Is “the Fed” Leonard from Memento?
One of my favorite movies of all time is Memento. It’s about a man, Leonard, that cannot create long-term memories after being hit over the head by his wife’s murderers. Despite his inability to remember anything new after a few minutes, he is set on finding the killer, who escaped at the time of the murder. The mind-blowing twist at the end (spoiler alert!) is that his wife hadn’t actually been murdered — Leonard himself had accidentally killed her by administering insulin shots one too many times. Outside of the amazing nonlinear plot, what I love about the movie is that protagonist and antagonist are unclear and lines are blurred. Come to think of it, the U.S. central bank kind of reminds me of Leonard.
As I discussed in Wealth vs Income, the wealthy earn via stock price appreciation rather than solely through wages, whilst everyone else relies on wages — which haven’t grown much. Part of the job of the central bank is to ensure that consumer inflation, which is driven by wage inflation, is neither too hot nor too cold. Wage inflation (the increase in wages) drives consumer inflation (the increase in prices of goods) in that the more you earn, the more likely you are to spend, and the happier you are to pay higher prices. If wages aren’t increasing, you’re less likely to be happy paying increased prices for goods.
In this blog, we’re gonna take a walk down memory lane in order to understand why the central bank was created and the evolution of its goals. With this as a backdrop, we will then discuss its recent, unprecedented actions to stabilize employment and inflation, and the potential, unintended consequences.
1800s — 1913: Wild Wild West
Prior to having a central bank acting as a lender of last resort, the U.S. economy was pretty messy. Between 1854 and 1914, the average recession lasted 23 months and the consequent expansion, 25 months. In other words, the U.S. experienced a pretty severe recession every four years. Pretty insane!
In 1907, a few trusts (equivalent to hedge funds of today) borrowed money from New York banks to corner the copper market. Their attempt failed and their inability to pay the banks back resulted in yet another run on the banks, which caused a recession and a -50% stock market drop. The severity of that recession was, in fact, worse than the one we saw in ’08. Not fun. Post this mess, the government created the Federal Reserve (the Fed) to be a lender of last resort. As you can see in the chart below, it’s fair to say that it was a good idea as recessions have become shorter and economic expansions longer since the Fed’s inception in 1913.
Ok, so the Fed’s job is to set up guardrails for the economy, but there was no roadmap indicating when it was appropriate for them to use them or not.
The Fed and Inflation
The 50-year average consumer inflation prior to the creation of the central bank in 1913 was zero. No joke. Check it out in the chart below. By 1963, the 50-year average rose to 2.5%. And despite the fact that the most recent core inflation print is 1.3%, the 50-year average remains at 4%. So inflation has risen from 0% to 4% since the Fed started printing money. This could be a coincidence, but as the famed economist, Milton Friedman’s stated: “Inflation is always and everywhere a monetary phenomenon”. In less cryptic terms, he argues that the central bank’s ability to print money has in itself been the driver of higher inflation. Now, that doesn’t mean the Fed has ignored inflation. Especially after Germany’s hyperinflation episode during and after WWI, the Fed might have actually cared too much about it.
Source: Reinhart, Carmen M. and Kenneth S. Rogoff. This Time is Different: Eight Centuries of Financial Folly. Princeton: Princeton University Press, 2009
1930s: The Great Depression. Deflation fear strikes.
In 1929, regional banks began to default following the stock market crash and yet the Fed thought it would be premature to jump in to help. Although the recession was not going to be avoided altogether, it is clear is that the Fed waited too long to help (and they acknowledged their poor judgment on that one). This is important as that mistake made the Fed more aggressive in preventing future recessions from turning into depressions, as deflation is harder to get out of than high inflation is. If you noticed, in the prior chart there was a big jump in the moving average in the 1970s let’s go there.
1970s: Inflation strikes
Post the Great Depression, the Fed jumped in to save the day every time the economy stumbled, as they were afraid of repeating the mistake of arriving too late to help. By the 1970s, the combination of very low interest rates, loose fiscal spending, and the unpegging of the U.S. Dollar from the gold standard, drove inflation from 4% to 12%.
The fear of surging inflation forced Congress to adjust the Fed’s mandate to “maximum employment, stable prices, and moderate long-term interest rates”. The idea being that the Fed should use interest rates not only as a tool to impede depressions and high unemployment, but also to stop the economy from overheating. Think of raising interest rates as splashing water on an overheating engine. It makes borrowing more expensive and thus cools consumer and business spending. With this new minted congressional mandate to reduce inflation, Paul Volcker was appointed Chairman of the Fed in 1979. This guy was no joke. He hiked interest rates to 20% until he broke the back of inflation. By the time he left in 1987, inflation was back to 4%. And ever since the 1970s inflation episode, the Fed, like Leonard searching for the killer, has been searching for inflation to destroy it.
2008–2009: Deflation strikes back
I’m not going to rehash the Great Recession, as we all lived it, but from the perspective of the Fed, in 2007/8 it tried to stabilize the economy by lowering interest rates from 5% to 0%. The plan was to make borrowing cheap enough to awaken animal spirits for people to borrow and spend more, to get the economy going again.
Source: Federal Reserve Bank of St. Louis
But by early ’09, the economy was still in a free fall, so the Fed felt it needed to do more. What do you do as a central bank when your main instrument to stabilize the economy, short-term interest rates, is already at 0%? You try to push long-term interest rates down.
The Fed began a “quantitative easing” (QE) program in which it bought over $3 trillion of government and mortgage back bonds in the open market. This is the magical part of the show kids. You see, the Fed has the power to create new money. So that $3 trillion used to buy the bonds, did not exist before! They literally pressed a button and the trillions of dollars appeared on their screen… crazy right? Anyways, the idea was to buy bonds that had long maturities (i.e. set to expire 5–30 years out) so their prices would rise and thus the interest rate the bonds yielded would, in return, fall. Basically, the Fed wanted to make it cheaper for people to borrow money to buy things. The chart below shows how much the Fed’s bond holdings grew between ’09 and ’14.
Source: JPMorgan Asset Management
Oh, by the way, the other large central banks saw what the Fed was doing and said “oh crap, we better do the same”. So the central banks of Japan, England, and Europe all went on a shopping spree for their local bonds. Did their efforts work? Partly. A recent IMF report tells us that employment growth has picked up and headline unemployment rates are now back to their pre-Great Recession ranges, for most developed economies. Still, wage growth remains well below where it was prior to the recession.
Where do we go from here?
It is impossible to know what would have happened if the Fed didn’t jump into action to fight the biggest recession since the Great Depression. Nevertheless, some prominent investors argue that the world has changed whilst the Fed’s mandate has remained the same. Investor and author of best-seller Breakout nationsdescribes it like this:
Increasing [global] competition puts downward pressure on consumer prices. The forces of expanding supply from China to Mexico are pushing the global average inflation rate down to a level that looks scary low only when compared with the 1970s highs. In fact, consumer price inflation is still above the long-term average, dating to the year 1200, which is 1%. But global competition wields the opposite effect on asset prices. The opening of financial markets means that many more buyers are bidding up prices for stocks… Central banks are unleashing easy money to fight an imaginary villain, consumer price deflation, at the risk of feeding a real monster, asset price inflation” — Ruchir Sharma.
Ruchir gets to the bottom of what we discussed in Wealth vs. Income. Since January 2009, U.S. wages have grown below 10% while the S&P 500 has been up +230%.
Starting this month, the Fed will begin to slowly unwind some of the bonds they own. And as you can see in the chart below, the other major central banks are set to do the same in the next two years.
Source JP Morgan Asset Management, Bloomberg, ECB
Will the unwinding of bond ownership, combined with higher short-term interest rates, derail the stock market rally? Over the last 35 years, data shows that interest rates have not been the main driver of equity returns. Having said that, the Fed’s purchase of over $3 trillion in bonds is unprecedented and thus it is difficult to dismiss the unwinding of these bonds as irrelevant to stock prices.
Back to Memento
So is the Fed’s attempt to generate wage inflation is the equivalent of Leonard’s search for an imaginative killer? Or even worst, are the Fed’s actions pushing stock markets higher and inadvertently becoming THE driver of further wealth inequality? Similar to the movie’s ending, this blog should put you in an uneasy foggy place, with no concrete answer.
Post orginally from Zoe’s Investment Insights Blog.