Tuesday, January 29, 2013

Maybe the Fed Won't Sell Off Its Balance Sheet

A major question overhanging the financial markets is what will the Federal Reserve do with its $3 trillion and growing balance sheet?  The conventional wisdom is that, eventually, it will have to sell off much or most of its holdings, lest the Inflation Monster come roaring out of its lair.  The specter of $1 trillion, $2 trillion or perhaps more of Treasury and mortgage-backed securities hitting the bond markets would send a shiver down the spines of many a market player.  Even a suggestion that such sales are impending could induce interest rates to pop and stocks to drop.  All the Fed's hard work to stimulate the economy could circle down the drain as rising borrowing costs smack down home purchases, consumption and corporate investment. 

To avoid such a scenario, maybe the Fed will simply not sell off its balance sheet.  In the often strange alternative universe of the Fed, where massive money printing isn't perceived as an inflationary threat until the Monster is tearing into our throats, this might make sense.  Once the Fed stops purchasing Treasury securities and other debt in the open markets, it can simply hold the assets on its balance sheet until they are paid off.  It would remit the interest and principal payments to the U.S. Treasury.  This would reduce the amount of taxes that the Treasury would need to squeeze from harried citizens, aiding their ability to consume, while lessening the threat of its balance sheet to the stability of the financial markets.  If the Fed were to sell its assets in the open markets, it would compete against private interests for capital.  If it were to hold its assets and remit the proceeds to the Treasury, more capital would be available for private investment. 

Sounds too easy?  It would be too easy if the truckloads of printed money that the Fed has dumped into the economy inflates the dollar at substantially more than today's low rate.  But the velocity of money today seems driven by little more than a three-cylinder, two-cycle engine.  The economy is hardly growing any faster.  Unless economic growth rises above the fast side of brisk, selling off the Fed's balance sheet will threaten the recovery.  The Fed may well be tempted to take advantage of today's low inflation rate, and simply hold its balance sheet until maturity.  We'll see.

Thursday, January 17, 2013

Consider a House To Hedge Against Inflation

The housing market, having walloped the bejesus out of tens of millions of Americans, may seem an unlikely hedge against inflation.  But history shows that home prices tend to move up briskly during inflationary times.  During the 1940s, inflation burst out, driven first by World War II rationing and then by pent up consumer demand after the war.  Consumer prices moved up about 72%.  Census Bureau data indicates that housing prices moved from a national average of $2,938 in 1940 to $7,354 in 1950 (unadjusted for inflation).  That's an increase of 150%.

During the stagflation of the 1970s, consumer prices rose 112%.  Housing prices rose from a national average of $17,000 in 1970 to $47,200 in 1980, an increase of 178% (unadjusted for inflation).  You can find Census Bureau data on housing at https://www.census.gov/hhes/www/housing/census/historic/values.html.

The data show that housing prices rose faster than inflation during two of the most inflationary decades in the past 75 years.  Of course, the sales prices of houses don't tell the entire story.  You can't directly compare prices of housing against prices of stocks or inflation-adjusted bonds like U.S. Treasury TIPS, because housing requires periodic lawn mowings, plumbing repairs, new roofs, maintenance of HVAC systems, and replacement of dishwashers.  It's also taxed locally every year, and sometimes hit up for special assessments if the water or sewer systems need to be gussied up.  But you'd directly or indirectly bear those expenses anyway if you rented.  So owning a house and capturing the upticks in value might work out well for you during inflationary flareups. 

Why would housing be such a good inflation hedge?  Professional economists might be tempted to wheel out a wagon load of regression analyses to demonstrate their erudition.  But the simple and obvious explanation is that a hard asset with substantial utility will have significant value no matter what the paper currency is doing.  A house provides shelter, warmth, indoor plumbing, and a private place to pig out on high fat, high sugar, low nutritional value junk foods while long-term parked in front of a 124-inch TV, parboiling your brain without the neighbors seeing what a couch burrito you really are.  Market forces will adjust the paper value of that hard asset upward when the fiat currency is going haywire.

At the moment, inflation seems to be spotted about as often as the ivory-billed woodpecker.  But that doesn't mean it's extinct.  History shows that inflation can be quiescent for long periods of time, and then burst forth like an oil well blowout.  Inflationary pressures right now are doing a fan dance, often out of sight but still faintly visible in profile.  Ultimately, unless the Fed and other central banks can repeal market forces, their massive money prints and asset purchases of recent years will eventually inflate paper currencies.

 Housing, like politics, is first and foremost local.  Some markets would make mediocre investments no matter what (like areas with high unemployment).  Some types of housing, like condos, may not be ideal for inflation hedging.  Their values tend to be less stable than that of the 4-bedroom, 2 1/2 bath Colonial with the white picket fence and English sheep dog.  A house isn't a substitute for sensible investment diversification.  Stocks, TIPS and perhaps other assets might also play a role as reasonable inflation hedges in a well-diversified portfolio. 

It's hard to have confidence in housing after the free fall in prices of recent years.  But investment success can often come from buying disfavored assets.  Buying bubbly assets like bonds (especially junk bonds) isn't likely to be the epitome of financial perspicacity.  Home sweet home, be it ever so humble, may work out better if inflation rears its ugly head.

Thursday, January 3, 2013

Reducing the Deficit: Should the Fed Monetize the Federal Debt?

Desperate times call for desperate measures.  We've seen yet another dysfunctional mess from the political process, and have to think expansively.

The recent fiscal cliff deal was largely a failure.  It raised taxes on most Americans, while doing virtually nothing to reduce federal spending.  While income taxes were not increased for the middle class, Social Security taxes were increased for all workers at all income levels.  The well-off (the $400,000 plus crowd) face a higher income tax rate of 39.6% (20% on qualified dividends and capital gains) and wealthy dead people now pay a 40% tax rate (instead of 35%) on the portions of their estates exceeding $5 million ($10 million for married couples).  The automatic spending cuts required by the cliff were deferred for two months (except for $24 billion in cuts that do go into effect), so spending largely continues apace.  Presumably, there will be a second face off over spending cuts when the President asks Congress to increase the debt ceiling in the next few weeks (even though the White House insists it won't negotiate over the debt ceiling).

One thing to take away from the cliff deal is that spending cuts are really hard to agree on--so hard that the Dems and Republicans simply kicked the can down the road.  But they will be even harder to agree on two months from now.  The Republicans have lost significant leverage by agreeing to tax increases now.  The tax side of the fiscal cliff has been resolved, more or less favorably to the Democrats (although some liberal Dems are still unhappy).  What incentive do the Dems, who control the Senate, now have to agree to spending cuts?  Of course, the Dems would agree to some spending cuts (the defense budget would be their target number one).  But Republicans are focused on hurting core constituencies of the Democratic Party through Social Security, Medicare and Medicaid cuts.  With the Dems having largely won on the tax issues, they have little reason to make concessions on the social safety net.  Even if the President is willing to give the Republicans some of what they want (which he seems to be), he may have a problem in the Senate, where Social Security, Medicare and Medicaid were stoutly ring-fenced and defended during the fiscal cliff talks.

Realistically speaking, we shouldn't expect our dysfunctional elected government to find grand solutions to the fiscal deficits.  Due to a variety of bad and intractable political dynamics, that simply won't happen.  We have to look elsewhere for solutions.

The next logical candidate to get the hot potato would be the Fed.  The central bank has played a central role in combating the Great Recession, not without some success.  In the course of its massive quantitative easing programs, it's accumulated a balance sheet of close to $3 trillion.  This total is likely to grow as the Fed continues to purchase debt on the open markets.  Slightly over half of the balance sheet consists of U.S. Treasury securities.  Total federal debt is about $16 trillion.  Thus, the Fed holds about 10% of all federal debt.

Why not have the Fed simply forgive some or even all of the U.S. Treasury debt it holds?  In other words, it would declare that the Treasury wouldn't be required to pay the debt.  That, by definition, would reduce the federal deficit by reducing the amount of federal debt outstanding.  And it's what happens anyway.  When the Fed receives debt payments from the Treasury (usually consisting of interest payments), it simply remits those funds back to the Treasury Dept. (except for a small amount retained to finance the Fed's budget).  Debt forgiveness by the Fed would simply expand on what happens in the ordinary course.   

Of course, such debt forgiveness would be tantamount to monetizing the debt, and has the potential to be inflationary.  But precisely what the heck do we think is going on now?  When the Fed launches repeated quantitative easing programs, with ever more asset purchases but not the tiniest hint of when, if ever, it would unwind its Brontosaurian balance sheet, it has functionally monetized the debt.  With the economy expected to be a sick puppy for years, reality is the Fed may hold a lot of its current inventory of U.S. Treasury securities until they mature.  When they mature, it will remit the principal payment it receives from the Treasury back to the Treasury (or use the funds to make more open market purchases of Treasury securities).  The federal debt has been monetized, even though no one on the government's payroll is going to admit it. 

Such debt forgiveness wouldn't fully resolve all the deficit problems.  But it could reduce the scope of the crisis, and would amount to little more than accurately accounting for what is actually going on.  If inflation flared, the Fed could suspend debt forgiveness and raise short term interest rates, combating inflation as it traditionally would.  But as long as inflation is subdued, debt forgiveness could contribute to resolving a problem that politicians clearly won't be able to solve, at least not comprehensively.

Ultimately, the best solution to the deficit problem is to boost economic growth.  Greater growth means higher employment levels and more income and corporate profits to be taxed.  If the economy were growing briskly and unemployment were around 5%, we probably wouldn't feel we have a deficit crisis.  Housing seems to be stabilizing, although its long term prospects remain clouded.  So we can't count on housing to be the engine for growth.  Measures the government could take include:  (a) rebuilding infrastructure--this is something the government has historically done well, and should do more of given the crumbling state of our infrastructure; (b) loosen up immigration restrictions for well-educated people and people who can invest substantial capital in America to create jobs--we need more innovators and entrepreneurs; (c) improve education, not by handing out loans to anyone who has a pulse and a signature (there's way too much student debt already, and it will be the next big debt bubble), but with measures to make education more efficient and inexpensive, like expanding Internet-based educational programs.  Achieving greater economic growth will take time, but it's a lot easier than trying to use the political process to agree on budget cuts.