Monthly Archives: December 2014

2015: A Happy New Year for Markets, or a #Fedache for Investors?

Once again, we come to that time of year where professional investors count their bonuses, or lick their wounds, and start planning their investment strategy for the New Year. The question on the mind of many is whether 2015 will be a continuation of the liquidity-fueled party of 2014 or whether 2015 will the year that a cruel and unusual hangover begins. Will the Fed take away the booze and what will the world look like when it does?

Let’s begin with a quick review of 2014. The most notable feature of 2014 is that there weren’t many notable features. The US equity market didn’t crash, most government bond portfolios suffered few casualties and even emerging markets were relatively tame (at least by historical standards).

There is a good reason that “not much happened” in investment markets in 2014: a tsunami of newly-created money continued to flood into global securities markets as central banks around the world continued to expand their balance sheets at an unprecedented pace.

Over the past six years, the US Federal Reserve has bought nearly $4 trillion worth of fixed-income securities. It is hard to put such a large number in context, but let’s try.

As at November 2014, there were 147m employed persons in the United States. If we assume that only working people can save money (those not working and the unemployed should, by definition, find it difficult to save money), then the US Federal Reserve’s actions were the equivalent of those 147 million Americans saving and investing an additional $27,210 each in the fixed-income securities markets over the past six years.

How does this compare with the current savings of the average US worker? Well, one newspaper article last year suggested that more than three-fourths of Americans don’t have enough money saved to pay their bills for six months. Is it likely that these Americans could have saved an additional $27,210 over the past six years and invested those savings in the securities markets? And could all of these 147 million Americans have saved this sort of money without causing a severe consumer-driven recession in the US? The easy answer, on both counts, is “no”.

Another way to think about the scale of the Fed’s quantitative easing program is to consider new car sales. Americans buy nearly 16 million new cars each year. According to Kelley Blue Book, the average price of a new vehicle was $32,086 in 2013. If we do the math, then we can say that over the past six years, Americans have spent nearly $3 trillion on new cars ($500 billion annually). Therefore, if Americans were to save the $4 trillion that the Fed has invested in the markets over the past six years, they would have to give up all purchases of new cars during that same period!

The point is that the additional $4 trillion that has been invested in the markets by the US Federal Reserve over the past six years is a “big deal”. The private sector could not have saved and invested this amount of money in this period of time without creating a severe economic recession. Moreover, the Federal Reserve is not the only major central bank that has been using money creation to fund the purchase of government securities.

So, where did this $4 trillion come from? Was it raised in taxation? No. Was it borrowed? No. (Note that borrowing the money would defeat the whole “purpose” of QE.) Rather, this $4 trillion was just “made up”.

As a society, we just decided to “make up” a whole bunch of new savings that we never had and invest them in the financial markets. This may sound like a great scheme, but there is a catch: “nothing in life is free”.

The question that investors should be asking as we enter 2015 is what is the cost of the past actions of the US Federal Reserve? How do we as a society pay for all the extra money that has been created? Moreover, and perhaps more importantly, when do we receive the bill for this grand experimentation in monetary policy?

There are two ways that we can pay for the Fed’s actions: either the Fed unwinds the six-year expansion in the monetary base and the markets crash, or the Fed does not reduce the monetary base and inflation takes off (and the markets crash). There is also a more realistic “middle-way”: the Fed makes a half-hearted attempt to reduce the monetary base, resulting in both a weak economy and higher inflation. Once again, this is a bad environment for most major asset classes.

Let’s consider each of the two major scenarios in turn.

In the first scenario, the Fed would need to sell at least $2-2.5 trillion of fixed-income securities in order to bring the monetary base back to its previous trend path (prior to the 2007/2008 crisis, the monetary base was growing at a roughly 6% annual rate).

If the Fed does reduce the monetary base by $2 trillion, then this will have an immediate and detrimental effect on all asset markets. In effect, the biggest marginal buyer in global asset markets suddenly becomes the biggest marginal seller. Just as many investors underestimated the impact of the Fed’s actions on the way up, so it is likely that most investors underestimate the impact on the markets of the Fed’s actions once those actions go into reverse.

It is worth remembering that this isn’t money that will be recycled through other parts of the economy: the Fed will not be selling bonds and using the proceeds to buy stocks or consumer products. Rather, the proceeds of these sales will simply “disappear” from the economy, just as the money used to make the original purchases magically appeared in the first place.

The second scenario is more interesting because it represents a more realistic path. As the Fed realizes the degree to which its actions have distorted the investment markets, it is unlikely that the Fed will have the courage to “put things right”. Therefore, we need to understand what will happen to the economy if the monetary base is not reduced from it current extended levels.

If the markets realize that the “temporary” expansion of the US monetary base is in fact a “permanent” expansion of the US monetary base, then this will lead to a decline in the market value of the US dollar. This decline may or may not be obvious in foreign exchange cross rates (after all, other nations are on a similar path), but it will become obvious in the general price level. Why? For the simple reason that, all else equal, as the market value of money falls, the price of all goods as expressed in money terms will rise.

The distinction between a “temporary” expansion in the monetary base and a “permanent” expansion in the monetary base is the key to the future of inflation. Quantitative easing was always advertised as a temporary solution to a temporary problem (a “soft patch” in the economy). Naturally, most investors expect that the expansion in the monetary base will be reversed in time. However, if these expectations are not met (i.e., if investors realize that QE was “falsely advertised”), then the market value of money will fall and the price level will rise.

Understanding why expectations are so important is a complicated issue that will be addressed in future posts. The view of The Enigma Series is that money is a long-duration, proportional claim on the output of society. As a consequence, the value of money is highly correlated to expectations of the long-term path of the “real output/base money” ratio.

At the present time, investors are quite optimistic regarding the long-term path of the “real output/base money” ratio. Investors seem to believe that the Fed will be true to its word and reduce the monetary base. Meanwhile, investors expect that this can be achieved with little impact on medium-term economic growth. If this is the case, then the value of a long-duration, proportional claim on the output of society (i.e., money) should be well supported and the rise in “money prices” (i.e., inflation) should be contained.

However, what would happen to the value of a proportional claim on the output of society if people suddenly decided that there would be a lot of more claims outstanding (a permanently higher monetary base) and/or lower growth in real output in the years to come? Clearly, the value of that proportional claim would decline.

The bottom line is that the Fed is approaching the end game. Either it remains true to its word and reduces the monetary base, an action that will lead to significant liquidity pressure on global investment markets, or the markets realize that the Fed has failed to live up to its word and the value of the USD adjusts accordingly.

It seems likely that 2015 will be the year that these issues come to the fore. Fiddling with “interest on reserves” is a distraction that may buy the Fed a little more time, but ultimately the Fed must reduce the US monetary base if it is to avoid putting the reputation and value of the US Dollar at risk.

2015. The party is over. The #Fedache begins.

Inflation or Deflation: Which is the Greater Risk in 2015?

Could 2015 be the year the markets experience both a “deflation scare” and an “inflation scare”?

The recent collapse of crude oil prices below $60 per barrel, combined with additional signs of global economic weakness, have renewed fears about an outbreak of deflation in the United States. Six years have passed since the US Federal Reserve first embarked on its current path of quantitative easing. The US Federal Reserve’s balance sheet has increased five-fold and other global central banks have followed in their footsteps. Despite this remarkable growth in the global monetary base, inflation has remained subdued.

The view of many in financial markets is that global deflationary forces are just too strong and that global central banks are increasingly impotent in their battle against deflation. This also seems to the view of at least one dissenter at the US Federal Reserve, Fed “dove” and Minneapolis Federal Reserve Bank President, Narayana Kocherlatkota, who argued that the Fed should be willing to further expand the monetary base if inflation continues running below the Fed’s 2% target.

While it may not be explicitly acknowledged by those who hold these deflationary expectations, this represents a quintessentially “Old Keynesian” perspective regarding the way the world operates. In essence, it is the view that if aggregate demand is weak, then prices must fall. Moreover, if global competition is pushing the aggregate supply curve to the right, then this only compounds the deflationary pressures.

The problem with this view is that it represents a very “one-sided” perspective on how “money prices” are determined in our economy. While it is true that well-entrenched deflationary forces (i.e., falling oil prices, global economic stagnation, and increasing global competition) have, and will probably continue to, put downward pressure on the value of global goods and services, there is a key element that is missing from our analysis: the future path of the value of money.

The value of money is the denominator of every “money price” in the economy. Every money-based transaction involves an exchange of two items of value. When you buy your morning cup of coffee, you receive one good of value and, in exchange, offer another good of value in return. This is the simple principle of all economic transactions dating all the way back to the barter economy of our ancestors. In our modern money-based society, the good of value that you offer in exchange for your morning cup of coffee is money.

The price of your morning coffee can rise for one of two basic reasons: the value of a cup of coffee can rise, or the value of money can fall. If the value of money falls, then, all else remaining equal, your local coffee shop will require you to give them more dollars for that morning cup of coffee.

We can extend this simple concept to the price level and changes in the price level (inflation). The value of money is the denominator of every “money price” in the economy and therefore the denominator of the price level. As the value of money falls, the price level rises.

In simple terms, this is the “Ratio Theory of the Price Level”, an economic theory of price level determination developed in The Enigma Series. Ratio Theory suggests that any “inflation versus deflation” debate needs to begin with a simple equation. Mathematically, the price level “p” can be described as a function of the value of goods and services “VG” and the value of money “VM” (see image below).

Ratio Theory of the Price Level

Inflation can be thought of as a game of “tug-of-war” between these two opponents. Currently, the world is experiencing strong deflationary forces that are placing downward pressure on the numerator in our equation, the value of goods and services. The current fall in oil prices should only accentuate these forces.

The bigger question relates to the future path of the value of money? The value of money has been relatively stable over the past few years, despite the massive expansion in the monetary base. However, is it reasonable to expect this stability to continue? And if the value of money does fall, then will it overwhelm the steady decline in the value of goods and services? In other words, will the denominator in our equation fall by more than our numerator?

You may ask why economics doesn’t present the “inflation/deflation” debate in these simple terms. Mainstream economics struggles with the concept outlined above because it does not recognize “the value of money” as a variable in its equations. In technical terms, economists struggle with the notion that price is a relative expression of two market values (the market value of a primary good as expressed in terms of the market value of a measurement good). Moreover, economics has largely failed to recognize that the property of “market value” can be thought of in both “absolute” and “relative” terms.

But before we get carried away with economic theory, let’s return to the topic at hand. What is the inflation outlook for 2015?

It seems reasonable to believe that the current weakness in the oil price, should it be sustained, will have some flow through effects over the course of the first few months of 2015. Energy costs represent a significant input cost for many industries and lower oil prices should contain any inflation over the next few months.

However, it seems unlikely that deflation represents the greatest risk to investors in the second half of 2015. Rather, the greatest risk to long-term investors remains a sudden collapse in the value of money and a significant jump in the rate of inflation. Indeed, 2015 may be remembered as a “flip-flop” year: fears of deflation in the first-half of the year rapidly switch to fears of inflation in the second-half of the year.

So, what is the risk of a sudden collapse in the value of money in 2015?

After six years of experimentation with the monetary base, many investors have been lulled into a false sense of security regarding this issue. The view of some investors is that if QE was going to negatively impact the value of the US Dollar, then it would have already happened by now. However, this is a naïve and simplistic view.

Ultimately, the value of a fiat currency is a function of the confidence that markets have in the long-term economic prospects of the society that issued it. More specifically, the value of money reflects expectations regarding the long-term path of the “output/money” ratio.

Over the past few years, markets have become more optimistic regarding the long-term prospects for the US economy. The view is that the US economy will continue to grow strongly over the next 10-20 years, even as the monetary base is “normalized” from its current extended levels.

However, if confidence in this view is shaken, then the value of the US Dollar will come under pressure. For example, if the Fed does reduce the monetary base, even modestly, and this results in a recession in the US, then investors’ long-term confidence in the path of the “output/money” ratio could be quickly shaken. The question for all investors is whether 2015 is the year that confidence turns.

Clearly, the role of expectations in the determination of the value of money and the price level is a complicated matter and future articles will be dedicated to exploring this issue further.

So, is deflation or inflation a greater risk in 2015? Near term, the risks may be on the side of deflation. But longer term, the risks are squarely in the inflation camp.

A Preview of Future Topics

Welcome to, home of The Enigma Series!

In the weeks and months ahead, I will use this blog to discuss many of the practical implications of The Enigma Series and to answer some of the questions that readers may have regarding the theory itself.

The Enigma Series is an expansive work that touches upon many areas of economic theory. As a result, there is an almost endless list of topics that we could discuss. While I believe that there are certain pressing topics that need to be discussed, such as the rising risk of inflation and the unsustainable path of government balance sheets across the Western World.

I would encourage all readers who are interested in this blog to subscribe to our email list. Many of the topics covered on this blog will be covered in greater depth and detail in subscriber-only emails.

So, what can readers expect in the weeks ahead?

Firstly, I think it is important to discuss the very simple notion that printing money and increasing government debt have consequences. At the present moment, these consequences are being obscured by what can only be described as extremely complacent conditions in financial markets. But, market sentiment can change overnight. Such a shift in market sentiment could have a major and dramatic impact upon the market value of money, the denominator of every money price in the economy.

Ultimately, the market value of money is a function of confidence regarding the long-term economic future of society. Most market commentators seem very optimistic regarding the future path of the “real output/base money” ratio: they expect real output to continue to grow steadily as the monetary base declines.

My personal view is that there are two key reasons why the markets will be disappointed in this regard. First, central banks will find it very difficult to reduce the global monetary base from its current extended levels for a wide variety of reasons that we will discuss in later posts. Second, even if central banks do manage to reduce the monetary base for a short period without damaging confidence in the long-term prospects of the economy, the defining economic event of our lifetime still looms large on the horizon: “the Great Debt-for-Equity Swap”.

“The Great-Debt-for-Equity Swap” refers to what I believe is the inevitable acquisition and cancellation of trillions of dollars of government debt by all of the major global central banks. Hope, optimism and a false sense of confidence may obscure this complex issue for a few more years. Nevertheless, markets will begin to discount this event long before it occurs and we will discuss how the models developed in The Enigma Series can be used to think about the possible market implications.

Finally, on a more theoretical note, one of the main purposes of this blog is to help explain the strengths and limitations of existing economic theories and how The Enigma Series can provide a better platform for economic analysis. Concepts such as the “output gap” and the “quantity theory of money” persist in economic teaching because they recognize some important element of “common sense” regarding the way the world works. The problem is that most of these concepts provide an incomplete or partial description of macroeconomic forces. The Enigma Series hopes to provide a platform that can both embrace and temper these traditional concepts.

I hope that you find this blog useful and I look forward to working with all of you over the months ahead.