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Buenos Aires



Beautiful day in Buenos Aires. We're staying in the trendy and quaint Palermo Soho district just a few miles from the heart of the city. Lots of boutiques and restaurants. Time to go out for lunch.

Going to Argentina

We're on our way to Argentina today for a few weeks. I'm looking forward to catching up on all the crazy things the government is doing to try to avoid another big devaluation. I'm also interested to know how the government plans to run YPF better than Repsol has. Before YPF was privatized in the 90s, it held the honor of being the world's most inefficient oil company, thanks to mismanagement by a series of peronist governments. It's deja vu all over again, it seems. In any event, we'll be seeing lots of friends and family and enjoying good food and wine in the process, so blogging may be light for awhile.

Understanding the risks of Fed policy


Here's an updated version of a chart that I've followed for decades. What it tells me is that the Fed is in the process of repeating past errors, since they almost always react to developments in the economy rather than being proactive. In short, the Fed is way too easy today, and this portends higher inflation in the future.

Capacity utilization (blue line) is arguably a good proxy for the strength of the economy. The stronger the economy, the higher the utilization rate of factor capacity. (It's a flawed measure, I'll be quick to admit, since there is no way the Fed can actually measure the factory utilization rate—they have to make all sorts of assumptions and estimates to arrive at this number. But nevertheless it does seem to track the business cycle reasonably well.) Whatever the Fed might say about what guides monetary policy, the evidence suggests that the strength of the economy is an extremely important input.

The real Federal funds rate (red line) is arguably the best measure of how "easy" or "tight" monetary policy is. High real rates tend to increase the demand for money and slow the growth of the money supply, and if the Fed tightens enough, a relative scarcity of money develops which usually precipitates a recession. At the same time, the scarcity of money tends to pull down inflation. That's why inflation usually falls during and after recessions. As the business cycle matures, inflation tends to pick up because the Fed is slow to react to changes in the economy (note how the red line almost always lags the blue line).

What the chart is telling us now is that there has been a significant improvement in the health of the economy (the rebound in capacity utilization in recent years is unprecedented) but the Fed's monetary policy stance continues to be about as "easy" as it has ever been. Rarely has the Fed failed to respond for so long to a significant improvement in the economy. This suggests that the Fed is "falling behind the curve." We saw a similar situation in the late 1970s, when capacity utilization surged but it took the Fed several years before it got the nerve to push the real Fed funds rate above zero. One result of this delayed reaction, we now know, was that inflation accelerated significantly, rising from 5% in 1976 to a high of almost 15% in 1980. There are other troubling similarities between then and now: the dollar was very weak in the mid-1970s, commodity and gold prices were soaring, and Treasury yields were generally lower than the rate of inflation (i.e., real yields were negative across the yield curve).

I would also note that there were a few times in the past several decades when monetary policy became exceptionally "tight:" in the early 1980s, the Fed pushed the funds rate well above the rate of inflation, and they did the same in the late 1990s. Both periods were characterized by a subsequent and substantial decline in inflation.

To summarize: Monetary policy is very powerful, but it works with a lag that can amount to several years or more. (I should know, since I have been making this same forecast for the past three years. In my defense, I note that inflation today is much higher than it was expected to be three years ago.) The Fed is fallible, and usually reacts to events rather than being proactive. The Fed once again appears to be making a mistake by keeping interest rates very low for too long, even though the economy is improving noticeably, the dollar is very weak, and commodity prices are generally quite strong. As a consequence, inflation in the years to come is likely to be higher than the market expects (current inflation expectations embedded in TIPS and Treasury prices are 2-2.5%), than to be lower.

I've argued for a long time that it is too late for investors to seek inflation protection in gold. I think gold at current prices has already anticipated the likely consequences of the Fed's overly-easy monetary policy stance, and I think gold also reflects a substantial premium that investors seem willing to pay for protection against geo-political risk (e.g., the Eurozone sovereign debt crisis, which might destroy the euro, and the ongoing turmoil in the Middle East). Moreover, I think gold would react very negatively to even a hint that the Fed is going to accelerate its plans to raise interest rates.

I think it makes more sense to seek inflation protection in real assets that are still relatively depressed, and real estate jumps out as arguably the ideal candidate. I also believe that equities represent decent inflation hedges, since PE ratios are generally low and corporate profits over time inevitably benefit from increases in nominal GDP. (If inflation picks up, this is good for everyone's cash flows.)

Cash is hardly a safe haven these days, since it currently offers no yield, whereas the earnings yield on equities and the yields on corporate bonds provide substantial cushions against downside risk. And of course, if inflation proves to be higher than expected, then the purchasing power of cash will deteriorate significantly. Cash could prove to be the world's worst investment in the years to come.

Industrial production is still strong



March industrial production and manufacturing production came in weaker than expected (production was flat and manufacturing declined by 0.2%). But as with the case of housing starts (see previous post), this is not a reason to think that the U.S. economy has taken a turn for the worse. No series ever moves in a straight line, and although first quarter industrial production was weakened by unseasonably warm weather which sharply reduced utility output, industrial production still rose at a 2.8% annualized pace in the first quarter. Abstracting from utility output, manufacturing production rose at a 7.1% annualized pace in the first quarter. This is robust growth.

The charts above should make it clear that the trend in both is clearly upwards, and it's impressive at that. Industrial production is up at a 4.7% annualized pace over the past six months, and manufacturing production is up at a 7.4% annualized pace. Moreover, U.S. output has far outpaced European output over the past seven months, which has suffered from the fallout from the Eurozone sovereign debt crisis.

Housing continues its recovery


March Housing Starts came in below expectations by a sizable amount, but I don't think that's a reason to think that the nascent housing recovery is dead. To begin with, March starts were still 37% higher than their 2009 all-time low, and still 10% above a year ago. Second, starts are a volatile series, and seasonal factors can contribute to that volatility in the winter months when starts are typically low.


But this chart of Building Permits helps clear things up. March Permits were well above expectations, and as the chart above shows, they are on a tear—up 46% from their 2009 low, and up 30% from a year ago. Seasonal factors have probably distorted this number as well, but between the two, the picture is still one of recovery. After all, permits come before starts.

Permits and starts track each other tightly over time, and you can see that in the last chart, with starts in orange and permits in white.


In my view, there is no doubt that the housing market continues to recover, even though activity is still at very low levels from an historical perspective.

Strong retail sales



No matter how you look at the numbers, retail sales continue to rise at an impressive rate; there is absolutely no sign of any weakness here. March sales were up much more than expected, and they have posted a 6.5% gain over the past year. The top chart shows the retail sales "control group," which subtracts autos, building materials, and gasoline: it is up 5% in the past year, and is up by an even stronger 8% annualized over the past three months. The bottom chart looks at total retail sales adjusted for inflation; this measure is up 4% over the past year and has now reached a post-recession high.

Very impressive gains here, especially considering there are some 5 million fewer people working today than at the peak of the last business cycle. I'm not worried that the U.S. economy is vulnerable to a slowdown.