Managing member Pavlik Capital Management LLC
"What's the point..." - Homer Simpson - Commentary August 2017
For those of you that are regular readers you know all too well that we have poked fun at the Fed…a lot. Not necessarily for trying to calm markets in 2008 and 2009 but for the blind acceptance of theories that had purely hypothetical origins. It is well understood in science that theories generally depend on two approaches: 1) Induction - the analysis of experiments and formulation of theories that explain the data 2) Deduction - analyzing the residing principles and postulates that are embraced as fact and deducing consequences from them. Most scientists/economists blend a combination of induction and deduction.
Up until 2008 the Fed had done a ton of inductive theorizing. After all, it is always easier to find patterns or correlations from data sets after the facts are established and results are in. So when markets unraveled 9 years ago the Fed opened their conventional textbook and implemented step one from chapter one: lower rates. Unfortunately the textbook had to be revisited via a rarely read addendum focused on printing money to purchase “assets” and the incorporation of “forward guidance”. The theory in total (at least initially) was simple. 1) Cut rates, everyone will borrow money and growth will arrive. 2) Purchase assets to stabilize the banking system, banks will lend and growth will arrive. 3) Issue “forward guidance” in an effort to emphasize lower rates for a long time, people will borrow and growth will arrive. In a nutshell the great philosopher Homer…Simpson said it best, “I have a great motivation technique. It is doughnuts and the possibility of more doughnuts.”
Understand, up until 2008 the universally accepted central banker economic theories had generally held true. So when Fed Chair Ben Bernanke launched and expanded his ginormous money printing experiment and “forward guidance” he was the perfect spokesman. He was considered an expert on the Great Depression and therefore deemed “qualified” by academics and politicians to explain and justify the extraordinary measures by the Fed. Eventually the Fed became the global spokesman for all things monetary policy that quickly became accepted as the status quo. When he was replaced by Janet Yellen she also offered little deductive thought and blindingly stuck to the newly established status quo…despite years of failed forecasts.
Where are we going is this? A simple quote by Albert Einstein sums it up, “Concepts that have proven useful in ordering things easily achieve such an authority over us that we forget their earthly origins and accept them as unalterable givens. Thus they come to be stamped as “necessities of thought,” “a priori givens,” etc. The path of scientific advance is often made impassable for a long time through such errors.” Holy crap do we wish we put this in every newsletter since 2009.
So imagine to our amazement when last week, 9 years post-crisis, after the Fed has taken their balance sheet from $800 million to $4.5 trillion, the Fed announced a plan to shrink their balance sheet and alter the status quo. Secretly, we heard the idea began at the Fed’s monthly pizza party (this may be fake news) when someone raised their hand and asked why the heck inflation was still so low and growth so anemic with employment at full capacity. Supposedly a flurry of deductive questions were then asked such as, “Maybe things like Obama Care as a tax on employers is keeping wages down? Maybe technology is decimating prices and margins for retailers? Maybe technology is allowing for fewer, more efficient workers? Maybe ‘forward guidance’ has pushed CFOs to issue debt and buy stock back in lieu of investing in their own companies? Or maybe, just maybe inflation is somewhere else like stocks, bonds and real estate?” A drunken Homer Simpson who snuck in the party immediately mumbled this analogy about the possible reduction of the balance sheet, “What’s the point of going out? We’re just going to wind up back here anyway.” To which he was promptly kicked out.
Anyway…while we hope we don’t go back from where we came we do believe the reduction of their $4.5 trillion balance sheet (a whopping 0.02% next month) is a direct rejection of the “unalterable givens” that had been considered “necessities of thought” for the last 9 years. While it wasn’t directly communicated that way this statement in the name of “forward guidance” and transparency by Fed Chair Janet Yellen said it all, “This year the shortfall of inflation from 2%...is more of a mystery. I will not say that the committee clearly understands what the causes of that are.” Seriously?!?!? After 9 years?!?!!?
To that end we give her credit for admitting her lack of understanding even though it took years for the Fed to recognize and off-handedly admit it. That said, the fact that something is finally being reversed given years of non-textbook results couldn’t come soon enough. Hopefully her recognition of the real inflation in stocks, bonds and real estate won’t take 9 years as well. After all, Homer Simpson still exemplifies a major portion of Fed communication, “I never apologize. I’m sorry that’s the way I am.” Stay hedged.