Janet Yellen's Choice: Market Bubbles or More Jobs?
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The Fiscal Times
July 17, 2014

All that seems to matter to the financial markets and the economy right now is what the Federal Reserve and its chair, Janet Yellen, has planned. Islamic extremists running amok in Iraq? Doesn't matter. Russian incursions into Ukraine? Who cares? Renewed troubles in the Eurozone? Germany won the World Cup, so stop complaining.

This singular focus was on display this week during Yellen's semi-annual testimony to Congress, with the market following every side comment, intonation change and body language shift. Emotions are high, as evidenced by this well-publicized exchange on CNBC that summarizes the ongoing holy war between Fed apologists and easy-money skeptics.

Related: Yellen Defends Loose Fed Policy

Those skeptics believe the Fed is inflating an asset price bubble, much larger than anything seen before, sowing the seeds of runaway inflation and the higher interest rates that will be needed to contain it, as well as the bank bailouts that will inevitably follow. The apologists are excited by record highs in the stock market and an improving job market that they say still needs plenty of help. They argue there’s little reason to pull away the punch bowl now.

But one gets the feeling that the Fed is nearing a crossroads and that one side is about to be proven right.

The ongoing QE3 bond purchase program is on track to wind down in October amid bubbling inflationary pressure. The job market is finally showing signs of tightening, with the unemployment rate dropping to 6.1 percent — just three-tenths away from the Congressional Budget Office's estimate of full employment through 2015.

Related: Yellen Shines a Light on Shadow Unemployment

A decision must soon be made. Should Yellen and the Federal Open Market Committee lean against inflation and the risk of bubbles by raising short-term interest rates sooner than and more aggressively than expected in early 2015? Or should they wait for inflation to become a clear problem in the hopes of encouraging faster job creation and wage growth?

The decision is complicated and the stakes couldn't be higher.

The Fed's monetary base has gone from around $800 billion before the financial crisis to nearly $4 trillion now while holding short-term interest rates near 0 percent for six years. Here we are, five years after the recession ended and stocks bottomed, and the Fed is still pumping its stimulus into the economy while its balance sheet has never been larger. Think about that.

If the apologists are right, inflation shouldn't become a problem, wage growth should accelerate once the long-term unemployment rate drops, and stocks should stay high as corporate earnings keep growing. If the skeptics are right, we could see a whiff of "stagflation" as inflation kicks higher and the economy stalls amid structural problems in the job market (which I explored in my last column). An overleveraged and overconfident stock market may well crash back to earth as corporate buybacks slow.

Related: Central Banks Ending Era of Clear Promises

There seems to be little agreement between the two sides.

White papers are thrown around. Academics and pundits bicker about the cyclicality of unemployment. Even politicians and non-governmental entities get in on the act, with the International Monetary Fund speaking up in favor more monetary stimulus while the Bank for International Settlements recently warned in its annual report that the Fed and other central banks have gone too far and risk repeating the mistakes that led to the housing bubble that caused the mess we're in now.

At the end of the day, the truth will only be known in retrospect. 

Yet the evidence is building that bubbles are forming, with the epicenter being the debt-fueled corporate stock buybacks that have been supporting the stock market's rise. If a chart of Phoenix home price gains typified the housing bubble back in 2006 then the chart above of corporate debt levels relative to GDP is indicative of the new bubble.

The increase in corporate debt, the increase in investor margin debt and the compression of bond yields to very low levels — all of which is enabling the stock market's persistent rise to new highs — is what makes the situation so vulnerable to any shifts in the status quo.

Higher margin debt makes investors more sensitive to any decline in the stock market, magnifying potential losses. Higher corporate debt makes corporate earnings more sensitive to any changes in revenue (due to a slower economy) or profitability (due to a tighter job market and higher wages). And ultra-low bond yields make bond prices more sensitive (due to a concept known as duration) to any increases in interest rates (due to Fed tightening, higher inflation, or higher corporate default risk).

All of this is spiked with very high investor sentiment and the return of money-losing IPOs and very high M&A buyout valuations.

That's why the stakes are so high for the Fed, the penalty for a misstep severe, and why it's been erring on the side of inaction and indecision for years by shying away from tightening whenever the market or the economy suffers a scare. It's just been easier to keep moving back the goalposts for starting its policy normalization as the Eurozone crisis, the fiscal standoffs in Washington, and other concerns provided just enough worry:

In 2008, the Fed pledged to hold rates at "Exceptionally low levels…for some time…"

In 2009, it became "…for an extended period…"

In 2011, it was "…at least through mid-2013…"

In early 2012, it was "…late 2014… 

In September 2012, it was "…through mid-2015…"

In December 2012, it was "…at least as long as the unemployment rate remains above 6.5%..."

And now, it's some "considerable period" after October that's interpreted to be roughly six months or a little longer.

While I personally think the Fed is only going to make the situation more vulnerable by waiting and letting the market amplify its animal spirits further, it's doing what's in its self-interest. The Fed is by nature a political institution. It gets no bonus points for casting ahead and trying to cut asset price bubbles down when many believe the rises are justifiable by the fundamentals and are fueling job market gains (although, to be fair, Yellen and other Fed officials have been trying "verbal tightening" by warning of overvaluations in small cap stocks, biotech and social media).

Let's remember that the choice between inflating assets and creating jobs or adhering to sound money principles and preventing market bubbles is an old one famously brought to life by Democratic presidential candidate William Jennings Bryan in his famous "Cross of Gold" speech of 1896.

In what was probably the most dramatic and emotional appeal for monetary policy change in human history, comparing tight money to the crucifixion of Christ, Bryan called for faster growth in the monetary base to ease the burdens of indebted farmers, encourage economic growth, free the country of international exchange-rate obligations, and lower unemployment by releasing the dollar from the shackles of gold convertibility.

At the time, it was specifically about allowing the coinage of both silver and gold to swell the money supply. But more broadly, it was about using the power of cheap and plentiful dollars to elevate American living standards. Bryan lost in 1896 and again in 1900 to President William McKinley as voters realized the dangers of trying to print your way to prosperity.

America eventually unindulged in the kind of aggressive, unfettered monetary expansion Bryan could only dream of in the 1970s, after President Nixon ended gold convertibility, as the Fed tried to trade higher inflation for lower unemployment. The cheap money junkies were rewarded with stagflation, twin recessions, and 20-plus percent interest rates after tensions in the Middle East resulted in an energy price shock.

Let's hope the Fed gets it right this time.

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm.

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Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm.​