Monday, October 17, 2022

A Thought Experiment

Finance 101 introduces the concept of the "time value of money." The idea is that there is an opportunity cost in having money today vs. an uncertain future, and a premium should be placed on having spendable money today vs. the future ("a bird in the hand is worth more than two in the bush"). The cash in your pocket pays no interest, and the money in your checking account pays little to no interest relative to where the current Federal Funds Rate is.

When evaluating financial assets, analysts look at the projected cash flows of the asset and "discounts" them to the present using a rate. This is referred to as a "discount rate," and reflects the opportunity cost of having cash today vs. in the future, the term premium demanded by investors, and the certainty those cash flows are secure.

A discount rate is exactly as it sounds - the higher it is, the bigger the discount to a buyer of that asset, similar to discounts offered by retailers selling goods. Larger discounts are a benefit to the buyer, at the cost of the seller. This concept can be observed when considering the market price of interest-bearing, zero-coupon securities: they trade at a discount to par value.

Any purchase of a financial asset involves a security interest or claim on a future pile of cash. In the case of equities, the size of that pile is highly variable, depending on the performance of the economy as well as idiosyncratic factors related to the underlying operational performance of the business and its capitalization structure. Fixed income securities by contrast are (as the name would suggest) fixed - you have a contractual claim on a future pile of cash which is nominally fixed in size.

When someone buys a US Treasury bill, note, or bond, they are purchasing a fixed-size pile of future cash. The rate paid by the government to the holder of the security is functionally the instrument's discount rate, and is used to come up with the "fair value" of the security. The discount rate is the price paid by the government to the UST holder for deferring spending power to the future. When the Fed raises rates, the Treasury offers a higher discount rate for its debt securities. Said differently, the government is offering bigger discounts to UST buyers. And yet, despite this truism, we refer to bigger discounts to buyers as "tightening."

The real tightening occurred when the interest rate was lowered. This represents the government forcing UST buyers to pay a premium in the form of accepting a lower discount rate. Forcing institutions and people to pay a premium for financial assets they want or have to purchase is a form of financial tightening, just like paying higher prices at the gas pump is a form of tightening.

When credit spreads go lower (i.e. the difference between yields on corporate bonds vs. UST securities goes down), financial professionals and the media refer to this as "tightening." And yet, when yields paid on UST securities go down, approaching the 0% rate for cash, the same people refer to it as "loose." This inconsistency makes zero sense.

Someone who purchased US 2-yr T-bills a year ago at a 0.5% rate will receive 100c on the dollar of their principal + 0.5% interest, compounded annually, at the security's maturity date. This will happen regardless of where rates go in the interim. The nominal size of the cash pile owed to the buyer is fixed. They will receive the pre-agreed upon contracted amount of dollars.

However, that piece of paper today trades at around 96c on the dollar. That 4c mark-to-market loss is what makes people think that the Fed is "tightening" credit. But that 4c hasn't been canceled or lost: if the holder sells at a 4c loss, that same 4c accrues to buyer as the security's maturity date approaches. It isn't lost so much as it is transferred from seller to buyer in a zero-sum fashion. Said differently, the net change in "money supply" is zero.

The Fed hasn't lowered the money supply or credit by raising rates. It's actually the opposite: the mark-to-market loss on the T-bill is a reflection of the Fed's policy to expand the money supply through the interest income channel, and therefore effectuates a decline in the relative value of that security. The holder of the T-bill will receive the same nominal amount if rates are at 0.5% or 4%. The reason its cheaper today is that the government is offering larger discounts for the same future cash piles.

This should be the very definition of inflation. In fact, economists in the 19th century used to use the term "depreciation" instead of inflation in reference to a general, sustained rise in prices/reduction in a currency's purchasing power. When the Fed raises interest rates, it is ostensibly depreciating the current value of future cash piles. Why we don't refer to this as "loosening" or inflationary is truly bizarre.

The implications for this are enormous. Purchasers of both equities and fixed income securities today are getting a bargain relative to a year ago. And in the case of equities, the government is promising to increase the nominal amount of dollars it will spend into the economy via the interest income channel, thus expanding the pool of potential dollars the business can accumulate through its operations. This is perhaps the best buying opportunity of my career. I have been increasing equities exposure lately, with a particular focus on pro-cyclical stocks that will be direct and indirect beneficiaries of recent policies enacted by the federal government, including the Inflation Reduction Act and student loan forgiveness.

Another way to think about this is what Warren Mosler calls the "term structure of prices." Higher discount rates for future cash piles are incorporated into market prices for real economic activity. A gold producer who sells on the spot market chooses to deliver gold in exchange for cash at the current price. If they decide to instead enter into a forward contract to deliver the gold in exchange for cash a year from today, the agreed upon price has to reflect the level of interest rates. If the producer can sell the same amount of gold for the same price on the spot market (i.e. today) and the forward market (i.e. a year from now), and 1yr UST bills were paying 5%, then the producer could sell it on the spot market, pocket the cash, and invest that cash to generate a free 5% return. The buyer therefore has to discount the price offered for delivery in one year vs. delivery today to reflect this reality and not hand a free lunch to the seller. Plus, there are storage costs associated with holding gold for a year, and the 5% discount rate will be baked into funding costs for that storage. The discount that the seller/producer must pay for delivery a year from now vs. delivery today reflects a discount in purchasing power of future dollars, which should be what we call inflation.

Friday, October 14, 2022

Rate Hikes Are Loose, Not Tight, Monetary Policy

Public (and private) discourse about inflation and rates is truly bizarre. Consider the following scenarios:

Scenario A:

Savings account beginning balance = $10,000

Savings account ending balance = $10,000

No contributions or withdrawals over the period

Time lapse = 1 year

Scenario B:

Savings account beginning balance = $10,000

Savings account ending balance = $10,300

No contributions or withdrawals over the period

Time lapse = 1 year

The only difference between Scenarios A and B is the ending balance, for which B is $300 more than A. It is self evident that Scenario B is more expansionary than scenario A - there are literally more dollars at the end of a year in Scenario B, whereas Scenario A's balance is flat. And yet, according to the economists at the Fed, the media, Wall Street, elected officials, most of academia, and basically everyone with an "informed" opinion on the subject, Scenario B is considered a form of monetary tightening. The finance and economics professions are some of the highest paid industries in the country, and generally employ our nation's "best and brightest" or "Masters of the Universe." And yet despite this incredible brain trust, people continue to accept the axiom that rate hikes = monetary tightening, generally without thinking twice about it. The Fed has never released any research supporting the assertion that rate hikes "tighten" credit, limiting the availability of credit and subsequently tightening the money supply. Over the past year, the Federal Funds Rate (i.e. the rate that banks lend reserves to each other overnight) has gone from nearly 0% to around 2.5%:

This has resulted in the 10-year US Treasury, the risk-free rate for which all securities are priced off of, to rise from around 1.5% a year ago to nearly 4% today:

And yet, despite this "tightening," credit growth has remained strong:

And the employment to population ratio has ticked higher:

With US debt to GDP at around 120%, the impact of rate hikes on US federal spending is amplified. Total interest paid on Treasury debt is up nearly 30% year-on-year:

This increase in federal spending is a form of fiscal stimulus for people with savings. Similar to the checks sent out to Americans in 2020 and 2021, this increase in government spending stimulates aggregate demand (albeit to a wealthier cohort than the COVID stimulus programs).

And yet, the vast majority of the population calls this "tightening."

While we have been fairly negative in our outlook for the economy, it appears these rate hikes are having the unintended effect of stimulating aggregate demand, keeping us out of recession. In addition, federal programs such as the CHIPS Act, the Inflation Reduction Act, and President Biden's executive order to cancel a portion of student loans are further sources of stimulus that are coming down the pike. The student loan cancellation is especially important: Penn Wharton has modeled the program will "cost" over $500 billion in 2022 (in reality, it's not a cost but rather savings for households who qualify). Functionally, this is a tax cut: it reduces households' payment obligations to the federal government. And it is progressive, as it targets lower-income households. This is a very positive development for the US economy, as it creates capacity for these households to borrow and spend money on things like a house, a car, or other productive goods.

I'm not ready to go all-in on US avoiding a recession, but these developments are noteworthy and the Atlanta Fed GDPNow predictor indicates 2.9% growth for the third quarter:

Remember: savings don't drive investment, it's the other way around - investment creates savings. When consumers and businesses borrow and spend, that spending creates income. Rate hikes ostensibly are a form of increased government spending, which increases income for those with savings. Recall the scenario comparison above: in Scenario A, rates were at 0% and there was no change in the savings balance over the course of a year. In Scenario B, the interest rate was 3% which resulted in a higher savings balance at the end of the year. People make economic decisions based on real supply/demand factors. If a family decides it needs to buy a house to accommodate the birth of a child, they will pay the rate that's offered - assuming they can afford it. Whether they can or can't is a matter of a host of other economic factors. Rate hikes impact the distribution of income - people with savings get paid more at the expense of people who are net borrowers. That can have very negative economic effects. But to call that "tightening" is a stretch.

On Inflation

[Note: I originally started writing this piece on December 23, 2022, then got held up with holiday festivities. More posts for the new year ...