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December 2013 • Volume 2, Issue 12

Hooked on Easy Money

By W. Michael Cox and Richard Alm Small Talk Going into 2013, the Federal Reserve had kept interest rates at rock bottom for five years and bought a • Taking stock. The press gushed as

net $2 trillion in financial assets—the most aggressive stampeding bulls pushed the Dow Jones Industrial Average and S&P 500 to record monetary policy in its 100-year history. All it got for its highs in November. As trading closed the day efforts was an economy slogging ahead with growth too after Thanksgiving, the Dow had gained 149 slow and unemployment too high. percent from its recessionary low in March Despite the poor results, the central bank held 2009; the S&P bounced back 150 percent. doggedly to its stimulus policies throughout 2013, Going back to pre-recession highs reached in 2007, however, the bulls seem to be keeping interest rates low and adding another $1 trillion moseying rather than stampeding. The to its stockpile of financial assets. The same policies increases were just 13.3 percent (2.2 delivered the same results—another year of sluggish percent a year) for the Dow and 16.1 percent growth and disappointing job creation. (2.7 percent a year) for the S&P. Today’s bull Going into 2014, we’re just about where we were market has a long way to go to match the epic 1,750 percent surge from 1982 to a year ago. Growth is weak. Unemployment is high. 2007—an average annual gain of nearly Interest rates are low. Inflation is tame. And the Fed 14 percent, dividends included. faces the same conundrum—how long to continue stomping on the monetary policy accelerator. • Privacy worries. The National Security Agency’s monitoring of phone calls and email Investors spent most of 2013 trying to read the Fed’s messages has received a lot of attention, but intentions. The guessing game will continue into 2014, Michael Mayfield and John Berlau of the focused on the same questions. Will the Fed’s massive Competitive Enterprise Institute raise a red monetary buildup unleash a burst of inflation? Will the Fed flag about snooping on Americans’ financial finally begin to taper off, allowing interest rates to rise? records. The Consumer Financial Protection Bureau, a creature of the Dodd-Frank legislation, One thing will change in 2014. If confirmed, Janet has collected financial information on more Yellen will take the Fed’s helm on February 1, replacing than 10 million consumers. The CFPB told Congress it intended to monitor 80 percent of all credit card accounts—more than 900 Pumping Up Base Money: Raising the million in all. The agency says the data are anonymous—but Mayfield and Berlau remain Billions (Base Money) $3,520 skeptical of this invasion of privacy. • Tallying redistribution. Looking at taxing and spending policies of federal, state and local governments, the Tax Foundation finds a total transfer of more than $2 trillion a year from the top 40 percent of the income distribution to the bottom 60 percent. Looking at annual benefit per household on the spending side, the second quintile receives the least at $30,052 and the top quintile the most at $35,141. The small gap suggests most redistribution takes place on the taxation side. An average household in the bottom 20 percent paid only $6,331 to all three levels of government; the top 20 percent shelled out $122,217.

Annual Monetary Policy Review Ben Bernanke, the chairman since 2006. As a Fed insider with a Keynesian bent, Yellen will probably stick with the stimulus—but, for investors, the transition only adds to uncertainty about the Fed and the economy. QE on the QT After pushing its policy rate close to zero, the Fed continued its stimulus through quantitative easing (QE), or buying securities to inject money into the economy. Since the financial crisis of 2008, the Fed has conducted three rounds of QE, the latest being the $85 billion a month that investors tracked in 2013. Getting from QE to an inflation threat starts with base money—bank reserves plus currency held by the non-bank private sector. Before the financial crisis, increases in base money ran roughly parallel to growth in M2, a closely watched money supply measure. Five years of QE have expanded base money far ahead of M2 (see chart below ). M2 growth minus GDP growth nearly matches ­inflation from 1959 to 2013—so a bulge in base money, with its potential to pump up M2, is cause for alarm. Continued on page 2

Risk of Higher Inflation Billions (M2)




$20,180 $2,520 QE2 $15,180




QE1 $1,020

Fed Watch and Chart Topper: Page 3

$5,180 M2


$20 1959

Base Money 1965






$180 2001


2013 Source: Federal Reserve

THE ARGENTUS OUTLOOK Continued from page 1

So far, huge increases in base money, with its potential to pump up M2, haven’t accelerated M2 growth. To understand why not, we need to look at the relationship between base money and M2—as defined by the money multiplier, or M2 divided by base money. In normal times, the ratio has been steady in the 8-9 range. Recently, it’s slipped into the 3-4 range, keeping base money from expanding M2 for the time being at least. What’s going on? Rather than expanding lending, banks have built up their reserves—to a staggering $3.5 trillion, up from $800 million in 2007. Low interest rates and financial instability have driven people toward liquidity and safety, increasing money demand. A weak economy also helps keep inflation tame by subduing the demand that starts prices rising. So don’t interpret today’s low inflation as a strong Fed commitment to price stability. Quite the contrary, low inflation may have merely allowed the Fed to pursue easy-money policies that in other circumstances would be regarded as irresponsible. On methamFEDamines The Fed’s balance sheet provides one measure of recent policies’ recklessness. Before the financial crisis, the Fed had held about $900 billion in assets for years. After three rounds of QE, the Fed has nearly $4 trillion in assets, with most of the recent buildup focused on mortgage-backed securities (see chart below ). The Fed could relieve potential inflationary pressures by shrinking its bloated balance sheet—a quantitative easing in reverse, selling securities to take money out of the economy. The Fed wavered and waffled, hinted and hesitated, but in the end it decided to persist in adding to a dangerous, inflationary balance sheet bulge. In effect, the Fed has the economy hooked on easy money—methamFEDamines, if you like. As with any

addiction, the good effects come first—notably, the stock market’s 150 percent surge since March 2009. The bad effects come later—in this case, perhaps higher inflation and slow growth in the future. When trying to kick an addiction, the bad effects come first, the good ones later, usually after enduring the pain of withdrawal. Once the Fed ends the stimulus and interest rates begin to rise, firms could cut back on borrowing, spending and hiring. Homebuyers could grow cautious, deflating a revived housing market. The stock market’s bubble could burst, leading consumers to pull back. The Fed wants none of that; nor does it want to rebuff the enablers lurking just outside its offices. For Congress and the Treasury, low interest rates make it easier to borrow and spend. The federal housing agencies like cheap mortgages and Fed support in the market for mortgage-backed securities. The Fed can’t keep the economy hooked on easy money forever. Everyone knows this, including Janet Yellen. Yet, the Fed persists, driven by hope that administering the drug a little longer will make the economy stronger, and allow for an end to addiction with minimal withdrawal pains. Investors shouldn’t count on it. Bad monetary policy rarely turns out well. A final thought. The Treasury benefits from the Fed’s hyped-up wheeling and dealing. Every year, the Fed turns a profit from buying and selling securities. After covering its expenses, the Fed’s remits what’s left to the Treasury. Before the financial crisis, the total ran between $18.1 billion in 2004 and $34.6 billion in 2007. The transfer has gotten a lot bigger—$81.7 billion 2010, $75.4 billion in 2011, $88.4 billion 2012. The Treasury can expect another windfall when the books close on 2013.

A Bloated Balance Sheet: How Will the Fed Unwind It? $4,000


on the verge of tapering its securities purchases and letting interest rates rise. In the end, the long-awaited policy shift never happened because the central bank worried the tepid recovery might falter without continuing stimulus. Your clients no doubt found Fed watching a frustrating enterprise this year. They’ll probably head into 2014 in a quandary about what to expect from the Fed. Dr. Cox portrays a central bank with no good options. It can continue current policies—but the inflation risk will only worsen. It can finally begin throttling back on its stimulus—but higher interest rates may squeeze a weak economy. Policy uncertainty has become a fact of life in our times. Your clients can’t just throw up their hands. To meet their financial goals, they have to make judgments about what the Fed will do— and what it will mean for the economy. In fact, these assessments should come before investment decisions. They will to

In sorting out macroeconomic prospects the help they can get. Even then, your clients will sometimes be wrong about the


Agency Securities Maiden Lane II and III, AIG

direction of the economy or the timing and

Mortgage-Backed Securities

impact of policies. They should be ready to

Currency Swaps PDCF Maiden Lane (Bear Sterns) Discount Loans

revise their judgments as new information points to changes in the outlook and the appropriate investment strategy.


Investing can’t be put on autopilot—


not in these times.

$500 $0 2007

quite a while. By August, the Fed seemed

and policies, today’s investors need all



to higher inflation have been in place for

put their money.



Easy money policies that could lead

a large extent determine where investors



What It Means for Your Clients

By Argentus Partners, LLC 2008






Source: Federal Reserve

About Michael Cox

Richard Alm

W. Michael Cox is director of the William J. O’Neil Center for Global Markets and Freedom at Southern Methodist University’s Cox School of Business. He is chief economic advisor to Argentus Partners, LLC.

Richard Alm is writer in residence at the William J. O’Neil Center for Global Markets and Freedom at Southern Methodist University’s Cox School of Business


W. Michael Cox’s Fed Watch: Young princes supposedly had whipping boys. When the prince misbehaved, the unfortunate lad would step in and take the punishment, presumably corporal. Princes and whipping boys are anachronisms, but the Federal Reserve has become a whipping boy of sorts for the transgressions of politicians and policy-makers. When their excess spending and economic meddling lead to calamity, they either blame it on the Fed or expect the Fed to fix it. Like a good whipping boy, the Fed never complains. Our central bank has resorted to extreme measures as it tried to manage financial crises, restore a stable economy, pump up stock prices and help out troubled industries. I see this taking place all over the world. In some parts of the European Union, politicians borrowed to the hilt to pass out goodies to voters. The countries ended up deep debt, their economies in tatters.

Now, the European Central Bank finds itself taking extreme measures as it tries to keep the crisis from getting even worse. The ECB has become the primary buyer of the distressed debt of Greece and other countries. It has taken on the job of recapitalizing banks on the brink of insolvency. Hoping to rev up the economy, the ECB last month dropped its policy interest rate to the lowest level ever. After 1990, Japan struggled through two decades of dismal economic growth. Massive government spending did little beyond saddling Japan with the developed world’s highest debt-to-GDP ratio. So the politicians shifted the burden of economic recovery to the Bank of Japan, which has, of course, now resorted to extreme measures. Its policies look a lot like the Fed’s—historically low

interest rates, supplemented by quantitative easing on an unprecedented scale. In April, the Bank of Japan announced that it planned to buy $1.4 trillion in bonds through the end of 2014. Being the whipping boy isn’t good for central banks. They don’t have the personnel or mandate for crisis management and industrial policy—and they’re unlikely to succeed. Extreme measures carry huge risks, including inflation. Worst of all, central banks compromise their independence by getting sucked into addressing problems that are essentially political rather than monetary. In 25 years at the Federal Reserve Bank of Dallas, Dr. Cox rose to chief economist and senior vice president, advising the bank’s president on monetary policy and other economic issues.

Chart Topper Laboring Under False Pretenses: How Far Has Unemployment Really Fallen? The U.S. unemployment rate stood at 7.3 percent in October—still high by historical standards but down almost 3 percentage points in the past four years (black line ). Just about all the gains, however, have come from a shrinking labor force rather than creation of new jobs. The labor force participation rate tells us the share of Americans who are either working or actively looking for a job. Before the country plunged into recession at the end of 2007, labor force participation hovered around 66 percent. Since then, it has steadily declined, reaching a low of 63.2 percent in October (blue line ). Many Americans have given up hope of finding work—so they are without jobs but no longer counted as unemployed because they’ve left the labor force. What would unemployment look like if all the discouraged workers were still in the labor force—that is, looking for work? It would mean the labor force participation rate would return to around 66 percent. If so, the unemployment rate would still be above 11 percent, hardly budging at all during the past four years (red line ). As the economy improves and unemployment benefits run out, many of those on the sidelines are likely to resume their job hunts. Unemployment will rise again—unless the pace of job creation picks up substantially from the average of 127,000 in the past 18 months.



Recalculated Unemployment Rate 10%

66% Official Unemployment Rate




64% Labor Force Participation Rate

4% 2004

63% 2005









Source: Bureau of Labor Statistics

About The Argentus Outlook A monthly publication of Argentus Partners, LLC, the newsletter strives to deliver current economic information relevant to investing and operating in today’s complex global economy.

Chief Executive Officer: Douglas Gill, CFP® Publisher: Susanna Joiner, Chief Marketing Officer Editor: Richard Alm Contact:


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Important Disclosures: Information herein in this newsletter and has been obtained from sources believed to be reliable, but its accuracy and completeness cannot be guaranteed. This newsletter is for informational purposes only, and should not be considered as an offer, invitation or solicitation to subscribe, purchase or sell or any securities, and is not intended to provide any specific investment advice or recommendation. You should review your personal financial situation, investment objectives, goals and risk tolerance prior to investing. All indices referenced are unmanaged and an investor cannot invest directly into any index. The economic forecasts and projections illustrated in the newsletter may not develop as predicted and there can be no guarantee or assurance that strategies promoted will be successful. All expressions of opinion reflect the judgment of Dr. Cox and his research conducted for Argentus Partners, LLC at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. This research material has been prepared by Argentus Partners, LLC. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that Argentus Partners, LLC is not an affiliate of and makes no representation with respect to such entity.