Saturday, August 25, 2012

Fed Musings

I’m going to post a short series on The Federal Reserve, its mandates and some of the consequences.

The stated mandates of the Federal Reserve, an institution which is neither federal nor has reserves, are laid out in section 2A of the Federal Reserve Act (as amended) the triple (not dual as so often is stated) goals are : "to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates”.

With regard to stable prices note that on February 25th, 2012 Dr. Bernanke announced that the Fed’s inflation target was 2% because it was best aligned with the mandated goals of full employment and price stability.

The first observation is that Dr. Bernanke appears to be doing congress’s job by changing the mandate of stable prices without any apparent instruction to do so from congress.

 An inflation target other than zero by definition means that prices are not stable. If balance in your Certificate of Deposit went down by 2% per year you would not call the balance of your CD “stable”, yet that is exactly what Dr. Bernanke’s announced goal is.

Inflation has not been zero for a long time so one way to interpret Bernanke’s inflation target as acknowledging that the “stable” part of the mandate is not reality. However, as the only time in recent history the US has had negative inflation was in the 1920s and 1930’s and, depending on the horizon of analysis long term inflation seems to have settled out around 3 percent even the non-congressionally mandated target of 2% is problematic and a systemic bias which has socially disturbing consequences.  An inflation rate different from zero causes winners and losers by means other than the actor’s actions, and to the extent the Fed has an effect on inflation the Fed is in the judge’s seat against the specific direction (“Stable prices”) of congress.

Let’s take a look at inflation.

Inflation causes a transfer of wealth from those who save currency to those who borrow currency. Inflation is also a wealth tax on the currency part and the non-currency part of one’s wealth which depreciates and which requires currency to be maintained. An inflation rate other than zero therefore introduces an asymmetry in the financial system at large and in the allocation function between savers and investors/borrowers specifically.

Please note that the US government, with whom the Federal Reserve is closely aligned is a significant borrower in the financial markets. 

Inflation, and perhaps even more importantly, the variability of inflation and inflation expectations over time and the variability in extend to which specific baskets of goods and services are subjected to inflation therefore introduces a temporal bias in the term structure of inflation expectations and biases other than the fundamental value (whatever that is (a topic for another post perhaps)) of specific asset classes and economic sectors.

If one’s net worth is greater than zero cash is not the place to hold your net worth when inflation is greater than zero. Inflation drives wealth out of cash and into non-cash / real assets because generally non-cash assets will keep pace with inflation. One of the consequences of this is that it reduces liquidity because the holder of the asset faces a hurdle in switching asset classes – transaction costs and lack of pricing transparency. Furthermore, viewed purely from a “store of value” perspective, not a business venture approach, the non-income producing real assets most investors have access to have are negative carry assets. The negative carry on a home owner occupied house with zero financing is somewhere around 2% - the same as Bernanke’s inflation goal.  As a private individual even if you own non-income producing assets such as a forest or oil fields you will have negative carry because of property taxes, ongoing expenses and amortized transaction costs. The only holders of real assets who have significantly less negative carry, and perhaps even have positive carry are entities which receive taxes, not pay them – entities with the power to tax. Precious metals come with storage costs, whether implicit such is when one buys an ETF or explicit when one rents storage space.  

As an aside, don’t confuse commodity futures with real assets – for every long position there is a short position and the net of both is always zero.  Even if one were to buy a physical commodity and put it in storage, because of the negative carry nature of storage at some point the commodity will be sold back into the market so the net effect on quantity supplied is zero. However, it is possible that speculation increases the volatility of the commodity price and that very well may have knock-on effects on longer term supply and demand decisions.

Inflation then drives holders of cash to relative illiquidity with the attendant lack of price discovery and thereby interferes with capital formation because it hinders capital movement.

Note that this is in direct conflict with what the Fed and other central banks have been doing in recent times by attempting to “create liquidity” in a greater than zero inflation environment.

The medicine then is partially responsible for the disease.
To be continued.