Hoisington Quarterly Review And Outlook, First Quarter 2018

Lacy Hunt is in the very top rank of US economists. He would have made an excellent Fed chairman, if you ask me (no one did who mattered); but he goes on holding down the fort, along with partner Van Hoisington, at Hoisington Investment Management in Austin; and so you and I continue to have the benefit of Lacy and Van’s quarterly updates, which I always feature here in Outside the Box.

Today’s is an amazing piece of academic economic analysis. Lacy and Van kick it off with this trenchant little summary of our predicament:

Nearly nine years into the current economic expansion Federal Reserve policy actions appear to be benign, as even after six increases, the federal funds rate remains less than 2%. Changes in the reserve, monetary and credit aggregates, which have always been the most important Fed levers both theoretically and empirically, indicate however that central bank policy has turned highly restrictive. These conditions put the economy’s growth at risk over the short run, while sizable increases in federal debt will serve to diminish, not enhance, economic growth over the long run.

That’s it in a nutshell.

Then Lacy leads us a ways into the weeds on interest rates and monetary decelerations and their impact on the Fed’s ability to act – you can get a real economic education reading these Hoisington reviews – and then on pg. 5 Lacy really busts out with some important new thinking. Here’s what he had to say about it in a note a couple days ago:

John,

Please take a close look at the section entitled “The Debt End Game – The Law of Diminishing Returns.” This is a more detailed discussion than I gave at SIC.

I have worked with the debt problem since the 1980s, but it was not until recently that I could describe the endgame using an economy’s production function and thus employing the law of diminishing returns. As I consider this my keenest insight, please read and let me know what you think.

The law of diminishing returns is a more direct answer for the debt endgame than going from Bohm Bawerk to Fisher to Kindleberger to Minsky to contemporary econometric studies. Very importantly, the two lines of thought yield the same answer.

Warm regards, Lacy

When Lacy Hunt tells me his letter contains the “keenest insight” of his career, I sit up and pay attention – and then read three or four times. I won’t tell you that today’s essay is easy going, but I am definitely trying to absorb it into my own limited economic understanding. It is important enough that you should, too.

Bottom line, friends: The crunch is upon us, or nearly.

Quarterly Review and Outlook, First Quarter 2018

By Lacy Hunt, PhD, and Van Hoisington, Hoisington Investment Management

Nearly nine years into the current economic expansion Federal Reserve policy actions appear to be benign, as even after six increases, the federal funds rate remains less than 2%. Changes in the reserve, monetary and credit aggregates, which have always been the most important Fed levers both theoretically and empirically, indicate however that central bank policy has turned highly restrictive. These conditions put the economy’s growth at risk over the short run, while sizable increases in federal debt will serve to diminish, not enhance, economic growth over the long run.

Interest Rates

Interest rates are not predictable over the short run but are controlled by fundamental forces on a long-term basis. Milton Friedman (1912- 2006) developed the most complete and internally consistent interest rate model to date, which is an extension of the Fisher equation. Friedman’s model reaches two conclusions: (1) although monetary decelerations may lead to transitory increases in interest rates over the short run, they ultimately lead to lower rates; (2) monetary accelerations result in higher rates. This reasoning is based on what Friedman termed “liquidity, income and price effects”. When the Fed reduces the reserve, monetary and credit aggregates (or what Friedman called monetary deceleration), initially short-term rates are forced upward through the “liquidity (or initial) effect”. As the Fed further tightens monetary conditions, an offsetting “income effect” follows. These restraining actions moderate growth in the economy, and the rise in interest rates continues but at a slower pace. Thus, in Friedman’s terms, the income effect begins to offset the liquidity effect. When the Fed sustains the tightening process long enough, the inflation rate will decrease as incomes fall and ultimately result in lower rates. This is the “price” or “Fisher effect” from the Fisher equation. Observationally, the highly inflation-sensitive long-term yields reflect the changing economic landscape faster than short-term rates, thus the yield curve flattens, serving to strengthen the Fed’s restraint on the reserve, monetary and credit aggregates.

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