the Federal Reserve's steering is becoming looser.

Deflationary - Commodities, Wage-Price

Neutral - Currency, Fiat, Good and Services

Inflationary -  Financial Assets, Tangible Assets

In this entry I again borrow the framework developed by A. Gary Schilling on inflation to breakdown the trends and hopefully glean a bit more insight into the future. His framework breaks down inflationary/ deflationary pressures into seven areas, which are commodity, wage-price, financial assets, tangible assets, currency, fiat, and goods and services.

Commodity - Deflationary

Wage-Price - Deflationary, but Possibly Recovering
If income growth is flat-to-down, then the only way demand for goods and services can increase is if either debt levels go up (savings go down), or prices go down. Not surprisingly, the radio station WBUR highlighted that breaks in income streams has increasingly contributed to greater financial difficulty amongst consumers.

Indeed, total consumer credit has steadily increased over the past couple years. The main driver of the growth in consumer credit is non-revolving credit, for credit for categories like automobiles, education. As total credit per capita increases, and income remains stagnant, the purchasing power of the consumer declines unless interest rates continue to decline. Alternatively, for a period of time consumption can continue if asset prices are increasing, enabling cash infusions from rising equity in homes and other assets. While debt continues to rise, I believe we are nearing the end game of both falling interest rates and rising home equity.

Financial Assets - Inflationary

Tangible Assets - Inflationary
House prices have been rising, and expectations about the rate of growth have been rising over the six months. This rise in expectations is likely the direct result of the Federal reserve purchasing mortgage-backed securities, pushing mortgage rates lower. Lower rates mean a person can afford to pay more for a house with the same income level. If banks loosen lending standards then the trend in housing prices may accelerate higher as another housing bubble is inflated. 

If major banks like Bank of America begin to aggressively go after new lending business then this category may provide a major inflationary force in the economy as banks draw down reserves in order to make loans, increasing the money multiplier and thus the amount of money in circulation.

Currency - Neutral
The US dollar continues to hold up fairly well relative to most other major currencies. This resilience is largely due to the aggressive monetary policies by most foreign central banks, although there is some puzzlement. In addition, the large reserves held by banks has so far reduced the multiplier effect, and thus the actual amount of money in circulation is not nearly as high as the potential. The potential inflationary force of a weaker dollar is likely held in check so long as the US dollar holds its value relative to other major currencies and banks remain conservative with their reserves.

Fiat - Uncertain, but Leaning Deflationary
How the debate about the overall role of government plays out likely determines whether this swings inflationary or deflationary. If the gridlock has accomplished anything, it has allowed the status quo to remain in place, neither applying further inflationary pressures through growing deficits nor swinging to deflationary pressures through austerity measures.

Clearly the Republicans prefer the road of austerity through reduced spending, although have accepted limited tax increases to avoid the "fiscal cliff." As we have seen in Europe, this path likely causes an economic slowdown in the near-term with deflationary forces. The Democrats don't want to cut spending and seem a little more accepting of deficit spending in order to spur economic growth, although higher taxes are clearly a part of their argument.

Across the Pacific is Japan, which has pursued endless rounds of stimulus to drive economic growth, only to pile national debt up to 2.5x GDP. Japan has been described as "a fly looking for a windshield," splat is only a matter of time with an aging population and mounting debt. Across the Atlantic is Europe, which has been taking its medicine through more austere measures and seen GDP growth fall. So long as the social and political structures remain in place, Europe should emerge stronger in the long run after a painful retrenchment.

If the "grand bargain" becomes additional higher taxes coupled with lower spending, then this segment swings definitively deflationary. If spending is not cut, and even increased to stimulate the economy, then this segment applies inflationary forces to the economy. More than likely, since the deficit has been trending down, the government agrees on moderate spending cuts. Simply reducing the spending on the war effort should be considered deflationary. Of course, Congress may not increase the debt ceiling and federal spending in indiscriminately and severely cut.

Goods and Services - Neutral
The combination of flat income and rising non-revolving debt balances leaves weaker consumer spending on items typically purchased with credit cards, either discretionary or non-discretionary. It is possible that more aggressive mortgage lending practices by banks may enable home prices to rise, thus providing home owners with larger equity balances with which to spend on goods and services. However, I fear that driver would only lead to another economic shock as US consumers are already tapping 401k balances to pay monthly bills.

Has the supply of retail declined, thus enabling a rise in prices due to lessening competition? The answer is simply "no." If anything, the American consumer remains over-supplied with stores, as highlighted by the recent weakness in retail REITs focused on strip malls. This over-supply of retail outlets reduces pricing power amongst retailers and provides a deflationary force to the economy. Lower mortgage payments through re-financing and tepid economic growth have so far kept the supply-demand dynamics in balance.

AIER's EPI - Everyday Price Index

Source: https://www.aier.org/epi

Forget Fiscal Cliff! Can the Economy Grow in Five Years Without Government Stimulus?

I don't know about you, but the hysteria about the fiscal cliff is beginning to really rub me raw. It is not so much the politicians doing their dance. It is instead the distraction from the larger fundamental question of: "What is right for the long-term health of the economy?"

After a big step back, let's consider what deficit spending has meant to the economy.

% of GDP	2000	2012
Total Government Receipts	20.6%	15.8%
Total Government Outlays	18.2%	24.3%

The amount of taxes paid, as a percentage of GDP, has declined almost 5% of GDP to 15.8%. In other words, instead of paying money to the government, individuals have been purchasing goods and services, a stimulant for the economy. Secondly, government outlays have increased over 6% of GDP to 24.3%. A significant stimulant to the economy has been higher government spending, especially in the area of healthcare.

One can argue that these figures suggest more stimulus is needed in order to avoid an economic slowdown. Indeed, there are economists on the left-side of the spectrum advocating up to $2 trillion of additional stimulus spending in order to grow the "denominator," or GDP. The basis of the argument is that cutting the government deficit produces a 1-to-1 reduction in the private surplus, hurting the economy as witnessed in Europe under austerity measures. Yes, we are talking defined formulas for calculating GDP. Also, intuitively it makes sense that slowing government spending or raising taxes will be a drag on the economy, just as the opposite was true during the last decade.

Source: New Economic Perspectives

However, this raises the philosophical question of whether the government should be the main driver of economic growth for an extended period of time. The government can obviously drive growth, but when pursued for a decade how does this type of growth driver pervert private economic activity? President Obama has maintained budget deficits in excess of 7% of GDP during his term in office. While this has helped avoid a more catastrophic depression, I fear it is also increasing systemic risk as companies increasingly rely on both government spending and lower income and capital gains taxes, either directly or indirectly.

Where I respectively disagree is sustainability of these policies. Economists advocating stimulus spending generally argue that by growing GDP through deficits, the economy can reach a self-perpetuating growth rate, at which point the government can remove stimulus spending and on-going growth can then pay down the debt. Based on this theory, you would think after 4 years of historically high deficits the economy would have performed better. In fact, the only period in the last 10 years of fiscal stimulus that has approached "normal" economic activity was the result of an inflating housing bubble that proved short lived. I suppose an ever increasing deficit and increasingly aggressive monetary policy can keep the economy growing, but there may be a diminishing impact on GDP growth as inefficiencies in the economy are allowed to remain.

The budget deficit as a percentage of GDP has been 10.1%, 9.0%, 8.7% and 7.0% for 2009 through 2012, respectively.  To put this in perspective, the largest budget deficits since WWII were a little over 5%, which only happened twice. In 2013, the budget deficit is forecast between 5.5% to 6.0%.

Again, let's review some numbers:

• US Debt Held by Public - $11.5 trillion (~ 75% of GDP)
• US Debt Outstanding - $16.3 trillion (Greater than 100% of GDP)
• Estimated US Debt Outstanding 2016 - $22.8 trillion (~ 150% of GDP)
• Total Liabilities of US Government (Soc Sec, Medicare, Govt pensions) - $86.8 trillion (550% of GDP)

Here is a measure Debt/GDP from other countries:

• Spain - 85%
• Greece - 175%
• UK - 75%
• Italy - 126%
• France - 90%
• Japan - 235%

Why does the US benefit from ultra-low interest rates while other countries with a slightly higher debt-to-GDP have interest rates spike upwards? One of the main reason, in my opinion, is because of the Fed's bond buying. However, the size and strength of the US economy, a focus mostly on public debt, falling debt service payments, and the view of the dollar as a safe currency play important roles. But, the disparity in interest rates has caused some head-scratching. I believe my Sagflation theory helps to explain this issue through the combination of fundamental deflationary forces offset by expansionary monetary policies, both of which are pushing interest rates lower. 

So debt levels have been rising. At what level does the bond market pull back from US debt is very much debatable. I will leave it by stating the obvious, the higher the leverage ratio the less forgiving is the bond market if the economy slows. Stimulative policies that raise the leverage ratio increase the risk of interest rates spiking should the economy slow before the debt can be reduced.

Why I Continue to Remain Bearish

Returning to two points made previously, and adding one more. Since 2000, the following has happened in the economy:

1. Taxes paid, as a percentage of GDP, has declined almost 5% of GDP to 15.8%. 
2. Government outlays have increased over 6% of GDP to 24.3%.
3. Interest rates on 10-Year Treasuries from around 6% to about 1.5%.

The lower taxes have added a general stimulus to the economy, enabling individuals to purchase more products and services because of a higher after-tax income. Given the current battle in Congress it appears as though taxes paid may go up, either through higher rates or lower deductions. Either way, this stimulant is about to reverse and become a drag as after-tax income declines. Luxury sales are likely to soften as taxes on incomes over $1 million potentially go up.

The larger government outlays as a percentage of GDP have driven growth rates above what is naturally sustainable in segments like defense and construction; and has enabled a woefully inefficient healthcare industry rife with fraud and over-billing. The growth rates in these industries likely moderate, although healthcare may prove more resilient given the changes to the healthcare laws.

The falling interest rates have added significant stimulus to the economy, especially in industries requiring debt financing like housing and autos. Not surprisingly, both the housing market and auto industry has enjoyed a lift as the Fed aggressively purchases treasuries and mortgage-backed securities.

The critical question, in my mind, and the one everyone is fighting over is this:

Is the economy structurally efficient for the long-term?

Hard to answer this question, but I think the fundamental deflationary forces, shadowed by excessive bank reserves, hint at over-supply and poor returns in many industries. Structurally the tax code is inefficient and this constant whining from business leaders about "uncertainty" in Washington hints of businesses too closely tied to the government and its policies.  Finally, the rising amount of poorly written regulation as the government reacts to crises is likely having a cooling effect on the economy.

Mr. Bernanke can keep the growth engine bouncing along as the Fed's balance sheet now exceeds $3 trillion, and in many ways he is doing what is necessary to avoid a deflationary death spiral. But, until the government enables the economy to become more efficient I believe we are doomed to Stagflation.


So while the federal government pursues stimulative measures the markets likely respond favorably. These policies could continue throughout President Obama's term in office. However, the exit of these policies becomes riskier as the debt balance rises and the Federal Reserve's balance sheet inflates. For a fundamental analyst, it is tough to swallow any company-specific analysis when the foundation of the economy seems softer and riskier than ever before.