Asset Markets See the Light: No Fed Taper on the (near) Horizon

It seems that financial asset markets have lost the jitters they've been feeling for the last several weeks based on the misguided fear of an imminent Fed "taper." The jobs report which came out today had unemployment at 7%, a half a percentage point above the metric Bernanke laid out as a parameter for the current bond-buying regimen of $85 billion per month. This return to complacency following the recent hand- wringing means one of two things: either I'm highly influential and my message has gotten through, or bond and equities traders have actually decided to take the explicit policy pronouncements of the FOMC at face value. I know which option I'd like to believe.

Like I've said, short-term interest rates are going to stay low as long as unemployment remains above at least 6.5%. Bond investors have nothing to fear but a strong labor market. When the FOMC meets on Dec. 18, lets hope they give me an early Christmas present in the form of a vindicated prognostication.

Sumner, Krugman, Williamson, and My Two Cents

There's been a recent row in the economics blogosphere over the nature of quantitative easing, and its long-term effects on the price level. FOMC member John Williamson recently implied that quantitative easing, instead of causing inflation, instead will exert deflationary pressures on the economy in the long-run. Here's a quote: "The Fed is stuck. It is committed to a future path for policy, and going back on that policy would require that people at the top absorb some new ideas, and maybe eat some crow. Not likely to happen. The observation of continued low, or falling, inflation will only confirm the Fed's belief that it is not doing enough, not committed to doing that for a long enough time, or not being convincing enough."

Paul Krugman, Scott Sumner, and Nick Rowe, among others, have already jumped into the fray, with predictably intriguing discourse ensuing. 

Here's my two cents: Williamson mixed up the difference between real and nominal. Its really as simple as that. Quantitative easing, i.e. dramatically increasing the supply of base money in an economy, doesn't by definition induce asset owners to increase their real holdings of money, i.e. a great amount of purchasing power over goods and services in the form of currency or demand deposits; it by definition induces them to increase holdings of nominal balances.

Lets investigate this using some preliminary algebra. The real money supply is equal to the nominal money supply divided by the price level so that we write:

mD = MS/P

This means the real purchasing power of the money supply is equal to total amount of base dollars in the economy, i.e. paper money plus bank reserves at the Fed, divided by the price level, which is the "average" price of all output in the economy. Quantitative easing means an increase in the nominal money supply, the MS term in the above equation. Williamson has in effect postulated that for an increase in MS, mD must rise by the same amount, which implies that P must correspondingly fall to maintain the equality. What he overlooked is that just because a central bank decides to increase the supply of nominal money, asset holders do not necessarily want to hold more purchasing power in the form of money base. Instead, it is the level of prices that rises via inflation so that the newly issued money is held as real balances to keep purchasing power constant.

Memo to Skittish Bond Holders: Remember the Dual Mandate

The Federal Open Market Committee is not going to "taper," or slow the rate of its bond-purchases, in the short or medium term. The Federal Reserve Act ultimately governs the policy goals of the FOMC, and the Act contains a dual mandate to "maintain long run growth of the monetary and credit aggregates .... so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

Under Bernanke's leadership, the Committee has made an explicit commitment to maintain the bond-purchases of $85 billion per month until unemployment falls below 6.5% or inflation rises above 2.5%. Unemployment is currently running at 7.3% while headline inflation is approximating 1%.

Even the 7.3% unemployment rate is a misleading indicator of conditions in the labor market. Only Americans who are actively seeking employment are counted- the official number excludes those who have become discouraged and dropped out of the labor force due to lack of job opportunities. A more representative measure of the condition of the labor market is the civilian employment - population ratio, which peaked at 63.3% in the third quarter of fiscal year 2007 but which was 58.3% in October.

The current population of the United States is 313.9 million. If the same proportion of the population was employed today as in the third quarter of 2007, it would take the creation of another 15.695 million jobs; with that kind of employment gap and inflation average less than 1%, securities markets shouldn't expect a hike in rates nor a "taper" in quantitative easing in the near future.

Bond Markets and the Ever Elusive Taper

Bond market watchers have, in recent weeks, become mindful of what is widely perceived to be an possible game changer: If the Federal Reserve, as expected, announces an exit strategy from its $85 billion per month bond-purchasing program, known as QE3, investors can expect a rise in yields and a fall on bond prices, effectively ending the secular bull market in fixed-income securities that has prevailed since the inception of the Fed's zero-interest rate policy in December of 2008.

A concurrent and highly relevant development is notably absent from the recent discussion of the trajectory of the bond market: the imminent (it now seems) appointment of Janet Yellen as the new Federal Reserve chairmanwoman. Yellen's academic career as well as her previous contributions to the direction of monetary policy (she is the current Vice Chair at the Fed) indicate one thing for certain: her moral suasion as formal leader of of the Federal Open Market Committee will favor continued monetary expansion. As far as inflation "hawks" and "doves" are concerned, she is firmly the later. 

Continued expansion in the short-term is just what bond markets ought to expect regardless of changes in leadership. At the inception of QE3 in December of last year, Chairman Bernanke stated that the bond purchases would continue until inflation exceeded 2.5% or unemployment fell to 6.5%. Neither metric is near these parameters. The Federal Reserve, always wary of losing institutional credibility, is even more so in the last five years since its primary policy tool, adjusting the Federal funds rate, has failed to return the economy to full employment. Reneging on an explicit policy pronouncement is unlikely to be on the Fed's agenda.

On a longer time spectrum, and with the assumption that Yellen's tenure will result in a continued expansionary stance for monetary policy, longer-term bond yields are actually as likely to rise as to fall. If unemployment remains high and the economy continues to operate below potential, the "liquidity effect" caused by swapping monetary base for interest-bearing Treasury bonds will hold rates down all along the yield curve. If, on the other hand, a consistently expansionary stance of policy actually succeeds in boosting demand, creating jobs, and moving the economy toward full employment, inflation expectations will rise. At this stage the "Fisher Effect" will dominate, and nominal interest rates will rise as investors demand a premium to protect their real yield from erosion by inflation. In short, bond investors won't feel the heat unless it's generated by the labor market.

Calibrating the Volcker Rule: Better Get It Right

The Frank-Dodd Wall Street Reform and Consumer Protection Act celebrated its third birthday in July. Yet regulators are just now attempting to hash out the specs of one of the most potent weapons in the new arsenal appropriated to regulators: the Volcker Rule.

Put simply, the Volcker Rule prevents bank deposits that are insured by the FDIC from being used in "proprietary trading," essentially buying and selling securities with depositor's money for profit. The logic behind the rule is as follows: since the deposits are insured by the FDIC, banks have less incentive to invest them carefully, since any losses will be covered by insurance premiums they've already paid. Thus moral hazard induces banks to take more risk onto their balance sheets than they otherwise would ceterus paribus. Heads, the banks win; tails, the FDIC loses.

The treatment for this ailment plaguing the financial system seems straight-forward: ban speculation with depositor's money. As with any complicated medical procedure, however, complications have arisen. Regulators at the SEC and the CFTC are having difficulty formulating a coherent distinction between proprietary trading and its close cousin, "market making." Market making occurs when a bank buys a security with the intention of selling it in the near future and pocketing the spread between the bid and offer. If these two transactions sound eerily similar it's because they are. Market making, however, is done with the intention of being able to offer clients a variety of financial instruments as well as being able to sell instruments on their behalf. In proprietary trading, the bank earns income from solely from successful speculation; market making generates income through commissions paid by clients.

Another banking practice liable to fall as collateral damage should the gauge of the Volcker Rule be set too low is the practice of "hedging". Hedging allows banks to protect the total value of their assets relative to deposit liabilities and hence protect their capital position. Even if a bank were to hold only risk-free Treasury securities, an increase in interest rates would cause a decline in the market value those bonds. Loan default has the same effect. To protect against these types of risks, banks may purchase securities such as forward rate agreements that are expected to reverse correlate with changes in price of the original asset.

Regulators need to properly and clearly define the "Volcker Rule" as expediently as possible, and in doing so take care not to preclude banks from performing functions essential to their stability. Buying and selling securities on behalf of clients is not a clandestine or risky business practice; hedging against risk does not destabilize the financial system.

The fact that the Volcker Rule was included in the Frank-Dodd bill yet is only being defined three years later suggests that regulators expect to wield large discretionary power in deciding what sorts of banking transactions pass muster. This is a mistake.

Financial regulations must be concrete and communicated with clarity, with a minimum of discretion left to the individual regulators. The reason is simple: Regulators at agencies such as the SEC or CFTC or the newly created CFPA are overseen by the House Financial Services Committee and the Senate Banking Committee. These committees are comprised of Congressmen and Senators who rely on the largess of campaign donations to finance their political careers. If broad discretion is left to individual regulators, the whole operation is reduced to something akin to a magic show: impressive sounding regulatory legislation serves as misdirection to distract the public into thinking lawmakers have "reigned in the big banks;" Congress serves as a false wall between the regulators and the firms swapping campaign cash for influence. In the end, no one is held accountable when there's no rabbit in the hat.

Genesis at Geneva: Let's Begin the De-fissilization of Iran

The latest fracas to widen the gulf between competing factions in the Federal government has arrived, a mere month after partisan gridlock nearly laid the global financial system low. Its origins lie not with Federal debt or deficits, nor even with the recent road-bumps in the implementation of President Obama's signature achievement, the Affordable Care Act. In fact, its origins aren't even in North America. The newest casus belli springs from some 4,078.1 miles away in Geneva, Switzerland, where the P5+1 (Britain, France, Russia, China, the U.S., + Germany) are convening to discuss the latest specter to haunt the security community of the advanced world: the nuclear ambitions of the Islamic Republic of Iran.

In 2006, the International Atomic Energy Agency was "unable to verify" whether Iran was pursuing nuclear technology capabilities for purely civilian purposes as claimed, or whether it was in violation of the Nuclear Non-Proliferation Treaty. Iran was given a one-month deadline to "suspend all enrichment-related and reprocessing activities, including research and development" or face increased economic sanctions from the U.N. Security Council. The deadline was not met.

Since then, sanctions placed by the U.N. have resulted in the halving of potential oil revenues, the prime source of income for the Iranian government and broader economy. Despite possessing some 15% of the world's natural gas reserves, Iran has been largely unable to develop this resource. Export markets in Europe remain closed, as does sources of foreign investment funds and industry expertise. In addition, tens of billions of dollars in financial assets held abroad have been frozen due to the banking portion of the sanctions. Under intense fiscal pressure, the government of Iran has turned to fill the gap from lost revenues with inflationary finance, which has resulted in inflation running at 40% for the last two years. Faced with supply constraints on imports and a soaring cost of living, the Iranian economy has entered a full-fledged inflationary recession (the same phenomena dubbed "stagflation" when it occurred in the US in the 1970s).

These pressures have sufficed to bring Iran to the negotiating table in Geneva, and President Obama now has an opportunity to initiate the diffusion of Iran's fissile ambitions. The specific terms of the negotiation are being constructed as I write this, but they seem to hedge around two premises: Iran will agree to curtail enrichment of uranium, which it has been producing at an accelerating rate thus far, and limit it nuclear reactor capacity. In return, the West will agree to a limited reduction in sanctions, possibly allowing for limited foreign investment and technology to develop the liquified natural gas sector and unfreeze around $10 billion in frozen assets.

Not everyone is convinced. Benjamin Netanyahu, the Israeli Prime Minster, has called for demands that Iran immediately cease enrichment of uranium and the halting of a plutonium reactor in the eastern city of Arak. Failure to meet these demands, according to Netanyahu, should be met with increased sanctions and advised the P5+1 to "keep the pressure up." Economic sanctions were enough to bring Iran to the table. By extrapolation, it follows that increased and prolonged sanctions should suffice to bring Iran to its knees. But this is logic defied by historical experience. Fifty-one years of embargo on Cuba have not resulted in any concessions from our island neighbor to the south. Nor has the economic isolation of North Korea proved efficacious in limiting it's nuclear program. It turns out a nation can remain obstinately committed to a nuclear program on a GDP per capita of $1,800.

This hardline stance is also inconsistent with recent developments in the international geopolitical landscape. The United States no longer enjoys the near monopoly on soft-power it once did. The market for power-projection is becoming increasingly competitive, with a resurgent Russia and a newly- potent China offering nations that evoke ire of Washington an alternative to isolation. Vladimir Putin demonstrated his nation's ability to punch above its weight when he (at least appeared to) single-handedly remove the impetus of the planned American strike on Damascus by orchestrating the removal of Assad's chemical weapons arsenal. Now Syrian government forces are making headway against rebels who only recently thought their victory was at hand, courtesy of Uncle Sam.

The proposed lightening of sanctions on Iran will have a palpable effect on the material standard of living for Iranians. By lessening some (not all) of the pressure that is squeezing their incomes, in return for concrete reductions in their nuclear program, Obama will signal to the Iranian people that there truly is a tradeoff between the nuclear ambitions of their despotic government and the purchasing power of their take-home pay. Let's give them a taste of what compromise can bring. With any luck, they'll be back for seconds.

It's A Long Way to Al Andalus (But My Heart's Right There)

Once again, domestic political theater has proved an irritating distraction from events that, in a sane world, would come front and center in the mind's eye of the cognoscenti. While Congressional Republicans hold a kangaroo court to decide the fate of the credit of the United States and the short-term growth rate of the global economy, let us not entirely neglect the civil wars and endemic violence that has recently engulfed our good friends in the Near East.

I'd like to stake out a stance that may strike some as controversial but is in fact rooted in the deepest throws of sound reasoning and fact: The United States, and her international sovereign and institutional allies, must decisively oppose the rampant proliferation of Islamist political growth in Egypt and Syria. 

Obama and the broader international community simply refuse to acknowledge the conflicts in the Middle East for what they are: a resurgent and dangerous inflammation of politically-oriented, radical, Islam. Mohammed Morsi, who was ousted from his position as President of Egypt by the army at the behest of the Egyptian people, is a member of the Muslim Brotherhood, and had taken steps while in office to undermine Egypt as a secular state. In the aftermath, pro-Islamist forces have slaughtered both military and civilian targets, especially amongst Egypt's long- beleaguered Coptic minority, whom they wrongly blame for the broadly popular "coup." A sizable and growing portion of the resistance forces in Syria are Al-Qaeda or Al-Qaeda affiliates. How does the President of the United States react to these situations? He eliminates military aid to Egypt and proposes bombing and ousting the very head of state against which Al-Qaeda is fighting. I would state that in starker terms: He proposed that we enter into a civil war on the side of Al-Qaeda.

Call me a neo-con, call me right-wing intolerant ignoramus, but I have a strong anti- Al-Qaeda bias. I don't want to attend any party they're attending, I don't even want to RSVP. And as I oppose Al-Qaeda, the same logic forms the corollary for my disdain for the Muslim Brotherhood. The Egyptian chapter of the Brotherhood has called for the resumption of the jizya or head tax on Christians and Jews, as well as their exclusion from the upper levels of the civil service. The Brotherhood has also advocated outlawing any criticism of Islam by Muslims or non-Muslims, as well as banning alcohol and sun bathing at the beach- two pillars of the Egyptian tourism sector. Oh, and I saved the best for last: the Brotherhood does not believe women should be able to file rape charges against their husbands. Morsi drafted the Brotherhood-designed Constitution AFTER his own election- which, not surprisingly, contained no clause for impeachment. American apologists for the "Brotherhood" need to take a long look in the mirror and ask themselves why they support a party of misogynists that promotes discrimination and limits on free speech, all while paving the path to another dictatorship.

Furthermore, apologists for the presence of politicized Islam in the emerging "democracies" of the region are likely to conjure images of a civilization long passed. There was a time and a place (actually several) where Qu'ranic law formed the basis for the government and the results were far from disastrous. The Caliphate of Cordoba (711-1492) originated many pivotal figures such as Avicenna and Arrezzo, and was instrumental in reintroducing the scientific method, algebra, classical philosophy, medicine, and economics to the Western world. Beginning in the 15th century, the Ottoman Empire forged a multi-Continent, cosmopolitan society that, with notable exceptions, successfully coupled internal tolerance with impressive external expansion. A quick anecdote just for fun: Saladin's mentor's father, (Zengi, father of Nur-al Din) and Sultan of Aleppo, met his death at the hands of his own slave. His slave killed him out of fear of being executed for theft. Theft of his master's private stock of high-quality wine. No one thought it was weird for a Muslim Sultan to have a wine cellar in the 12th century. I categorically oppose political parties that want to retard their nations to standards that predate the Middle Ages. The burden of proof rests with my opponents.

The mere fact that a majority of voters in a nation may elect an Islamist party to power does NOT legitimize that actions of that subsequent government. The Jim-Crow state governments of the Deep South in the post-bellum period were elected and supported by the majority of voters. And, to blatantly violate Godwin's Law, You Know Who was likewise elected with a majority of his constituency's votes. Did the United States out step it's bounds when it helped to put an end to that nonsense?

Here in 2013, gone are the doctors, mathematicians, proto-economists, philosophers, and wine aficianados from the Islamist movements of yore. It's infinitely regrettable, because they were an interesting and, I can only presume, affable lot. But in their place has emerged a movement run by the most deplorable, intolerant, and despicable people on this side of reality. The Al-Nursa front in Syria has already instituted public stoning as a form of execution in some northern regions it has occupied, as well as cutting off the fingers of people caught smoking tobacco and forcing women to wear the veil. One telling video shows an Islamist militant who absentmindedly brushed aside a poster with the Muslim declaration of faith on it receiving 40 lashes. With a heavy steel pipe.

The question of whether or not these radical, politicized versions of Islam are a true or fair representation of the religion are irrelevant. I've known many faithful Muslims in my day, and think highly of almost all of them. I once worked a polling station on election day in a local mosque, and was stunned by the hospitality and cordiality of our hosts. Let's just say I spent more than the recommended hour feasting on lunch, to say nothing of the catered breakfast that awaited us when we arrived at 5:30 a.m. My criticisms lie not with the literally hundreds of millions of well meaning Muslims who merely want to live in peace and raise their families. Indeed, I would expect them to be amongst the staunchest opponents of those who would legislate violence and discrimination against their neighbors.

I aspire to a world of equal rights and equality between all people. Christian, Muslim, Jews, Hindus, whatever; man and woman; all citizens of every society, enjoying equal rights, protection, and opportunity under the law. Indeed, I believe this is the only proper aspiration for anyone of any moral conscience to hold. And the Islamist movements that have infected the public spheres of several of our planet's most vulnerable nations stand in stark contrast to this goal. We in the West are not the only ones who deserve equality and individual liberties under the law. Millions of religious minorities and women stand to live in a sub-standard Hell because they happen to have been born on the wrong side of the Atlantic Ocean and the Mediterranean Sea; that's not fair.