Is a Huge Monetary Policy Error Coming?

James Juliano Insights

US stock markets and the US Dollar have been weak in 2016 as fears mount that the US is determined to “catch down” to the rest of the world’s bad economic policies.

As our regular readers know, markets hate policy uncertainty, and the 2016 presidential election is providing an unusually high amount of it.  There is uncertainty in each of the three policy domains: Fiscal, Regulatory and Monetary.  These policies will either be pro-growth and attract global capital or anti-growth and deter global capital once it becomes clear which policy menu gets elected in November.  These three policy domains can be further broken into two separate but related groups.

Fiscal and Regulatory policies are similarly grouped since they determine how much capacity can be added to the economy.  These policies determine the growth rate of the economy’s productive capacity or the maximum possible output of an economy. Bad policies in any of these areas act as wedge between risk taking and after tax reward, essentially becoming a friction on our $18 trillion economy.  As these wedges increase, the rate of capital addition diminishes. Uncertainty about this policy set has been creeping into markets since last summer and accelerated in early January as Hillary Clinton’s email scandal escalation provided Bernie Sanders and his growth killing fiscal/regulatory ideas a surge in support.

Monetary policy stands alone from the other policies for several reasons.  Monetary policy is arguably the most important policy because it is nearly impossible to avoid and can be so volatile over the short term.  While fiscal and regulatory policies move at slow speed and often only change course due to election outcomes, monetary policy can shift more rapidly by comparison.  The Federal Reserve Board meets frequently, and policy announcements or language change often.  Additionally, there is a plethora of current and former Federal Reserve members, bank presidents, scholars and more who get air and print time daily to opine about what the Federal Reserve has done, is doing or should do.

While fiscal/regulatory policies set the economy’s maximum possible output, monetary policy can be seen as setting the rate at which we fill that capacity with production. Monetary policy governs not the rate of capital expansion but the rate of change in the operating rate, how quickly we might grow into that shrinking or expanding capacity.

A perfect monetary policy stabilizes the value of the currency at all times, accelerating the operating rate and eliminating uncertainty for workers, savers and investors. As one can imagine, the need for currency hedging disappears with a stable currency.  We are far from having a Federal Reserve that follows a gold standard or price level targeting system which would consistently stabilize the value of the US Dollar. However, despite its flawed models and horrendous track record, the Federal Reserve had managed to run an improving monetary policy for several years.

According to us, since late 2012 the Federal Reserve, more by accident than design, has overseen a consistent US Dollar strengthening.  This US Dollar strength was a welcome correction from the course of rampant US Dollar devaluation and inflationary monetary policy in place from 2002 through 2012 when gold prices rose from $250 to over $1900.

Since late 2012 there has been a gradual and consistent increase in the value of the US Dollar evidenced by falling gold prices.  The ten month average price of gold at the beginning of 2013 was $1600 and today is $1150.  Gold prices have fallen (US Dollar strengthened) by about 10% per year for three years.  There were many weak dollar moments along the way sending gold prices shooting higher for short intervals, but most of those moments were connected to foreign economies or geopolitical risks that were soon reversed.  In three years there was no serious monetary policy error or even a hint that the Federal Reserve would engage in a repeat of the US Dollar devaluation mistake of 2002-2012.  This recently changed.

Let’s look at gold’s signal.  Remember, changes in the price of gold are changes in the value of the currency.  Gold prices rise when there are more Dollars supplied than demanded.  Gold prices fall when there are more Dollars demanded than supplied. Most of the time the ideal situation is to have more demand than supply for US Dollars resulting in a gradually declining gold price.  This strong US Dollar condition is a symptom of good economic policies that attract capital to the US.  Pro-growth economic policies cause more global demand for US Dollars than supply, leading to economic expansion and resulting in falling prices.  We call this “Good Deflation,” and it is exactly the policy environment in place from 2012 to present.

Importantly, there are two other monetary policy conditions, or mixes of supply and demand for Dollars that can exist.  Both are bad and inferior to a “Good Deflation.” They are Inflation and “Bad Deflation.”

The peril of inflation is so obvious that we are shocked when otherwise apparently intelligent people say the perfect inflation rate is 2% annually.  This implies a confiscation rate of half your money over 35 years.  Inflation destroys saving and investing.

“Bad Deflation” is similar to “Good Deflation” in that there is more demand for Dollars than supply.  However, in a “Good Deflation” that demand for Dollars is a result of pro-growth policies, but in a “Bad Deflation” the surge in demand for Dollars is a margin call or forced liquidation.  A bad deflation begins with a policy error that causes a rapid collapse in the real demand for resources.  This is what was happening as gold prices crashed in 2008 and during the Great Depression.

As we said above, since 2012 we have experienced a “Good Deflation.”  US economic policies were the best in the world and attracted capital from Europe, Japan, China, etc. because capital was best treated here.  Policy was far from perfect in the US, but at the margin policy seemed to be moving towards pro-growth while the majority of the rest of the world leapt toward anti-growth.  In early 2016, gold prices began rising a bit from recent lows near $1050 towards $1100.  This slight shift in less demand for Dollars versus supply was no surprise given the unfolding election uncertainty.  In fact, we were surprised how tame the gold rally was given the mounting Sanders/Clinton policy threat. Gold’s move up seemed overly ordinary.

This changed in late January as the gold price increase became larger and more rapid around the time the Bank of Japan followed Europe and adopted negative interest rate policy on January 29th.  Demand for US Dollars sank and the gold price shot higher to $1200 as many feared Janet Yellen and the Federal Reserve were next to make the serious monetary policy error of negative interest rates.  Gold markets fears were confirmed recently when Janet Yellen said negative interest rates in the US “were not off the table.”

Since 2012 US Dollar “Good Deflation” had taken hold in spite of the Federal Reserve, and now the head of the Fed was talking about following the world’s central banks down a monetary policy mistake path of negative interest rates.  Negative interest rates are a terrible policy mistake in Europe and Japan, and they would be no different here in the US.  Negative rates would cause a misallocation of capital, credit and savings flows even greater than distortions caused by Quantitative Easing.  Credit flows would be further misallocated away from small business borrowers towards the largest, corporate borrowers so credit worthy they only borrow to pay off higher cost debt.

Stock markets not only worried only about negative rates, but futures markets began pricing in the odds that another interest rate hike would not occur until 2017.  The Federal Reserve began normalizing rates higher in December and announced a plan to do roughly four more hikes this year.  A few months later and the Fed was now talking about no more hikes, negative interest rates and even rumors about another round of Quantitative Easing being needed quickly.

A monetary policy error was back on the table.  This new layer of policy uncertainty coupled with election policy uncertainty sent US stocks near lows and gold prices near highs.  We cannot predict the election outcome and therefore cannot know what the policy mix will be until much closer to November or possibly even after the election.

However, we can watch what the Fed does daily with monetary policy.  We do not think the Federal Reserve will err into negative rates or more QE. As markets grasp this more clearly the panic move higher in gold prices will subside and US equities will find support.

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