Originally sent to VIXCONTANGO subscribers on December 12th, 2017
Trust me, I don’t like him because he kind of looks like Jeb Bush. But that will most assuredly secure him a passage through the Senate. Democrats would have Jeb Bush over Trump any day of the week. Especially on the FED board.
I honestly have no idea why he hasn’t received a Nobel Prize yet. Perhaps, it was not his time yet. But with what is about to unfold over the next few years, he will most certainly be on the short list for a Nobel Prize. I have never seen a monetary policy architecture as simple, as effective and as elegant as the one he has outlined. It is almost Russian in its combination of fundamental simplicity and devastating effectiveness.
Marvin Goodfriend started out on Reagan’s Council of Economic Advisers. Then he became an economist and Director of Research at the Richmond Fed from 1993 till 2005, where he attended FOMC meetings regularly. He is considered to be an internationalist and has frequently been a visiting scholar at the European Central Bank, the Swiss National Bank, the central banks of Sweden, Norway, Germany, China and South Korea. He has been around the block and is well known and respected. He has delivered speeches at the Jackson Hole conference. He is also a member of the Shadow Open Market Committee (SOMC) or the Shadow FED – an organization of former FED members and other monetarists whose job is to criticize the FED. Currently he is a Professor of Economics at the Carnegie Mellon’s Tepper School of Business. He is an established thought leader on the subject of monetary policy on par with Stanley Fischer, Janet Yellen and Ben Bernanke. He will be the architect of FED monetary policy in the Powell FED. Jerome Powell (the FED chairman) is an executive manager. He is like Trump – he hires good people to do the work. But unlike Yellen or Bernanke, he is not a monetary policy architect or activist with a plan. You give Powell a plan, he checks it out if it makes sense, and if it does, signs off on it. Dr. Goodfriend will be THE architect of monetary policy while Powell is in charge. Powell’s job will be to sell Goodfriend’s plan to Congress, Trump and the American public.
The rough scoop on him is the following:
- He supports Congressional Oversight of the FED. That means measuring the FED’s actions against a mathematical formula such as the Taylor Rule. That is not something anybody at the FED has ever liked.
- He thinks 2% inflation target should be written into law by Congress to make it more credible. Again not something that anybody at the FED has ever liked. They like to change their mind all the time.
- He does not like Quantitative Easing. He was a mild proponent of QE in a 2000 paper, but even then it was a secondary approach to combat recession for him. Now he thinks that QE is too much of a “Fiscal Policy” tool to be used by a Central Bank. He particularly does not like the FED buying Mortgage Backed Securities. He thinks this is something that Congress or the Treasury should do but not the FED. Again, this is at odds with the present orthodoxy at the FED.
Overcoming the Zero Bound on Interest Rate Policy
Let’s get down to what Dr. Goodfriend is really about. The heading above is literally the name of one of his papers written in August of 2000. For 20 years, he has been a staunch advocate of a particular approach to monetary policy at the zero lower bound which for some very good reasons has not been used. But now it seems that his time has finally come.
At the 2016 Jackson Hole Conference “Designing Resilient Monetary Policy Frameworks for the Future”, he presented a new paper on overcoming the zero bound on interest rate policy which was the latest and greatest version of his research on the topic. It was the most talked about presentation at that conference. I didn’t cover this conference in great detail because I didn’t think that the US economy was about to enter a recession or that inflation would stay particularly low. As such I didn’t think that the discussions about Negative Interest Rate Policy (NIRP) in that conference were particularly relevant for the stock market at the time. As we saw clearly later, they weren’t. But that does not mean that the NIRP discussion is irrelevant overall. It is very relevant for crypto-currency markets today and eventually it will become relevant for stock and bond markets as well.
The Jackson Hole paper starts with how monetary policy has evolved over the decades. First, the Gold Standard was abolished because it limited the money supply at exactly the wrong time and inflicted random economic recessions because the gold price of goods fluctuated wildly. Gold is, after all, a commodity with relatively wild volatility compared to what a stable medium of exchange (currency) should have. In the place of a Gold Standard, Fixed Foreign Exchange Rate regime was put in place, but that construct also failed because it infused domestic price levels with the volatility of international trade. Fixed exchange rates were abandoned so that central banks could pursue domestic monetary policy to stabilize employment and inflation without worrying about the side-effect of subsidizing international trade. So today, all “traditional” constraints on monetary policy have been removed except for one – the Zero Bound on Interest Rates (i.e. nominal interest rates cannot go below zero). And Dr. Goodfriend goal in life is to remove that Zero Lower Bound (ZLB).
Let’s start with the “why” and then move onto the “how”.
Why Remove the Zero Lower Bound
Dr. Goodfriend thinks that when the economy goes into a recession and the FED lowers the rates to zero, businesses and consumers also lower their inflation expectations (I very much agree with this observation, it is astounding he is the only major monetarist to acknowledge that the FED directly affects broader inflation expectations). When businesses and consumers expect inflation in the future and are confident of their higher earnings prospects, they borrow from future earnings today to bring some consumption forward. Thus they are willing to take on credit to invest in purchases and capital investments and the economy is humming. However, if businesses and consumer expect deflation in the future and are sure they will earn less in the future and that goods will cost less in the future, they hoard their savings and their investment capital today because they will get more bang for the buck later. So they delay consumption and the economy comes to a halt.
A Central Bank can effectively control inflation expectations by hiking interest rates as much as needed (see Paul Volcker and his 20% interest rates in the 1980s). However, a Central Bank can NOT effectively control DEFLATION expectations because it can’t go lower than zero on interest rates (Bernanke in the 2010s). So when the FED rate is pegged at zero and remains substantially higher than negative inflationary expectations, then monetary policy is actually restrictive. It is tighter than it should be. Many people wondered why we didn’t have hyperinflation after 2008 and that is precisely the reason: monetary policy was actually very hawkish. Relatively speaking.
Dr. Goodfriend thinks that the FED has earned a very good reputation for combating inflation after Volcker and Greenspan slaughtered the inflation beast in the 80s and 90s. However, he doesn’t think the FED has earned a good reputation for fighting DEFLATION. According to him the last 10 years of monetary policy have been an abject debacle in that respect. And if you use his standards, they have been.
Dr. Goodfriend believes in a 2% inflationary target. But he doesn’t believe it the way the current FED does. The current FED is perfectly satisfied with less than average of 2% inflation over a long period of time. The FED is concerned with deflation and with higher than 2% inflation, but is somewhat content with disinflation. There are some on the FED that are ok with inflation overshooting the 2% target to bring the average inflation over time to 2%, but most actually are perfectly ok with hitting the brakes at 2% and thus letting inflation average less than 2% over time. For the current FED, 2% is a target to aspire to but not necessarily a target to actually attain. Dr. Goodfriend is not in these camps. He thinks if inflation is low, it must be immediately raised back to 2%. And if inflation is above 2%, it must be immediately put back down to 2%. 2% is a hard target. And ideally, it is enshrined as such by a Congressional mandate!
Dr. Goodfriend does not like Quantitative Easing. He does not think “Balance Sheet Stimulus” was effective in pushing inflation higher. He views it as government subsidy for the bond carry trade. In his view, if the interest rate is pegged at zero and Central Banks use only balance sheet policy in lieu of interest rate policy they create distortionary credit allocations, the assumption of credit risk and maturity transformation, which are all risk taken on behalf of tax payers. He calls this “destructive inflationary finance” (I couldn’t agree more). In his view, interest rate policy is far superior to balance sheet stimulus and he views it as necessary and SUFFICIENT for countercyclical stabilization purposes.
Dr. Goodfriend also thinks that we have a big unacknowledged problem. He thinks that large government debt burdens are hindering business capital investment. He cites Reinhard & Rogoff study that the average level of gross public debt to GDP in advanced economies exceeds 90% (it is more than 100% in the US) and that since 1800 in 26 different situations debt overhang slowed the expected potential output of an economy. High public debt burdens signal to businesses that they will encounter higher taxes in the future (as governments try to pay back their debts) and they curtail their capital investment activities today. Households become pessimistic about the future because they will work less hours and face higher taxes. Thus the “intertemporal terms of trade” become depressed as wealth and consumption is moved to the future where it is expected to be more valuable on the margin. So large public debt, in his view, is a significant and unacknowledged factor that drives inflationary expectations permanently lower.
Still wonder why the 10-year Treasury Yield is hanging out at 2.30% for years on end?
In Dr. Goodfriend’s own words:
It is only a matter of time before another cyclical downturn calls for aggressive negative nominal interest rate policy actions
Given the current 1.5% on the 10-year Treasury yield in the United States today, the federal funds rate would have to be taken down at least -1% and more likely to -2% to stimulate recovery from the next cyclical downturn.
How to Remove the Zero Lower Bound
This is all fine and dandy in theory. The real question is how do you implement negative interest rates? This is where Dr. Goodfriend is considered to be very controversial in some circles. Libertarian think tanks like the Mises Institute are going bananas over him. New York Times, Wall Street Journal, Financial Times editorial boards (as you can guess) are fine with him, because they like the concept of negative interest rates. But the small and very vocal libertarian group is opposed to him. So what are the libertarians freaking about?
The practical implementation of a negative interest rate policy has 2 major obstacles. First, Banks are committed to honor paper currency at par. Second, while Central Banks can charge Banks negative interest rates, Banks can’t charge retail customers negative interest rates without a sparking a run on the bank (to cash). In a fractional banking system, that is a really bad idea, because no bank actually holds the money that people have deposited, only a fraction of it. So these 2 obstacles have made attempts at breaking the Zero Lower Bound very ineffective in the few places (Switzerland, Japan and Sweden) where it has been tried. How do you implement NIRP without sparking bank runs?
- Abolish Paper Currency
That is really straight forward and requires no technical innovation. But it will be highly unpopular (just ask Rand Paul). Paper currency enables low value transactions and is readily accessible for low income consumers. Until buying with a phone is ubiquitous enough, it’s not practical.
- Variable Market Based Price of Paper Currency
This is similar to replacing a foreign currency exchange peg with a floating currency. Or removing the gold standard. Currently Central Banks and banks are committed at meeting paper currency at par. Par is the peg. Remove the peg and set the value of the currency based on a formula which includes the GDP growth rate and currency demand. The idea is that in a recession, once the currency starts to go below par (because GDP is contracting), people will be incentivized to spend it or invest it, rather than hoard it. And vice versa in good economic times, paper currency will be higher than par and that allows consumers to combat inflation more effectively.
- Provide Electronic Currency
Quoting Dr. Goodfriend, “one can imagine the central bank offering electronic currency as a substitute for paper currency. As a direct liability of the central bank, electronic currency would be as safe as paper currency”. Basically you get a debit card with FED crypto money. That card then is used for purchases alongside your existing credit and debit cards. Since these cards are a direct liability of the FED, the banking system is BYPASSED and the FED can directly change rates on consumer accounts. This eliminates the system friction that banks have caused monetary policy implementations in the past. You will still have paper currency, but over time the convenience and popularity of the electronic currency will start to surpass the paper in circulation.
Option Number 3 is particularly attractive, especially in the age of bitcoin. The concept of FED electronic currency keeps showing up in Dr. Goodfriend’s writings. There is some speculation that bitcoin is actually a US government invention. Online “sources” point to this 1996 paper by the NSA Cryptology Division that outlines the architectural design of Anonymous Electronic Cash. You look at this architecture and it is identical to the Bitcoin network and how it functions. The only thing missing is the miner reward system and the replacement of a centralized clearing system with a distributed computer network that acts as a centralized clearing system (or what we call “blockchain” today).
As you can imagine the libertarian Mises Institute is up in arms about Options 1 and 2 mentioned above. These guys like their cash in their mattresses and the gold in their vaults and they don’t want these touched. So it is highly unlikely that this will happen. The public backlash will be large. But Option 3 is definitely coming. Both current FED board members, Jay Powell and Lael Brainard are crypto currency experts and now Trump is adding Dr. Goodfriend – the intellectual godfather of electronic currency.
I think the astronomic appreciation of bitcoin this year after 4 years of slumber is not a coincidence. I think financial institutions are preparing themselves for an upcoming NIRP regime and it appears the only way to escape NIRP in volume would be to buy limited supply digital currencies like bitcoin. The cash in the system is orders of magnitude bigger than the bond market not to mention the stock market. So there is extra cash left over that needs to find a home outside of the current financial and banking system. By investing in bitcoin infrastructure, financial institutions are building the plumbing that will allow them to effectively counteract Dr. Goodfriend’s upcoming policies. Everything happens for a reason. This is the reason why you can no longer buy a bitcoin with lunch money. Bitcoin is now nearly $20,000 which is a single VIX futures contract. Soon a bitcoin will be as much as an SPX futures contract ($200,000). CBOE and CME exchanges launched futures trading in bitcoin because bitcoin will be an institutional vehicle in the future. I have said since 2013 that bitcoin will eventually be a Tier 1 Central Bank asset (as the FED tries to control that limited commodity, just like it does with Gold). But before bitcoin shows up on the FED balance sheet, the first step will be financial institutions running to crypto-currencies to escape negative interest rates.
You should do the same thing by the way! Get yourself some crypto.
So while the Mises Institute is panicking about Dr. Goodfriend’s thinking on NIRP, at present NIRP is not a relevant issue. Right now, the economy is growing 3% driven by excessive Fiscal Policy stimulus (corporate tax cuts) and inflation is hitting 3% on some measures (Producer Price Index). In a good economy, Dr. Goodfriend is a conventional Taylor rule thinker. Dr. Goodfriend points out in his speech at the Shadow Open Market Committee (SOMC) how Alan Greenspan slayed the Inflation Dragon in 1994 by pre-emptively hiking the interest rates while the full employment objective hadn’t been yet attained. In good economic times, Dr. Goodfriend advocates for substantially higher rates. The Taylor rule specified below is something he would like to see the FED implement.
I have to say that using the Taylor rule would most likely have prevented the Housing Bubble of the mid 2000s by hiking rates a lot earlier than Alan Greenspan did. And also it would have helped the economy recover faster after the Great Recession by emboldening bank lending through rate hikes (higher rates lead to more risk taking by banks). Also negative rates as prescribed by the Taylor rule would have sparked much needed inflation in 2008 and halted the stock market decline midstream. It looks like the Taylor Rule would have worked very well in the recent past… and it looks like it may finally be put to use!
Dr. Goodfriend’s High Voltage Markets
What does Dr. Goodfriend’s monetary policy architecture mean for the financial markets? In a word, volatility.
Volcker and Greenspan’s primary goal in life was to defeat inflation because of the hyper-inflation after the removal of the Gold Standard in 1973. Bernanke and Yellen FED were obsessed with eradicating volatility because of the precipitous market declines during the Great Recession. Goodfriend’s primary goal in life will be to unwind the excesses of the Bernanke/Yellen FED. He will unwind the short volatility trade in all of its forms that succeeded so greatly during the previous monetary regime. He will normalize interest rates, normalize volatility, normalize the economy and normalize the financial markets. Bring back cyclicality.
Markets that never go down are not good for society. Never ending bubbles are not good for society just as much as never ending bear markets are not good for society. Young people do not choose when they will enter saving age which unfortunately might coincide with the peak of a stock market bubble and result low forward returns. Middle age people do not choose when to buy a house – they buy when they have kids. They can’t sit and time the housing market. Retirees can’t choose when they need to sell their stock investments and move into bonds. They do it when it is time to retire. Hundreds of millions of people cannot be expected to be astute market timers. They cannot be expected to suffer through decades of one way markets. As such the market needs to provide opportunities for some to accumulate productive assets at a cheap price and for others to dispense of productive assets at a high price. Markets accomplish that through volatility. Dr. Goodfriend will bring back volatility.
At the onset of the next easing cycle when we expect negative interest rates via a FED electronic currency, what you will want to invest in is limited supply commodities that are effective inflation hedges – gold, silver, bitcoin, litecoin. Markets will front run the negative interest rates which will culminate in businesses and consumers panically buying commodities instead of keeping cash at a negative rate in their bank accounts. Financial institutions will move into crypto-currencies and regular folks will go to the metals. You will also want to invest in high dividend sectors such as staples and utilities and secular growth sectors such as tech and health care. Any dividend is better than negative dividend. And secular growth likes low rates. You want to be short cyclical growth like industrials, materials and financials. You will want to be long volatility.
But then as the economy starts to recover, interest rates will swing fast back into the positive. There will be no more 0% interest rates for 10 years. Then you want to be playing cyclical growth sectors – industrials, materials, financials and you want to short defensive sectors like staples and utilities. You will also want to short volatility.
Basically you will have the normal investment playbook that we utilized before the Obama years. Active management will pay off much better. Hedge funds will look a lot better as well. The financial world will not be dominated by the nanny state and the heavy hand of the government will not extinguish every market gyration. Bonds will be able to deliver much higher returns either through higher yields or capital appreciation. The economy will be more dynamic and grow faster. But also there will be down cycles which will provide upcoming generations with good opportunities to buy the dip.
It’s not going to be all good, it’s not going to be all bad, but for sure it won’t be purgatory like the last 8 years.
Once Goodfriend is on the FED board, he will be in favor of faster Quantitative Tightening schedule as he wants the QE rolled back quickly and completely. He will also want to jack up the rates as quickly as possible to the 2.5%-3% area (where the Taylor rule is) in order to slay the oncoming inflation because of tax cuts and infrastructure spending. So strap on your seat-belts.
The Greenspan, Bernanke and Yellen put under the market is no more.