Doug Noland: Yellen on Inflation

Global Markets rallied sharply this week. The DJIA rose 223 points to a record 21,638. The S&P500 gained 1.4% to a new all-time high. The Nasdaq100 (NDX) surged 3.2%, increasing 2017 gains to 20.0%. The Morgan Stanley High Tech Index rose 3.4% (up 24.6% y-t-d), and the Semiconductors surged 4.7% (up 21.8%).

Emerging markets were notably strong. Equities rallied 5.0% in Brazil, 5.5% in Hong Kong, 5.1% in Turkey, 2.5% in Russia, 2.2% in Mexico and 2.1% in India. The Brazilian real gained 3.2%, the Mexican peso 3.0%, the South African rand 2.7% and the Turkish lira 2.3%. Global bond markets also rallied. Yields (local currency) dropped 27 bps in Brazil, 18 bps in South Africa, 16 bps in Turkey and 22 bps in Argentina. Here at home, five-year Treasury yields dropped eight bps (to 1.87%). U.S. corporate Credit also enjoyed solid gains. Across global markets, it appeared that short positions were under pressure.

Markets reacted with elation to Janet Yellen’s Washington testimony – widely perceived as dovish. In particular, the chair’s timely comments on inflation were cheered throughout global securities markets. A headline from the Financial Times: “Fed Chair Yellen’s Inflation Concern Buoys Markets.” And Friday afternoon from Bloomberg: “S&P 500 Hits Record as Inflation View Turns Iffy”.

July 12 – Financial Times (Sam Fleming): “Janet Yellen acknowledged… that the US’s persistently subdued inflation could raise questions about the Federal Reserve’s current path of gradually raising interest rates and vowed to watch prices ‘very closely’ for signs they were stagnating. The Fed chair insisted it was ‘premature’ to second guess policymakers’ determination inflation was slowly headed to the central bank’s target of 2%. But her note of caution helped spark a rally in US Treasuries and equities, with investors hopeful Ms Yellen would keep the Fed’s easy money stance for longer… Ms Yellen was broadly positive about the economy’s recent performance…, stressing there had been a rebound in household spending over recent months and the Fed was still anticipating further rate increases. But she also said she was studying the low inflation numbers for signs that short-term drags on prices may not be the only factors holding it back. She added that rates may not need to be lifted a lot more to get back to a neutral stance. ‘We are watching inflation very carefully,’ Ms Yellen said… ‘I do believe part of the weakness in inflation reflects transitory factors, but well recognise that inflation has been running under our 2% objective, that there could be more going on there.’ Analysts said Ms Yellen’s remarks marked a small but significant change of thinking, putting the Fed’s path of gradually pulling back on economic stimulus in question. ‘Yellen’s statement today reveals that the Fed isn’t as sure about inflation as they led us to believe,’ said Luke Bartholomew, investment strategist at Aberdeen Asset Management.”

It’s fair to say that the whole issue of “inflation” confounds the Fed these days. Despite antiquated analytical frameworks and econometric models, the Federal Reserve is showing zero inclination to rethink its approach. At the minimum, objective policy analysis would recognize today’s nebulous link between monetary stimulus and consumer price inflation. Rational thinking would downgrade CPI as a policy guidepost, especially relative to indicators of broader price and financial stability. Still, consumer prices rising slightly below 2% have somehow become central to the argument for maintaining aggressive monetary accommodation.

The nature of economic output has fundamentally changed – from mass-produced high tech hardware, to limitless software and digitalized content, to endless pharmaceuticals and wellness to energy alternatives to, even, the proliferation of organic foods – just to get started. There is today essentially unlimited capacity to supply many of the things we now use in everyday life (sopping up purchasing power like a sponge). Much of this supply is sourced overseas, which further diminishes the traditional relationship between domestic monetary conditions and consumer price inflation.

These dynamics have unfolded over years and are well recognized in the marketplace. To be sure, ongoing tepid consumer price inflation seems to be the one view that markets hold with strong conviction. So when Yellen suggested that below target inflation would alter the trajectory of Fed “normalization,” the markets immediately took notice. When she again referred to the “neutral rate” and implied that the Fed was currently near neutral, this further signaled a Fed that has developed its own notion of what these days constitutes “normal.” Throw in that the FOMC plans to pause rate increases while gauging market reaction to its (cautious) balance sheet operations, and it has become apparent to the markets that the Fed won’t be pushing rates much higher any time soon.

We’ll wait to see if Fed officials push back against the market’s dovish interpretation of Yellen testimony. There’s certainly no conundrum. If the Fed is confused that financial conditions have loosened in the face of “tightening” measures, look in the mirror. Chair Yellen needed to choose her words carefully, especially on the subject of inflation. The markets were near all-time highs, with what has likely been a decent amount of hedging/shorting over the past month. An upside breakout risks a bout of destabilizing speculation. At the same time, there were early indications of fledgling risk aversion. Global yields had recently jumped. Weakness was notable in the periphery debt markets (i.e. Italy, EM), and even U.S. corporate Credit was hinting vulnerability.

Importantly, there was heightened market concern that a concerted effort was underway to begin removing central bank accommodation – that booming markets and stubbornly loose financial conditions might force central bankers to adopt more aggressive tightening measures.

Understandably, the markets will interpret a dovish Yellen – especially the nuanced language on the topic of inflation – as rushing to the markets’ defense. The view that the Fed won’t tolerate even a modest market pullback is, again, further emboldened. And quickly global markets will return to the view that central bankers may talk “normalization,” while their overarching anxiety for upsetting markets has diminished little.

July 12 – Bloomberg (Vivien Lou Chen): “Fed Chair Janet Yellen says that in looking at asset prices and valuations, the central bank is ‘not trying to opine on whether they’re correct’; instead, policy makers are assessing the risk of potential spillovers. As asset prices rise, there hasn’t been a substantial increase in borrowing, Yellen said. [The] financial system is strong and resilient.”

I assume chair Yellen is referring to U.S. non-financial and non-government borrowings. Clearly, central bank Credit and government borrowings have expanded spectacularly around the globe. I suspect as well there has been a major expansion in speculative leveraging and securities Credit at home and abroad.

Georgia Senator David Purdue: “Thank you for being here and for your service. I just have two quick questions. I’m very concerned about global debt. The Institute of International Finance recently reported that their estimate of total global debt is $217 trillion, or more than 300% of global GDP. Do you agree with that?”

Chair Yellen: “So, I haven’t heard that number. That could be. I don’t have that number.”

Purdue: “Of that, $60 trillion is estimated to be sovereign debt. We have about $20 trillion of the $60 trillion. With that as background, the four large central banks also have their largest historic balance sheets. Japan, China, EU and US have collectively close to approaching $20 trillion now of balance sheet size. As you talk about reducing the size of the Fed’s balance sheet, are you coordinating with these other central banks and looking at emerging market debt – particularly the $300 billion that’s coming due by the end of 2018 – relative to the size of your balance sheet here in the United States?”

Yellen: “I wouldn’t say coordinate. We try to make sure we meet regularly and discuss our policy approaches; to make sure that central banks understand how we are looking at economies and policy options. I think the major central banks understand the approach that others are taking. But trying to ask in an aggregate sense how much debt is outstanding is something we’re not doing. Our economies are in rather different situations. While we all encountered weaknesses that were sufficiently severe that Japan, the ECB, the Bank of England, the United States, we all resorted to purchases of longer-term assets to support growth. It leaves the Bank of Japan and the ECB.”

Purdue: “Are you concerned about so much of that [debt] denominated in dollars today?”

Yellen: “It is a risk. A significant amount of that is in China, but that’s not the only country where there are substantial corporate dollar-denominated debts. And certainly that is a risk that we have considered that affects the global economy.”

Senator Bob Menendez: “Let me ask you finally, how does—we see high rising levels of household debt, widening inequality, a neutral interest rate at historically low levels. To me, it’s critical that the Fed has the ability to respond in the event of another economic decline. How does below target inflation impact household debt? And what signs do you see of inflation coming close to the Fed’s 2% target, let alone exceeding it by dangerous amounts?”

Yellen: “As I said, I think the risks with respect to inflation are two-sided. But we’re very aware of the fact that inflation has been running below our 2% objective now for many years, and we’re very focused on trying to bring inflation up to our 2% objective. That’s a symmetric objective and not a ceiling. We know from periods [when] we’ve had deflation, which of course we don’t have in this country. But that is something that has a very adverse effect on debtors and can leave debtors drowned in debt. Now, we don’t have a situation nearly that serious. But it is important when we have a 2% inflation objective to make sure that we achieve it and we’re focused on doing that.”

Yellen stated during that the Fed’s inflation mandate is “symmetrical.” Yet it’s unimaginable that the FOMC would keep monetary conditions extraordinarily tight for nine years in response to CPI modestly above its 2% target?

It’s by this point abundantly clear that contemporary monetary management exerts major direct influences on the structure of asset prices, while having dubious effect on aggregate consumer prices. This now discernable dynamic creates a momentous dilemma for central banks. Especially after the worldwide adoption of the Bernanke doctrine, it’s fundamental to their approach that central banks retain the power to inflate out of trouble as necessary. Why fret debt accumulation, speculation and asset price Bubbles when central banks can always inflate the general price level, thereby reducing debt burdens and asset overvaluation?

Central bankers have a penchant for speaking in terms of “fighting the scourge of deflation.” More specifically, they view inflation as the indispensable mechanism for reflating systems out of the consequences of debt and asset Bubbles. If central bankers were to admit they don’t control “inflation,” then their policy doctrine of promoting reflationary debt growth and higher asset prices turns spurious.

It has been my longstanding position that it’s not possible to inflate out of major Credit and asset Bubbles. As we’ve witnessed for years now, central bank stimulus fuels self-reinforcing speculative excess, with a resulting accumulation of speculative leverage and securities-related Credit more generally. At the same time, years of abundant cheap global liquidity work to feed overcapacity and attendant downward price pressure on many things. Rampant inflation within the Financial Sphere nurtures pricing vulnerabilities and instability throughout the Real Economy Sphere. Bubbles Inflate Only Bigger.

As such, if one accepts the reality that central banks don’t control inflation, the policy course of repeatedly inflating serial Bubbles can be viewed as risking eventual catastrophic policy failure. There’s simply no escaping the day of reckoning. This analysis certainly applies to China. Led by strong lending ($214bn), June growth in Total Social Financing jumped to $263bn. This puts first-half non-government Credit growth at $1.65 TN (up 14% from last year’s record pace), consistent with my expectation for total Chinese Credit growth this year to exceed $3.5 TN.

Along with Yellen’s testimony, China developments were likely a factor in this week’s global risk market rally. The view is taking hold that Chinese officials have at least temporarily pulled back from tightening measures, perhaps in preparation for this autumn’s 19th National Congress of the Communist Party of China.

July 12 – Wall Street Journal (Grace Zhu): “Chinese banks extended higher-than-expected volume of loans last month even as growth in the money supply continued to slow amid Beijing’s efforts to reduce leverage in its financial system. New yuan loans issued by Chinese banks surged to 1.54 trillion yuan ($226.38bn) in June, up from 1.11 trillion yuan in May… The volume was well above the 1.3 trillion yuan forecast by economists… June is typically a high point for new credit from Chinese banks’ as loan officers rush to meet quarterly targets. Beyond that, demand for credit from households—mostly for mortgages in the hot property market—remained strong, and companies too turned to banks for loans, instead of issuing bonds.”

July 12 – Financial Times (Gabriel Wildau): “China’s central bank injected $53bn into the banking system on Thursday, the latest sign that policymakers have eased up on a fierce deleveraging campaign that has caused turmoil among lenders in recent months. President Xi Jinping told the politburo in April that ‘financial security’ was a top policy priority for the year. That led the central bank to tighten liquidity, while the ambitious new banking regulator unleashed a ‘regulatory windstorm’ that sent shockwaves through the banking system. The storm appears to be passing, as the People’s Bank of China has become more generous with cash injections while the China Banking Regulatory Commission has delayed implementation of a significant new directive. ‘There are clear signs in recent weeks of monetary and supervisory tightening being eased,’ Tao Wang, co-head of Asia economics at UBS in Hong Kong, wrote…”

Original Post 15 July 2017

Categories: Doug Noland, Perspectives