The Photocopier Remains On

As the WSJ's trusty FOMC statement tracker reveals, the FOMC statements was once again almost an exact copy of the previous statement. As a result, there was nothing to surprise market participants, and the reaction to the statement was accordingly a big yawn. A quick overview over the changes (the old text is in brackets)

“Information received since the Federal Open Market Committee met in (March) April indicates that growth in economic activity has (picked up recently, after having slowed sharply during the winter in part because of adverse weather condition) rebounded in recent months. Labor market indicators (were mixed but on balance) generally showed further improvement. The unemployment rate, though lower, remains elevated. Household spending appears to be rising (more quickly) moderately and business fixed investment (edged down) resumed its advance, while the recovery in the housing sector remained slow.”

That's it. Nothing else was changed (with he exception of the announcement of further 'tapering'). Not that there was any reason to change anything, after all, the economic recovery remains as tepid as before, which is a direct result of the Fed's interventionism and massive money printing over recent years.

Obviously, suppressing interest rates and printing money cannot create any wealth. All it can achieve is a reverse redistribution of wealth from later to earlier receivers of the new money, as well as exchanges of nothing (money created ex nihilo) for something (real resources), which leads to the misallocation of capital and represents an obstacle to all those engaged in genuine wealth creation. Moreover, the liquidation of capital malinvestment from the previous boom was arrested prematurely, and these old misallocations are now augmented by new, additional ones. This can for a time give the impression of a resumption of growth, as aggregate economic data reflect an increase in “economic activity”, but a great part of this activity in fact results in capital consumption, as economic calculation has been distorted by the manipulation of interest rates.

Taper, Taper …

In that sense, the only other change in the FOMC statement must be welcomed – with certain reservations as you will see further below – as  QE will be reduced further:

“Beginning in (May) July, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $15 billion per month rather than $20 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $20 billion per month rather than $25 billion per month.”

Thus the direct injection of new money into the economy by the Fed (note that 'QE' by the Fed not only creates bank reserves, but concurrently creates new deposit money to the same extent, as the primary dealers are legally non-bank subsidiaries of banks) will decrease from $45 billion per month to $35 billion per month. A the moment, this makes however little difference to the pace of monetary inflation in the economy, because inflationary lending by the commercial banking system has resumed in parallel with the Fed's 'QE tapering'.

We have already reported on this phenomenon in early March (see: “An Overview of Recent Monetary Trends” for details). As we noted at the time, it was not yet certain in March whether the trend of bank credit creation increasing in parallel with QE tapering would continue:

“The most recent data show that the true broad US money supply has by now expanded to almost $10 trillion, with the year-on-year growth rate ticking up again slightly in January, but still remaining below the y/y growth rate recorded a quarter ago and a year ago. In short, the downtrend in the rate of growth in evidence since the end of 'QE2' has not really been interrupted. That may change if commercial banks increase their lending at a faster pace than the Fed reduces its securities purchases.  While bank lending growth has indeed picked up since the 'taper' announcement, it is too early to come to conclusions about it, as it is a fairly recent phenomenon that may yet be reversed.”

As it turns out, it hasn't been reversed just yet. Below you can see the year-on-year growth rate in commercial bank credit, as well as total bank credit outstanding (in billions) – naturally, outstanding credit is at a new all time high, as the 2008 'deleveraging' episode was in hindsight little more that a brief intermezzo in the system's tendency to incessantly increase the debt mountain's size.

Year-on-year growth in commercial bank credit - click to enlarge.

Commercial bank credit, total in USD billions. A new all time high has been attained, and growth in credit creation has recently accelerated – click to enlarge.

Apparently, what our vaunted central planners really mean when they talk about a “self-sustaining economic recovery” is a “self-sustaining resumption of the credit bubble”.

Interestingly, the gold market has rallied on news of the continuation of 'tapering', and as we have remarked previously, we believe this is due to the gold market exhibiting an extreme lead time in discounting future economic developments as well as the monetary policy decisions they will eventually provoke (whereas the stock market has become a coincident or sometimes even slightly lagging indicator of the economy).

What the market in our opinion sees, is that sooner or later, 'tapering' will lead to a crash or at least a mini-crash in the asset price bubbles currently underway, whereupon the central bank will either resume 'QE', or implement some other monetary pumping measures by way of experiment.

However, the current tapering exercise is certainly likely to continue for now. As Jim Rickards recently pointed out to us, the Fed's board of governors currently has three open seats, so the voices of the more hawkish regional Fed presidents like e.g. Richard Fisher and Richard Plosser currently carry a little bit more weight in the FOMC. Fisher and Plosser have both been adamant that 'tapering' must continue. A decline in the stock market would certainly not sway Fisher either, but we believe that if a very large decline were to eventuate at some point, it would definitely sway a great many other FOMC members.

Mainstream Commentary

Lastly, Jon Hilsenrath at the WSJ, the Fed's preferred media mouthpiece, has also commented on the decision. Here are a few excerpts:

“In a statement released after the Fed's latest two-day policy meeting and a news conference by Chairwoman Janet Yellen, the central bank underlined the economy's rebound in the past few weeks after output shrank in the first quarter.

That contraction forced officials—as part of their quarterly projections for growth, employment, inflation and interest rates—to sharply lower their expectations for growth this year. But they stuck to an optimistic outlook for the next two years and projected a path of further declines in unemployment.

"Economic activity is rebounding in the current quarter and will continue to expand at a moderate pace thereafter," Ms. Yellen said. She added there are good reasons to expect faster growth in 2015 and 2016, including an improving labor market, the Fed's easy credit policies, reduced household debt, rising stock and home prices and less-restrictive government tax and spending policies.

The Fed also said it would reduce monthly purchases of mortgage and Treasury bonds by another $10 billion next month to $35 billion. Those purchases started in 2012 in an effort to hold down long-term interest rates and spur growth and hiring.

With the job market gradually improving, the Fed is taking away that support and slowly turning its attention to the timing and pace of short-term interest rate increases. It has kept short-term rates near zero since December 2008 and isn't planning to start raising them until next year.

Investors appeared cheered by that timing. The Dow Jones Industrial Average rose 98.13 points, or 0.58%, to 16906.62 after earlier being down 26 points, while the 10-year U.S. Treasury note rose 12/32 in price to push the yield down to 2.611%.

Against that market backdrop, the Fed faces a dilemma. The five-year recovery has continuously failed to live up to the Fed's growth forecasts and officials are lowering their expectations of how much the economy can expand in the long-run. Still, unemployment is coming down faster than expected and inflation shows signs of rising to the Fed's 2% goal.

If the Fed sets rates too low in response, it could spark inflation or financial instability, but if it raises them too quickly it could derail a fragile economy.”

“Inflation” is not merely “showing signs of rising to the Fed's 2% goal”, as Mr. Hilsenrath avers, it is already above that level as of May. However, his comments illustrate the problems faced by central planners nicely. They have not the slightest clue what they are doing. This is not a comment on their intelligence or personal abilities -  if entirely different people were running the Fed, they would be equally clueless. What the monetary bureaucrats are supposed to know, simply cannot be known by a central planning agency. There is no way for anyone to ascertain what the 'correct' interest rate should be, and pumping up  the money supply certainly cannot possibly confer a single benefit on society at large.

If interest rate hikes were to “derail the fragile economy”, it would mean that malinvested capital will be liquidated or, where possible, transferred to better uses. The loose monetary policy is the cause for these misallocations and the longer it continues, the worse the situation will become. An economic bust is no fun, but it is in reality a healing process. Meanwhile, the central bank can only delay, but not truly avert this process in the long run, unless it wants to risk a complete annihilation of the underlying currency system.

A chart shown by Jon Hilsenrath, illustrating what is currently held to be the major dilemma faced by the central planners.

Here is another passage from Mr. Hilsenrath's article worth commenting on:

“The revisions from March suggest the Fed sees less slack in the economy than previously thought, which could lead to higher inflation and helps explain the slightly higher near-run interest rate projections. Ms. Yellen dismissed as "noisy" recent increases in inflation, though some market analysts said the Fed risks allowing inflation pressures to build as unemployment falls.

At the same time, however, the Fed is a little less optimistic about the long-term growth outlook. Officials said the economy's growth potential might be as low as 2.1% in the long-run, the latest in a string of downward revisions in recent years. That gloomier long-run growth outlook could help explain why the central bank is producing a lower long-run interest rate forecast of 3.75%.

Another challenge is that the Fed's assurances of low rates could make investors complacent about risk. Ms. Yellen repeatedly warned investors not to become overly confident the ultra-easy monetary policy will be around forever or that the Fed will stick to the plans it has laid out.

"There is uncertainty about what the path of interest rates, short-term rates, will be, and that's necessary because there's uncertainty about what the path of the economy will be," she said.

Underscoring that point, she noted there is a wide range of views even among Fed officials about where rates will be by 2016. Fed forecasts range between 0.5% and 4.25%.”

We find it interesting that Ms. Yellen believes the recent rise in consumer prices to be mere “noise”. This is currently a widely held consensus, and it could well turn out to be wrong. “Inflation” in the sense of rising consumer prices is certainly  not a result of economic growth. Economic growth means that more goods and services are produced, hence their prices should be expected to fall, not rise (the Keynesians have this exactly the wrong way around, like so many things). If there is one major reason why prices are now rising, it is this: the broad US money supply has been increased by almost 95% since 2008.

As to the statement “the Fed's assurances of low rates could make investors complacent about risk. Ms. Yellen repeatedly warned investors not to become overly confident…” – is this meant to be some kind of in-joke?

What exactly is meant by investors “could” become complacent? The mother of all bubbles has been underway for quite some time now in stocks, junk bonds and many other assets. There cannot be the slightest doubt that investors are complacent and  overconfident.

Ms. Yellen is “warning” investors? Give us a break! The central bank and its policies have caused the bubble. It is the height of cynicism for its chairwoman to come out at this juncture and “warn” people of the possible drawbacks of an asset bubble the central bank is not only directly responsible for but in fact wanted to happen.

Lastly, it should be no surprise that the interest rate forecasts of FOMC members are diverging so widely – as noted above, they are merely “guessers” – they have no clue about what is going to happen. That they have even less clue than usually is a result of the fact that their monetary policy experiments have been conducted in ad-hoc fashion, with not the slightest idea what the long term consequences may turn out to be.

Conclusion:

There were no surprises, as the FOMC has delivered exactly what was widely expected. However, the gold market's reaction was certainly interesting (more on this tomorrow), and as 'tapering' of QE continues, the air is undoubtedly getting ever thinner for a number of asset bubbles the loose monetary policy has caused. If the central planners think they are facing a dilemma now, they are definitely in for a surprise in our opinion. Far greater dilemmas are wont to present themselves further down the road.

Charts by: St. Louis Fed, WSJ