Friday, February 24, 2017

Yield Curve Watch

Here is a scatterplot of the Fed Funds Rate with the slope of the yield curve.  A flat or inverted yield curve is a well-known sign of a coming contraction.  But, the zero lower bound will confound this signal because there is option value in the longer bond maturities, so if short term rates are low, long term rates are less likely to get as low as long term rates.

A very broad review of this relationship suggests that at low rates, a 1% incline is probably, for practical purposes, an inversion.  We were close to this level after the rate hike in late 2015, but something pulled us back up.  If the Fed had hiked earlier in 2016, that might have tipped the scales back down.

As we proceed through 2017, it will be important to watch long term rates.  If they remain low or decline, and if at the same time new data on employment and inflation triggers a new rate hike from the Fed, then that will be bearish.  The 10 year yield is currently about 1.8% above the Fed Funds Rate.

Source

Wednesday, February 22, 2017

With friends like this....

FOMC minutes from the January meeting are out.  They include this:
In discussing the outlook for monetary policy over the period ahead, many participants expressed the view that it might be appropriate to raise the federal funds rate again fairly soon if incoming information on the labor market and inflation was in line with or stronger than their current expectations or if the risks of overshooting the Committee's maximum-employment and inflation objectives increased. A few participants noted that continuing to remove policy accommodation in a timely manner, potentially at an upcoming meeting, would allow the Committee greater flexibility in responding to subsequent changes in economic conditions.
When the Fed began paying interest on reserves in October 2008, this was their stated reason.  They had disastrously left their target rate at 2% when they could have probably already pegged it at zero.  Markets went haywire, and they refused to lower the rate.  They were afraid of hitting the zero lower bound, so they....moved the lower bound up.
We needed the authority to solve an increasingly serious problem: the risk that our emergency lending, which has the side effect of increasing bank reserves, would lead short-term interest rates to fall below our federal funds target and thereby cause us to lose control of monetary policy.  When banks have lost of reserves, they have less need to borrow from each other, which pushes down the interest rate on that borrowing-the federal funds rate....by setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much lending we did. (The Courage to Act, pg. 325-326)
My shorthand for this is that the Fed normally creates currency by lending cash from their magic vault to the government.  After August 2007, when they started making emergency loans to banks, they would sell treasuries back to the market so that those loans didn't lead to currency creation.  In October 2008, they were running out of treasuries, so they started borrowing that cash back from the banks, in the form of interest bearing excess reserves, in order to prevent that cash from entering the economy.  In other words, from August 2007 to October 2008, the Fed was pulling cash out of the economy in order to sterilize emergency loans.  After October 2008, they were pulling credit out of the economy in order to sterilize emergency loans.

The idea that maintaining an interest rate that is above the neutral rate while Rome burns around them is a strange way to think of being "in control" of monetary policy.  It is so odd how Congress was being asked to basically sign a blank check and to give the Fed an entirely new tool, yet it seems that nobody seriously considered lowering the rate as everything collapsed following that September 2008 meeting.

This is sort of like an anorexic person being in control of their body size.  What exactly is the point?

Anyway, apparently the results of 2008-2009 were not enough to defeat this way of thinking.  That comment from the January meeting is a decent piece of the puzzle that leads me to shade toward pessimism in the short term.

I like to think of it like a Monte Carlo simulation.  Imagine a model that has some random movement, some uncertainty, and some independent variable (here, the neutral Fed Funds Rate) that can maintain some sort of mean reversion in a dependent variable (here, GDP growth, or inflation, or unemployment - economic growth, by one measure or another).  Simulation after simulation should produce some different version of growth moving through time, within some range of a target.  Now, add the implication of that first quote to the specification.  The system is bound to break below the mean.  Every simulation will be growth shifting through time for a little while and then falling.  Eventually, some noise will trigger a premature rise based on this reasoning, and the Fed will be chasing the rate down.  The only question is how long does it take for this to happen and how bad does it get while the FOMC attempts to save face.

Current political uncertainties mean that in our real-life simulation, variance in the random movement and noise has gone way up, which could actually help us avoid this problem if real improvements in the economy move faster than Fed attempts to "control" the interest rate.  Maybe the neutral rate in some of those simulations rises enough to escape this destiny.  So, ironically, I think a sane administration would have led to a more certain near-term contraction.  But, it still seems prudent for the mean expected economic activity, say, one year out, to be shading lower.

Monday, February 20, 2017

Housing: Part 208 - Underwriting or money?

Here is a graph of the values of AAA rated securities on CDOs in 2006-2011.

Source
Here also is a graph of NGDP growth in 2006-2011.

So, was it underwriting that led to these changing values?  Or was it monetary policy?  Did the rating agencies that gave these securities AAA ratings err in their estimation of the underwriting standards, or did they err in their forecasts of monetary policy?


Source
Those early 2006 pools were at the height of prices and of mortgage issuance, yet they nearly regained face value even after the recession and the severe collapse in collateral values.

Re-imagine these graphs if the Fed had stabilized GDP growth in the summer of 2008, or the spring, or in late 2007, then re-consider the question of whether the outcomes for these securities were more due to underwriting or to monetary policy. If you are tempted to respond that earlier stabilization would only have encouraged more recklessness, remind yourself that by the time these securities were trading below full value, origination markets for private securitizations were effectively dead.  That ship had sailed.

If we count the closing down of mortgage issuance to middle and lower-middle portions of the market that continued after GSE conservatorship, literally years worth of destabilizing policies were implemented after new issues for the private securitization market died.  The reversal of any of those policies that happened after these securities started trading at discounts would have decreased the damage done.

At the September 2007 FOMC meeting, Bernanke notes in The Courage to Act (p. 162):
As in August, we again discussed the issue of moral hazard – the notion, in this context, that we should refrain from helping the economy with lower interest rates because that would simultaneously let investors who had misjudged risk off the hook. Richard Fisher warned that too large a rate cut would be giving in to a “siren call” to “indulge rather than discipline risky financial behavior.” But, given the rising threat to the broader economy, most members, including myself, Don Kohn, Tim Geithner, Janet Yellen, and Mishkin, had lost patience with this argument. “As the central bank, we have a responsibility to help markets function normally and to promote economic stability broadly speaking,” I said.
In the end, the Richard Fishers' won and the rest of us lost.  The oddity is that it seems to me that the consensus, even in hindsight, remains with Fisher.

Friday, February 17, 2017

We are the 100% follow up.

Earlier, I was lazy, and I compared compensation and capital income over time with a measure of capital income that included corporate tax.  But, over the long term it is after tax capital income that will equilibrate in domestic incomes.  So, I subtracted corporate tax from the "operating surplus" measure.  This makes the relationship stronger.  Over time, real compensation and real capital income before tax have a .9724 correlation.  Compensation and real capital income after tax have a .9756 correlation.  This is especially interesting, since corporate taxes are pro-cyclical, and so on a cyclical level, corporate income is more noisy after taxes.  (Effective corporate tax rates go up during contractions because losses aren't fully and immediately deductible.)  Even with that extra cyclical noise, removing tax from capital profit strengthens the relationship.

Taxing capital income is not an effective way to break us apart.  We are the 100%.

PS: As commenter Blissex pointed out on the earlier post, this should probably also be adjusted for population.  Adjusting both income levels with the size of the labor force reduces the correlation to about 92%.

We are the 100%.

Eons ago, I told commenter TravisV that I intended to look at this paper, and I finally have.  The abstract is:
Three mutually uncorrelated economic disturbances that we measure empirically explain 85% of the quarterly variation in real stock market wealth since 1952. A model is employed to interpret these disturbances in terms of three latent primitive shocks. In the short run, shocks that affect the willingness to bear risk independently of macroeconomic fundamentals explain most of the variation in the market. In the long run, the market is profoundly affected by shocks that reallocate the rewards of a given level of production between workers and shareholders. Productivity shocks play a small role in historical stock market fluctuations at all horizons.
This would appear on the surface to push against the notion that we are the 100%.  Over the long term, fluctuations in stock market value come from reallocation between workers and shareholders.

The actual findings of this paper are interesting and useful, but I think we need to be careful about how they are interpreted.  Much like the Mian & Sufi findings about the housing boom, mostly what is going on here is that they have adjusted away almost the entire story, and they are analyzing the small sliver that is left.  They have detrended the data exponentially.  For instance, take a look at this graph from the voxeu article:

Over the long term, we can see here that fluctuations from the trend largely correlate with changes in the share of income to shareholders.

From the article's conclusion:

Technological progress that raises aggregate consumption and benefits both workers and shareholders plays a small role in historical stock market fluctuations at all horizons...
Indeed, without these shocks, today's stock market would be about 10% lower than it was in 1980. The shocks responsible for big historical movements in stock market wealth are not those that raise or lower aggregate rewards, but are instead ones that redistribute a given level of rewards between workers and shareholders.
This seems like misleading interpretation to me.  We are talking about a 10% fluctuation over a period where the trend growth was something like 700% in real terms.

Here is a scatterplot of real capital income and real compensation since WW II.  If you want to know what capital income will be in a given year, an extremely good proxy would be knowing the level of compensation in that year - and vice versa.  The correlation is .97.

So, whatever we might learn from this paper - and there are things to learn from it - it seems very important to keep in mind that this paper is about a 3% portion of the total story.

It seems to me that the quote above should be prefaced with the sentence: Technological progress that raises aggregate consumption and benefits both workers and shareholders explains general growth in stock market values, which is about 97% of the growth in income and wealth.  Shifting factor shares might explain much of the other 3%.

It's a shame that the human psyche is so drawn to battles over relative status.  The story of human history and human advancement is a story of the battle to overcome this mental defect.  We are the 100%.  How much social attention is paid to the 97% of the story versus the 3%?

The largest risk of economic dislocations, like what we have seen over the past couple of decades, isn't the actual shocks themselves.  It is the human tendency to retreat into battles over relative status.  Notice that their measure of the effect of factor shares on stock wealth has declined since the late 1990s.  How's that workin' for ya?  Is there any disagreement that 1968 and 1998 were better for both shareholders and workers than 1978 or 2008?

Follow-up

Thursday, February 16, 2017

NY Fed Household Debt Report: Signs of Debt Growth?

The New York Fed reports that household debt rose in 2016 4Q.  This is a positive sign.  The scenario for continued recovery would center on housing recovery and mortgage recovery.  Positive signals include a decline in shelter inflation, a rise in non-shelter inflation, a rise in interest rates, a rise in housing starts and prices, and a rise in mortgages outstanding.  If that doesn't come together, I expect the Fed to overtighten and to trigger a contraction.

Last month's CPI data suggests a possible shift in this direction.  Now, the 2016 4Q household debt data also suggests a positive shift.  Mortgage debt increased by about $130 billion and other household debt also increased.

In both cases, I am concerned that these are just the latest head-fake.  Data from commercial banks suggests that the mortgage data is (not sustained).

Source
So, I remain tentatively neutral-to-bearish, in wait-and-see mode.  There isn't any reason that the expansion should reverse simply due to its age, but this seems like a context where, nevertheless, the risks of being exposed to a contraction are higher than usual.

Wednesday, February 15, 2017

January 2017 CPI Inflation

A major reversal this month.  Good news or noise?

Month over month change in non-shelter core CPI was over 0.3%.  Year over year non-shelter core inflation is at about 1.3%.  Rent at Zillow has been signaling moderation recently.  Does that mean CPI shelter inflation will now also continue to moderate?  If non-shelter inflation is from demand-side pressures, I don't see how it could.  I'm still mostly in wait-and-see mode here.

Tuesday, February 14, 2017

Housing: Part 207 - The Glut of Houses

1.
This is covering old territory, but I thought this chart was worth tossing up here.

Source - table 8
This should show the massive misallocation of capital into housing during the 2000s bubble.  The huge run-up in housing units, fueled by loose credit and cheap money.  A run-up so massive it would take years to work off.  Bernanke noted in 2011, "Builders would start construction on only about 600,000 private homes in 2011, compared with more than 2 million in 2005.  To some extent, that drop represented the flip side of the pre-crisis boom.  Too many houses had been built, and now the excess supply was being worked off." (The Courage to Act, p. 503)

Millions of extra homes must have been built in order to create inventory that would take that long to work off.  There are a lot of books on the bubble that I haven't read.  I can only assume that this data appears somewhere.  Maybe they have a different version than I do, or maybe my scale is messed up.


2.
I see two frequent comments about Closed Access real estate.

1) The supply limit is due to geography.  There just isn't a way to build much in those cities.

2) Markets are getting hot.  There is a bit of a bubble.  Skylines are dotted with cranes.  There is too much building.  Rents are starting to soften.  The building market needs to pull back before it creates another boom and bust cycle.


These two observations are mutually exclusive.  Either there is a geographical limit to building, in which case, all potential building can only partially accommodate the demand for housing in those cities, or there is the potential to build too much, leading to a bust.  It's one or another.  Functionally, we appear to govern as if we believe both at the same time.  So, we make excuses for the lack of building that keeps rents high, and then, when enough building occasionally makes it through the political gauntlet to actually cause rents to moderate, we, maddeningly act like that is a problem to solve.

The idea that geography is the limiting factor here is wrong on its face, in either case, which is clear simply by opening one's eyes.  Are developers throwing up their hands in the Closed Access cities because there is just no developable land to purchase, or do they have many potential projects that are stuck in political limbo?  Is anyone going to honestly try to argue that if every building project in the pipeline now was fast-tracked, that developers wouldn't have any potential projects to follow up with?

This is the odd position we are in because of Closed Access policies.  Closed Access is an unstable equilibrium.  The current rent and price levels of Closed Access homes depends on exclusion.  The price of Closed Access homes contains an implicit assumption that millions of low-income households will have to move away for lack of affordable housing.  Dislocation is baked into the Closed Access market.

If there was ever enough building in those cities to heal that future dislocation, home prices in that city would collapse.  A natural supply and demand equilibrium would be destabilizing in the short run.  It would lead to billions of dollars in capital losses.  So, we govern the economy to maintain an unstable equilibrium, where the unmet demand for Closed Access housing is balanced against expectations of future supply deprivation and future dislocation of disadvantaged residents who Closed Access cities just won't make room for.

There is no way to balance that equilibrium.  In places like Texas, the equilibrium is basically the cost of building, and supply and demand shift to maintain that basic balance.  But, since Closed Access has come to define our economy, and since we have managed to address it with delusions of attribution error, we bounce from boom to bust, always nervous about the next big kick in one direction or another, because so much wealth in Closed Access economies is derived from the presumed ownership of exclusionary policies in the far future, which are imputed into the prices of those restricted assets today.

Wednesday, February 8, 2017

Liberalism wins with capitalism, but first, there need to be liberals.

One might have a standard that we should refuse to admit refugees if this will lead to even a single terrorist or criminal incident.

One might also have a standard that we should refuse to mine for coal if this will lead to a single drop of toxic materials in a watershed.

I dream of a country where political factions are divided between those who see these statements both as wrong, in a similar way, opposed by those who see them both as acceptable.

Instead, we have a country where few people seem to see these both as similarly wrong, and there are two larger groups who see one version as correct and the other as wrong.  Their different positions seem to be based on a pre-programmed double-standard.  In both cases, the optimal standard in the world we live in clearly involves compromise.  The optimal amount of refugee acceptance or immigration will, unfortunately, inevitably lead to some instances of crime involving those immigrants.  The optimal amount of electricity will, unfortunately, inevitably lead to some instances of environmental accidents or increases in trace toxins.  We accept these compromises as endogenous when it comes to crimes committed by citizens, or when it comes to toxins we release from our backyard fireplace, or the production of solar panels, or the delivery of some fossil fuels within the status quo.

The differences in these positions seem to come from different forms of sectarianism, who have different suppositions about who are insiders and who are outsiders.  Outsiders don't get compromises.  They get ultimatums.

We will be moving in the right direction if we can somehow break away from sectarianism and move to a political context where the disagreements are between conservativism and liberalism.  The great miracle of markets and capitalism has been capitalism's tendency to deal a winning hand to liberalism, freeing the world's communities from their local status battles, within which the potential of the community is held back in service of the protection of the powerful.  It is difficult for this miracle to play out if there are no liberals to carry the mantle.  Liberals deal in principles, not identities.  Liberals are relativists, not absolutists.

Monday, February 6, 2017

Bank deregulation

John Cochrane has a post today about the potential for Dodd-Frank reform.  The short version is: it would be a good development if we could find a compromise where banks are less regulated in exchange for requiring higher capital requirements.

I agree with this, but really, I think this is simply the what any real deregulation looks like.  I think the GSEs really help to bring clarity to this issue.  They are similar here to commercial banks.  They have very low capital requirements, which worries a lot of observers.  Along with those capital requirements is de facto government backing for their debt and issued securities.

So, banks have FDIC insurance, which provides safety for depositors.  This means that as banks take in deposits (which are liabilities for banks), the interest rates required by those depositors don't react to the risks created by leverage, since FDIC insurance is basically like a credit default swap for the depositors.  Any non-financial corporation would naturally remain less leveraged, outside of crisis situations, because they would have to pay higher interest rates for debt as their leverage increases.  Since FDIC insurance undermines this basic market source of moderation, banks have to be regulated so that they don't become too leveraged.  They are forced to keep a minimum level of capital.

But, the minimum level of capital required has to be less than what the natural market level of capital would have been.  Otherwise, what's the point?  And, banks would simply be out-competed by non-regulated substitutes if they were forced to hold capital levels above the natural market level.

I'm not an expert on the repo market, but it seems to me that we created a similar problem by inventing the accounting fiction that repos are not loans, which also makes the interest rate on repo financing non-responsive to leverage risk.

In any case, there is a natural pairing between capital requirements and regulatory restraints.  As regulation and public insurance of various kinds ratchet up, capital requirements naturally decline.  If banks were completely deregulated, they would naturally hold more capital.

I wonder if commercial banks, as they exist today, are an anachronism anyway.  If they were deregulated, I wonder if they would mostly go away.  Is the central intermediation that they engage in - borrowing short and lending long - even necessary today?  Is the regulatory framework that supports this intermediation actually maintaining a risk in the economy that isn't even necessary today?  Would money market funds, REITs, investment banks, and a host of other financial agents rise up in ways that would match asset-liability maturities within each institution?

This is really clear when thinking about the GSEs.  If they didn't have federal backing, their business model would probably be ineffective.  And, if their capital requirements were set too high, their business model would probably be ineffective.  Both of those factors need to be in place for the GSEs to exist, and those factors come as a pair.  What point is there of having capital requirements if there is no guarantee?  The bondholders would not be accepting a discounted interest rate in that case, and they would be perfectly able to demand their own bankruptcy terms if there was no federal backing.  Imagine how awkward it would be to have the capital requirement without federal backing.  If the bondholders held securities that had become impaired, or where there was a probability of future default, they would naturally be in communication with the boards of the GSEs to manage the firms in everyone's best interest.  Imagine if, without giving them any support, the federal government stepped in and imposed a settlement on them that neither the equity holders or the bondholders had invoked.  What would be the point?  The capital requirement without the guarantee would do nothing but add risk.  That's what is so strange about how so many policymakers still pretend like there was never a government guarantee on GSE debt.  Of course there was.  There had to be.  And, it was invoked in 2008, if there was ever any doubt.

In the book, I walk through the argument that there should not be GSE debt, but that there should be a government guarantee of GSE MBSs.  It would be a public good which really can only be provided publicly.  That's a story for another day.  But, clearly, in the case of the GSEs we can see that, in and of itself, regulatory insurance and capital requirements go together, and they can induce institutional forms that increase systematic risk.  Public insurance increases systematic risk.  Maybe that is counterintuitive.

It seems to me that many people assume that deregulation somehow helps insiders and powerful institutions, and that, if we did deregulate banks, those same people would quite naturally and quickly, shift toward getting mortgages from privately funded REITs, investment banks, and MBS investors and toward putting their short term savings into money markets that invested in commercial paper and short term treasuries, and it would never occur to them that they were intimately involved in the devolution of power from previously regulated institutions.

Cochrane's idea of deregulating and raising capital requirements seems like a step in the direction of simply deregulating, which is all for the best.  But, if there was only some deregulation, then the capital requirements would still have to remain lower than what the completely deregulated market would provide.  In fact, it seems like what we see in the marketplace of substitutions for commercial banks are many forms of saving that don't particularly use leverage at all.  This would be even more the case if we stopped giving debt tax advantages over equity.