Sunday, November 29, 2020

Yellen Speaks Japanese

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As Yellen spoke on Friday, the markets surged back into the trading range that we have been locked into for the past few weeks. Despite GDP being revised lower and economic data continuing to remain weak, the hopes for a strengthening economic recovery from the Fed remain. Here are Yellen’s key points:

  • YELLEN SAYS RATE-HIKE CASE `HAS STRENGTHENED IN RECENT MONTHS’
  • YELLEN SAYS ECONOMY NEARING FED’S EMPLOYMENT, INFLATION GOALS
  • YELLEN: FOMC NOT ACTIVELY CONSIDERING ADDITIONAL TOOLS
  • YELLEN SAYS GROWTH NOT RAPID BUT ENOUGH TO IMPROVE LABOR MKT

On those headlines, the market rallied as the expectations for a September rate hike dissolved.

Remember, raising the Fed Funds rate is a tightening of monetary policy which withdraws liquidity from the financial markets. With fundamentals and economics weak, the only supportive argument for higher asset prices, and for “yield chasers” paying 3.5x sales for a 2.5% dividend, is continued accommodative policy.

But it was this statement that sent the markets surging higher:

“On the monetary policy side, future policymakers might choose to consider some additional tools that have been employed by other central banks, though adding them to our toolkit would require a very careful weighing of costs and benefits and, in some cases, could require legislation. For example, future policymakers may wish to explore the possibility of purchasing a broader range of assets.”

This, of course, dovetails with my article from Thursday discussing the recent Fed research paper on the possibility of another $4 Trillion in QE to offset the next recession.

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“David Reifschneider, deputy director of the division of research and statistics for the Federal Reserve board in Washington, D.C., released a staff working paper entitled ‘Gauging The Ability Of The FOMC To Respond To Future Recessions.’

The conclusion was simply this:

‘Simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited [ability] to cut short-term interest rates in most, but probably not all, circumstances.’

In other words, the Federal Reserve is rapidly becoming aware they have become caught in a liquidity trap keeping them unable to raise interest rates sufficiently to reload that particular policy tool. As I havediscussed in recent weeks, and below, there are an ever growing number of indications the U.S. economy is currently headed towards the next recession.

He compares three policy approaches to offset the next recession.

  1. Fed funds goes into negative territory but there is no breakdown in the structure of economic relationships.
  2. Fed funds returns to zero and keeps it there long enough for unemployment to return to baseline.
  3. Fed funds returns to zero and the FOMC augments it with additional $2-4 Trillion of QE and forward guidance.

In other words, the Fed is already factoring in a scenario in which a shock to the economy leads to additional QE of either $2 trillion, or in a worst case scenario, $4 trillion, effectively doubling the current size of the Fed’s balance sheet.

Here is the problem with the entire analysis. It assumes a normalized economic environment in which the Federal Reserve has several years before the next recession AND that large-scale asset purchases actually create economic growth. Both are likely faulty conclusions.”




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