FISCAL/MONETARY REPORT – THE RUBBER MEETS THE ROAD AT THE FED, AND THE ABSURDITY OF THE REPORTED CONSUMER PRICE INDEX
PREAMBLE: it is worth noting that gold bullion and the gold mining stocks are opening strong again this morning. Gold bullion is now up about 7% for the year and the mining stocks are up about 20%, destroying the two “myths” that a strong US Dollar and higher interest rates do not allow for higher gold prices. We have pointed out many times that in the 1970s, when inflation pushed interest rates much higher (similar to the current situation) gold bullion made a little move from $35 to $850/oz. Relative to the value of the US Dollar, gold’s performance depends on the time interval chosen. We can find relative performance that goes either way. In any event, it’s been our long held belief that gold is the “real money”, a proven store of value over thousands of years, and the gold mining stocks are an extreme value among various asset classes. That is why we have a major portion of our liquid net worth in our investment partnership (which is still open to investors).
It is relevant that the value of the gold that central banks own, compared to the paper currency outstanding, is virtually the same as it was in 1971, before the huge price increase. In retrospect, $850 was overpriced but $250-300 (up about 6-8x) would have been rational. A case can be made today that gold bullion today should be priced at $10,000/oz, up by five times, and the gold mining stocks could move 2-4x that amount. We have said for years that it’s not a question of “if”, but “when”. Stay tuned.
Back to our planned message of the morning:
The Rubber Meets the Road at the Federal Reserve
In addition to raising short term interest rates steadily over the next twelve to eighteen months to perhaps 2.5-3.0% (hardly anyone predicts rates much higher than 3%), the latest indication is that they will also shrink the Fed balance sheet from the current all time high of $9 trillion.
Recall that the Fed’s assets reflected approximately $1 trillion in 2007, so a cool $8 trillion has been printed out of thin air, to purchase fixed income securities of all stripes, US treasury securities and mortgage-backed securities in particular. The Fed’s purchase of trillions of dollars of US Treasuries has financed something like half of the government’s operating deficit, and kept interest rates from rising in the process. Recall also that in May, 2013, with Fed Assets at “only” $3.4 trillion, up $500 billion in the prior six months, Fed Chair Ben Bernanke announced a plan to start reducing (“tapering”) asset purchases. In short order, a “taper tantrum” in the bond market took the yield on 10 yr. treasuries from around 2% in May to around 3% in December and…. the Fed backed off. More recently, in Mid ’18, when the Fed assets were “only” about $4.4 trillion, newly installed Fed Chair Jerome Powell established an “automatic” reduction of $50 billion per month. This lasted about eight months, reducing assets only modestly to about $3.7 trillion before the stock market sank by about 18%, the politicians screamed “do something” and the supposedly independent Fed once again backed off. So the trillion dollar balance sheet in 2007 grew to $3.4 trillion by 2013, never coming down in spite of Bernanke’s originally worthwhile intentions. Five years later, with the balance sheet at $4.4 trillion, up a third in five years and a quadruple over ten, the Fed’s courage waned after less than a 15% reduction.
Presently, having capped off the largest financial experiment in the history of the planet, with interest rates suppressed essentially at zero for ten years by the printing of about $8 trillion of Made in the USA “cryptocurrencies” the Fed is planning an immediate $95 billion/month reduction of their balance sheet, at the same time that interest rates are allowed to “normalize”. It seems relevant that until two weeks ago they were still printing $40B per month, with a slight increase even last week. One might ask why, if the plan was to start reducing within a matter of months, they would continue to print right up to the infection point. Keep in mind that the purpose of this newly installed strategy is to get inflation under control. It seems like the hundreds of economic PHDs at the Fed don’t realize that “real interest rates” would have to be in positive territory if inflation is to be subdued, which would require short term rates in the area of 6-7%, assuming inflation abates to 4-5%, which is questionable. Never mind that 6-7% short term rates would wreck the already weak economy. Paul Volcker took Fed Funds rates to 18% to squeeze out the 13% inflation, and the result was a three year economic downturn. Of course the US debt, as a percentage of GDP, was only 30% in 1979 vs. 120% today, and that ignores many tens of trillions of unfunded entitlements that have been put in place in the last forty years.
This is not “your father’s CPI”. If the CPI were calculated the same way today that it was in 1980, the inflation rate would be over 15%, not the current 7.5-8.5%. Perhaps the most notable absurdity in today’s calculation is that the “housing component”, which represents over 20% of today’s CPI calculation, is largely based on a creatively crafted statistic called “Owner’s Equivalent Rent” (“OER”). OER is the result of a survey that asks homeowners how much their home would theoretically rent for. The housing component of the current CPI calculation, largely based on OER, currently shows an annual price increase of about 4.5%. On the other hand, actual rents are up about 20% and the average price of a new home is also up about 20%. A new home buyer, paying off today’s 30 year mortgage, at a rate close to 5%, compares to a rate of 3.25% a year ago on a home 20% cheaper. The resultant monthly mortgage payment will therefore be ABOUT 40% HIGHER THAN A YEAR AGO. People, this is a lot more than the 4.5% increase in the housing component of the CPI. The above numbers are rough, but you get the point.
Back at the Fed: We’ll see how long the reversal from $40B of monthly “accommodation” to $95B of contraction, along with already rising interest rates, is tolerated by the capital markets. We suspect that Federal Reserve chairman, Jerome Powell, will be strongly encouraged to back off. There’s plenty of time to do what needs to be done after November eighth. It’s a fact that no Fed Chairman since Paul Volcker has been willing to take away the “punch bowl”. We doubt that Jerome Powell will be the first.