I’m going to wonder off the reservation a little today and talk about the Fed, its balance sheet and risk assets.
Janet Yellen is Vice Chair to Ben Bernanke at the Fed. She is one of the Fed Governors. I always thought she was pretty switched on but last night she gave a speech that has me flabbergasted:
In my remarks today, I will make the case that recent developments in commodity prices can be explained largely by rising global demand and disruptions to global supply rather than by Federal Reserve policy… In my view, the run-up in the prices of crude oil, food, and other commodities we’ve seen over the past year can best be explained by the fundamentals of global supply and demand rather than by the stance of U.S. monetary policy.
She’s joking isn’t she? She must be!
Nope, Yellen believes that it’s all about the growth of the emerging economies and says:
In my view, the run-up in the prices of crude oil, food, and other commodities we’ve seen over the past year can best be explained by the fundamentals of global supply and demand rather than by the stance of U.S. monetary policy.
In particular, a rapid pace of expansion of the emerging market economies (EMEs), which played a major role in driving up commodity prices from 2002 to 2008, appears to be the key factor driving the more recent run-up as well. Although real activity in the EMEs slowed appreciably immediately following the financial crisis, those economies resumed expanding briskly by the middle of 2009 after global financial conditions began improving, with China–which has accounted for roughly half of global growth in oil consumption over the past decade–again leading the way. By contrast, demand for commodities by the United States and other developed economies has grown very slowly; for example, in 2010 overall U.S. consumption of crude oil was lower in than in 1999 even though U.S. real gross domestic output (GDP) has risen more than 20 percent since then. On the supply side, heightened concerns about oil production in the Middle East and North Africa have recently put significant upward pressure on oil prices, while droughts in China and Russia and other weather-related supply disruptions have contributed to the jump in global food prices.
In contrast, the arguments linking the run-up in commodity prices to the stance of U.S. monetary policy do not seem to hold up to close scrutiny. In particular, some observers have pointed to dollar depreciation, speculative behavior, and international monetary linkages as key channels through which accommodative U.S. monetary policy might be exacerbating the boom in commodity markets.
Yellen goes on to deal with these in turn in her speech and rather than reprint her words here let me just say she reckons it wasn’t and isn’t the Fed.
Yellen is making this point because she is trying to say that the Fed isn’t responsible for these moves and so the Fed doesn’t need to withdraw stimulus anytime soon because with a weak economy and has no responsibility for the inflation that is rising globally.
But the as I wrote previously “if Central Bankers feel the need to take away the punchbowl earlier than the market expects or the economy can bear I’m fairly sure we will see market ructions erupt” . Yellen may be in the other camp and looking to protect the economy from an early tightening but in not understanding the risks to both sides from QE, it seems to me the chances of a misstep are higher. As I’ve said before I strongly believe the end to QE poses a clear and present danger to markets in general and risk assets in particular.
So let’s have a look at what the raw data tells us. The table below is the correlation of the moves between the Fed’s balance sheet and selected assets at monthly rests since the beginning of 2009. What we have is the Dow, S&P 500, Aussie, USD Index, Goldman Sachs Commodity Index and West Texas Intermediate Crude.
It would appear to me that somehow, somewhere there is a linkage to the Fed’s monetary policy and moves in these markets. So I find Yellen’s dismissal all the more troubling. This is particularly the case when we know that Chairman Bernanke is on the record as saying that QE was aimed at lifting Equity prices and buttressing confidence while the rest of the economy caught up. Certainly Yellen’s assertion that it’s not just the USD seems to have some credibility on this basis but I’d argue that this was distorted by the original safe haven flow earlier in this period before the USD weakened again in the past 6 months. The chart below shows the USD (DXY) versus the Fed’s balance sheet inverted and I think you’d agree that QE appears to have some role to play in the more recent, and I’d say frothy, move lower in the USD since late last year:
But if I look at a few other markets I see a definite correlation with the Fed’s balance sheet:
Note particularly how the moves tighten up in the past 6 months and particular since the USD has been moving more closely with the Fed’s balance sheet as well
Readers know I am leery of correlation without causality but when I look at the moves in asset market since the Fed embarked on its “alternative” monetary operations and expanded its balance sheet via quantitative easing I see Fed induced moves in prices. At the very least the Fed has supported these moves.
Why does all this matter? Because if, as I think, the Fed is blowing bubbles and we are in the frothy stage, we have some instability ahead of us later this year when QE ends. Instability that can seriously knock global confidence and growth. Yellen may not be in the camp that says the Fed needs to withdraw the stimulus but her denial of the Fed’s complicity in the moves we are seeing in markets and commodities, and crucially, inflation, worries me because when the stimulus is withdrawn it may be more abrupt than the market is expecting because they simply weren’t considered.