An Imaginary Bogeyman

What’s a Keynesian monetary quack to do when the economy and markets fail to remain “on message” within a few weeks of grandiose declarations that this time, printing truckloads of money has somehow “worked”, in defiance of centuries of experience, and in blatant violation of sound theory?

In the weeks since the largely meaningless December rate hike, numerous armchair central planners, many of whom seem to be pining for even more monetary insanity than the actual planners, have begun to berate the Fed for inadvertently summoning that great bugaboo of modern-day money cranks, the “ghost of 1937”.


Bugaboo of monetary cranks
The bugaboo of Keynesian money cranks – the ghost of 1937.


As the story goes, the fact that the FDR administration’s run-away deficit declined a bit, combined with a small hike in reserve requirements by the Fed “caused” the “depression-within-the-depression” of 1937-1938, which saw the stock market plunging by more than 50% and unemployment soaring back to levels close to the peaks seen in 1932-33.

This is of course balderdash. If anything, it demonstrates that the data of economic history are by themselves useless in determining cause and effect in economics. It is fairly easy to find historical periods in which deficit spending declined a great deal more than in 1937 and a much tighter monetary policy was implemented, to no ill effect whatsoever. If one believes the widely accepted account of the reasons for the 1937 bust, how does one explain these seeming “aberrations”?


1-USDJIND1937crThe DJIA in 1937 (eventually, an even lower low was made in 1938, see also next chart) – click to enlarge.


As we often stress, economics is a social science and therefore simply does not work like physics or other natural sciences. Only economic theory can explain economic laws – while economic history can only be properly interpreted with the aid of sound theory.

Here is how we see it: If the authorities had left well enough alone after Hoover’s depression had bottomed out, the economy would have recovered quite nicely on its own. Instead, they decided to intervene all-out. The result was yet another artificial inflationary boom. By 1937 the Fed finally began to worry a bit about the growing risk of run-away inflation, so it took a baby step to make its policy slightly less accommodative.

Once the artificial support propping up an inflationary boom is removed, the underlying economic reality is unmasked. The cause of the 1937 bust was not the Fed’s small step toward tightening. Capital had been malinvested and consumed in the preceding boom, a fact which the bust revealed. Note also that a huge inflow of gold from Europe in the wake of Hitler’s rise to power boosted liquidity in the US enormously in 1935-36, with no offsetting actions taken by the Fed.

Moreover, the Supreme Court had just affirmed the legality of several of the worst economic interventions of the crypto-socialist FDR administration, which inter alia led to a collapse in labor productivity as the power of unions was vastly increased, as Jonathan Finegold Catalan points out here. He also notes that bank credit only began to contract after the stock market collapse was already well underway – in other words, the Fed’s tiny hike in the minimum reserve requirement by itself didn’t have any noteworthy effect.

On the other hand, if the Fed had implemented the Bernanke doctrine in 1937 and had continued to implement monetary pumping at full blast in order to extend the boom, it would only have succeeded in structurally undermining the economy and currency even more. Inevitably, an even worse bust would eventually have followed.


2-SPX-1937 vs today1A chart pattern comparison: the S&P 500 Index in 1937 (black line) vs. today (red line) – click to enlarge.


Disappointed Liquidity Junkies

Nevertheless, the establishment-approved version of history is that the crucial mistake the central planners made at the time was that they “tightened too early”. This view is definitely shared by the bureaucrats at the helm of the the Fed. After the market swoon of early January and the string of horrible economic data released in just the past few weeks, the January Fed meeting therefore promised to provide Kremlinologists with an FOMC statement full of delightful verbal acrobatics.

After all, the official line is currently that “everything is fine” and that monetary policy can and will be “normalized” – whatever that means. Note that it actually doesn’t mean much; the Fed has hiked the federal funds rate, which applies to a market that has become utterly zombified. Transaction volumes have collapsed, as banks are drowning in excess reserves thanks to QE.

Moreover, in the pre-QE era, the FF rate target did influence money supply growth indirectly. This is no longer the case. Since the Fed will continue to replace maturing securities in its asset portfolio, the only factor that matters is the mood of commercial bankers – if they tighten lending standards, money supply growth will falter (and the opposite will happen if they become more reckless).

The task the bureaucrats faced this week was how to credibly keep up their pretend-confidence, while concurrently conveying a thinly veiled promise of more easy money, so as not to invite renewed waves of selling in the stock market and to prevent a further strengthening of the dollar. The result can be seen by looking at the WSJ’s trusty Fed statement tracker, which compares the verbiage of the new statement to that of the preceding one.

Considering that absolutely no action was taken at the January meeting, there has been an unusual amount of tinkering with the statement. The bone specifically thrown to the increasingly nervous punters on Wall Street consisted of the following sentence:


“The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook.”


This sounds a bit as though the Yellen put has just been put in place. Alas, the wording of the rest of the statement was apparently considered way too sunny by assorted liquidity junkies hoping for an instant bailout.


3-DJIA-5 minAt first blush, the FOMC statement was considered wanting by punters in the casino – click to enlarge.


Imploding Debtberg

Money supply growth remains fairly brisk by historical standards, but as we have recenty pointed out, there are strong indications that the slowdown that has been in train since late 2011 is set to resume. One has to keep in mind that without QE, only an increase in credit and fiduciary media issued by private banks can lead to money supply growth. However, there is a big problem now: the corporate bond market is increasingly under stress. One would think that this has to affect bank credit as well – and this is indeed the case.

The amount of debt issued by the energy sector alone in recent years has been staggering. In the meantime, bonds of energy companies represent roughly 13.5% of all outstanding corporate bonds in the US. The average debt/EBITDA ratio of US energy companies has risen 10-fold since 2006, to never before seen levels. Not surprisingly, a huge number of energy sector bonds is in by now in distress – and emerging market corporate bonds have followed suit.


4-energy distressDistressed energy sector debt compared to other industries – click to enlarge.


5-EM debtEM corporate debt – distress levels have jumped threefold in just the past six months – click to enlarge.


The entire corporate sector is in fact leveraged to the hilt. In the US, the ratio of corporate debt to earnings across all sectors of the economy has reached a 12-year high in 2015. It is fair to assume that the situation is even worse in a great many emerging markets. In China it is probably a lot worse.


6-corporate debtThe corporate debt-to-earnings ratio in the US reaches a 12 year high – click to enlarge.


The point we are trying to make here is the following: it probably no longer matters what the Fed says or does. The situation is already out of control and has developed its own momentum. The mistakes made during Bernanke’s echo boom cannot be “unmade” retrospectively. Capital that has been malinvested due to ZIRP and QE and the unsound debt associated with it will have to be liquidated – and the markets are telling us that this process has begun.


7-Junk bondsUS corporate junk bond yields – black line: overall index (Merrill Master II); red line: worst rated bonds (CCC and below) – click to enlarge.


From the perspective of assorted armchair planners, the Fed is now seen as akin to Nero, fiddling while Rome burns. These range from the FT’s Martin Wolf, who has never encountered a printing press he didn’t like, to hedge fund manager Ray Dalio, whose “all weather” portfolio is suddenly stuck in inclement weather that has reportedly proved unpalatable to it (maybe it should be renamed the “almost all weather” portfolio). Evidently they aren’t getting yet that it is probably already too late for interventions to alter the trend.


The Pace of the Manufacturing Sector’s Demise is Accelerating

Just one day after the FOMC (which remains firmly focused on the most lagging of economic indicators, namely the labor market) vainly attempted to spread some more cheer about the state of the economy, new data releases have confirmed that a recession has already begun in the manufacturing sector.

Durable goods orders for December – admittedly a highly volatile data series – collapsed unexpectedly by a rather stunning 5.1%. Core capital goods orders (excl. defense and aircraft) were down 4.3%. Such an acceleration in the downtrend of new orders for capital goods is usually only seen shortly ahead of recessions. The chart below compares the Wilshire 5000 Index to the y/y rate of change in total business sales and the y/y rate of change in new business orders for core capital goods.


8-Wilshire vs. economic dataThe Wilshire total market index (red) vs. the annual rate of change in total business sales (black) and new orders for core capital goods (blue). The acceleration in the rate of change of the latter series is consistent with a recessionary reading – click to enlarge.


In terms of the business cycle this confirms that the liquidation phase is indeed beginning. The price distortions of the boom period have begun to reverse. As an aside, this should be very bearish for the stock market, which has been at the forefront of said price distortions.

Given the lag with which money supply growth and gross market interest rates affect bubble activities in the real economy, there is nothing that the central bank can possibly do to stop this process from unfolding in the near to medium term.

We have recently come across a video in which an analyst proclaims that “the Dow will go to 25,000 because QE 4 is coming”. Such faith in the Fed’s magical powers is incredibly naïve. Consider for instance that Japan is currently engaged in QE 6 or 7 (we have lost count) and the Nikkei Index is still more than 50% below the level it reached 26 years ago.

It is certainly possible for a central bank to vastly inflate stock prices. All it needs to do is to utterly destroy the currency it issues. However, investors will then be in a situation akin to that Zimbabwean investors experienced a few years ago. They made trillions in the Harare stock market. Unfortunately, all they could afford with their massive stock market gains were three eggs, as Kyle Bass once remarked.


9-capital goods ordersNew orders for capital goods, quarterly change annualized: from bad to worse – click to enlarge.



The Fed’s “forward looking” monetary policy is in reality backward-looking. Not that it really matters: central planning and price fixing cannot possibly work anyway. Neither the intentions and/or the intelligence of the planners, nor the quality of the data policy decisions are based on matter in this context. Even under the most generous and heroic assumption that the planners are all angels with nothing but society’s well-being on their mind, they would still be attempting to do what is literally impossible. It is therefore a complete waste of time and effort to propose allegedly “better plans” to them as the endless parade of armchair planners mentioned above keeps doing day in day out.


eyes-1Looking forward, Fed style.


The end of QE 3 has led to a slowdown in money supply growth, and more and more bubble activities have become unsustainable as a result. Given the associated time lag, recent economic trends are set to continue and are highly likely to spread to more and more sectors of the economy.

The energy and commodities bust is not going to remain “contained”. The Fed’s assessment of the state of the economy – which is usually not much to write home about even at the best of times – seems increasingly divorced from reality. This is likely to exacerbate the speed and extent of the unfolding bust.

As Jim Rickards recently pointed out to us (readers will be able to read all about it in detail next week, when we will post the transcript of the most recent Incrementum advisory board discussion), the Fed’s hands are moreover tied due to the fact that 2016 is an election year in the US. The monetary bureaucracy will be hesitant to take any actions that could be interpreted as supportive of a specific candidate or party.

One thing seems therefore almost certain: we can probably look forward to even more tortured verbal acrobatics in upcoming FOMC statements.


Charts by: ShareLynx, Nautilus Investment Research, StockCharts, St. Louis Federal Reserve Research, Bloomberg



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8 Responses to “The FOMC Decision: The Boxed in Fed”

  • zerobs:

    the only factor that matters is the mood of commercial bankers – if they tighten lending standards…

    Didn’t Dodd-Frank contribute to tightening lending standards?

    The Fed gave the lenders actual cash to replace non-performing mortgage loan assets, but there certainly was not a new crop of creditworthy borrowers applying for mortgages that the lenders could/would loan that cash to, and even if they wanted to lend to even worse credit risks than before, Dodd-Frank attempted to prevent it (and certainly had a chilling effect).

    • rodney:

      Yes, but it’s not only that: As the credit cycle progresses, lending standards tend to tighten by themselves. That’s because the pool of creditworthy borrowers gets depleted, and you get to a point where the only thing left is subprime debt and ninja loans. Many institutions (may be most?) will stop lending, but some reckless ones will keep playing the game. The only thing that stops the madness is when loans start going bad.

  • therooster:

    For the sake of not putting the audience to sleep, let’s keep a simple issue simple, shall we ???

    The fiat price model of the day allows for the price comparison of any two debt-free widgets and on the basis of market agreement, those two debt-free widgets can trade directly for each other, without any debt involved in the trade. The trade becomes complete and fully closed.

    Now, simply make one of the above referenced widgets gold or a fully gold backed gold currency and you have debt-free trading. No debt involved.

    As an added extension to the debt-free trading that is now taking place in the market (daily), debt-free liquidity also has the ability to support the purging of existing debt (fiat currency) out of circulation. It is this process of “market osmosis” that leads to a market driven yin-yang of liquidity, a hybrid where debts and assets both circulate and where power is shared.

    • zerobs:

      The trade becomes complete and fully closed.

      So what? The fact that someone is willing to offer credit to purchase widgets affects the aggregate demand for the widget, whether or not I use debt to purchase from the seller. The price will take those credit transactions into account in the aggregate.

      If you want to argue that there is a market price model and a Fed price model, I won’t dispute. But one of them is based on market data and the other is based on market data + fudge factor. You can call it theory instead of fudge factor, but that doesn’t change its nature nor make it more credible.

  • therooster:

    That’s what I would call a decent “dark side” analysis where debt-free liquidity does not exist. The reality is that it does exist.

    A central bank can only do two things: it can implement policies that further encourage price discovery or it can implement policies that further discourage price discovery. The more different “policies and tools” implemented the longer it takes for the market to adjust to its price discovery trend.

    This last paragraph is not totally accurate. A central bank can (and does !) create a real-time measure that should be fully utilized as a real-time measure in support of debt-free trades. Unfortunately, we are creatures of habit who continue to look at the central bank’s product as a currency (debt).

    If one looks to the “other end” of the currency application, one discovers the price model, which can provide the support for the debt-free trading that’s been referenced.

    The pricing application of a CB’s product opens so many more possibilities, possibilities that are taking shape in the market.

    Example : Gold is now a debt-free currency for settlement with fully scalable and expandable liquidity as per market demands. You can thank the CB’s for the creation of the price measures.

    It is light that comes out of darkness in the order of creation. Nothing new.

    • zerobs:

      A central bank can (and does !) create a real-time measure that should be fully utilized as a real-time measure in support of debt-free trades.

      This, to me, is pointless. Debt-free trades do not exist in an economy of their own. In any debt-free trade the price agreed upon is based on supply and demand, and those are influenced by the concurrent existence of credit-based transactions.

      I’m trying to think of a good or service who entire market consists of debt-free transactions and I’m having difficulty. It’s possible that crystal meth transactions are all debt-free, but even then the raw materials for it, the labor, and the plant and equipment to produce it probably are not all acquired on debt-free trades.

      I certainly don’t consider gold to be a debt-free medium. Physical gold certainly isn’t a currency although GLD is considered one, but physical gold’s market price is affected by the existence of GLD transactions.

  • therooster:

    Printing truckloads of money works wonders when your objective is to simply buy time so that the grass roots of the marketplace can come to the rescue.

    Q: When is a dollar not a currency or medium of exchange ?

    A: When it acts as a real-time and comparative pricing measure that supports debt-free trading and the purging of debt.

    You need to look to “the other end” of what a dollar really is. It’s NOT just a debt based medium of exchange.
    Sorry if I have confused anyone with this fact. I know a bad habit is hard to change.

    • zerobs:

      The natural state of the market is toward price discovery. There are hiccups along the way as producers come and go and new technologies and discoveries change productivity levels in individual sectors.

      A central bank can only do two things: it can implement policies that further encourage price discovery or it can implement policies that further discourage price discovery. The more different “policies and tools” implemented the longer it takes for the market to adjust to its price discovery trend.

      There is no question the taper is a “toward price discovery” policy. There is no question the minuscule interest rate increase toward the natural interest rate range is a “toward price discovery” policy.

      Printing money is certainly an “away from price discovery” policy. The problem is lowering interest rates is not necessarily an “away from price discovery” policy – as you get closer to zero the policy reduces the amount of credit. Pushing rates closer to zero only affected the auto sector because the item can be repossessed easily, and the student loan sector because of the government backstop. Whatever yield-chasing was done in the energy sector stopped because of the market’s natural tendency toward price discovery. If anything, OPEC’s over-production is a “toward price discovery” policy toward energy-sector debt – and this is a policy that the Fed has no control over.

      Add in the fact that state/municipal property and sales taxes have increased, as well as the implementation of Obamacare, and you have money-and-credit supply shrinkage policies implemented independently of the Fed’s “away from price discovery” policies; you wind up with global and domestic central planners all counter-balancing each other and confusing the market. The market will eventually absorb all these changes, but the only thing worse than a central planner is two central planners. Implement too many policies (intentionally or not) and you shrink credit because it simply can’t reconcile whether lending is a risk worth taking.

      In other words, you can shrink overall credit by enacting interest-raising policies (a la Volcker, suppressing borrowing) or by enacting interest-lowering policies (a la Sharia Law, suppressing lending). It all depends on what the natural interest rate range is at a given moment, but “away from price discovery” policies – like monetary or tax policy shocks – makes it more difficult to figure out what that natural interest rate range is.

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