Declawing of the Federal Reserve by Stephen Duneier First published October 28, 2014
Times have changed dramatically since Alan Greenspan took the reins of the Federal Reserve. The shift in wealth distribution from the bottom 95% to the top 1% has been nothing short of amazing. In 1987, more than half the country’s wealth was controlled by the bottom 95% while the top 1% owned roughly half as much. Fast forward to the financial crisis and that gap had collapsed to near zero, with the divergent paths having continued unabated since (see Share of US Wealth chart).
No matter how you look at the landscape of wealth and income in the United States, the disparity has been growing at an astounding pace. What started it, whether it’s sustainable or even justified, is not my concern here. What is of great importance, however, is the impact this shift in the composition of the Federal Reserve’s target audience has had on the economy and the consequences for the effectiveness of the Fed itself.
Behavior Modification What gets lost in conversations about Fed policy is the fact that the Federal Reserve, for all intents and purposes, is in the business of behavior modification. Every tool, from open market operations to the discount rate and even quantitative easing, is meant to alter the behavior patterns of its target audience. Interestingly, their tools were devised for an economic demographic that no longer exists, and that is what makes it difficult to set policy and predict it, but also calls into question whether it even matters. Diminishing Marginal Utility What is rational to one individual isn’t necessarily so for another equally intelligent person. This is particularly the case when it comes to marginal utility, a concept that underpins Fed policy. To review, marginal utility is the additional satisfaction or benefit that a consumer derives from buying an additional unit of a commodity or service. Merriam-Webster uses the example that an additional slice of bread given to a family that has 5 slices will provide much greater marginal utility than it would to a family that has 30. This example is reflective of the sort of proportionality most of us consider when thinking about how changes in interest rates affect consumers and investors. The issue these days, is that the overwhelming majority have somewhere between 5 and 30 slices of bread, while a tiny minority has wheat farms and bread factories. In other words, the law of diminishing marginal utility plays out very differently between a multi-billionaire and the average American consumer. That dramatic divergence in behavior patterns, combined with the extraordinary proportion of the country’s wealth now being controlled by that tiny minority, is affecting the effectiveness of the Federal Reserve’s tools. Unfortunately, rather than acknowledging it and making adjustments by devising new tools, monetary or otherwise, we seem to be advocating the marginalization of the signals that are sounding off the loudest alarms, such as velocity (seeIncome Dispersion and the Velocity of Money chart) and underemployment, both of which are being dismissed due to the difficulty in gathering accurate data.
Target Audience I am purposely using the term Target Audience, because I am trying to drive home the point that the Fed is not just some obscure, bureaucratic entity that waves its wand and effects change. It is very much like any other business whereby it must assess the environment in which it exists, understand the behavior of its target audience and craft a suitable strategy for guiding that behavior in the direction it desires.
Take a look at the savings rates by income leveland you quickly see, the more one makes, the more one can, and does, save. When you get to the Top 0.1%, the savings rate approaches 100%. Give a household with an income of $25,000 per year an additional $500 and they are very likely to quickly purchase something with it. When the majority of the economy is made up of people in a similar situation, those transactions get repeated over and over again. That is the velocity of money. However, when that household purchases $500 worth of goods from a multi-billionaire or even WalMart, where Michael Duke made 1,372 times more than a full-time minimum wage employee of WalMart, you can see how quickly the velocity of that $500 injection dies. So while the Fed and other central banks around the world have been “priming the pump” and “printing money”, it’s had surprisingly little effect on the overall money stock, inflation and growth.
Some argue that the economy has struggled even with the massive injections and so any reduction in stimulus would have a devastating effect. Recall the tantrum triggered by Bernanke’s taper comment on May 22, 2013. At the time, while the markets were in a frenzy over the potentially disastrous effect of the removal of stimulus, I made the argument that it didn’t actually matter. Although many point to the economy’s performance since tapering began as evidence of an underlying strength, I believe it simply didn’t matter very much.
Now we are facing a similar situation with the imminent removal of “considerable period” language, debate over the timing of the first hike and the speed at which they will rise. For the last several Fed meetings it has caused quite a stir. I contend once again, it probably doesn’t matter as much as we’d like to think. The problem the economy faces is not one of money supply, but of velocity.
Behavior by Proxy There’s one more rather significant phenomenon that compounds the issue I’m attempting to highlight. While the great majority of Americans control a rapidly dwindling proportion of wealth in this country, it is still a rather sizable chunk. What’s noteworthy is that the amount of that wealth now directed by pension fund managers, rather than the individuals themselves, has ballooned (see Composition of Wealth chart).
What this means is that the people now controlling velocity are the mega wealthy, CEOs and pension fund managers. All of them have very different incentive systems and behavior patterns, than the bottom 95%. For years, the new power players have been more focused on controlling risk than on initiating it. Much of it has to do with the post financial crisis zeitgeist (see Seeds of Thought, February 21, 2013) which demonizes risk taking and criticizes those who profit from it. Cash is hoarded or shuffled between players with similar marginal utility levels. Companies are borrowing from the pool of wealth to buy back stock which only serves to return more capital to the pool. It kind of reminds me of the movie, Brewster’s Millions.
Real vs Financial Economy What ultimately stands in the way of the economy realizing its true potential is that the money that has been pumped into the system can’t seem to find its way to the real economy, and instead is being dumped into the financial economy. The traditional transmission mechanisms are broken and unless the Federal Reserve devises new tools, the only thing raising rates will eventually confirm is just how impotent the institution has become.
Implications So what do we do with this information? First, we must recognize that the Fed probably matters less than we think. There is a massive pool of wealth that was created from 20 years of uninterrupted global prosperity thanks to financial innovation and loose monetary policy which, even when you factor in the financial crisis, has experienced little more than a brief hiccup. That money is no longer being put to work and the velocity of it is on a downward trend. Wealth isn’t being invested so much as it is being parked.
Corporate borrowing to buy back stock and the recent spike in M&A activity represents the low hanging remnants of financial innovation, but it has limited upside potential. Higher equity prices since the crisis have also helped the bottom 95% move forward. When they could no longer tap into skyrocketing home equity loans to fuel their spending, the rising balances in their pension accounts cushioned the psychological blow.
Bottom line, the giant Ponzi scheme in which everyone is participating is the only thing to keep an eye on. So long as none of the participants panic, the path we have been on for the past 5 years will likely continue. The sheer magnitude of excess cash in the system will keep things moving in the same direction. The US government will continue to have access to as much cash as it desires. From there, the excess cash will likely continue to flow into the lowest risk assets in the investor’s home country first, with everything else attracting capital on a risk adjusted basis. I believe returns will be harder and harder to come by, with risk/reward ratios continuing to recede. Implied vols should remain compressed, except for the occasional blip, for while protection is an important thing to have, remember that the “risk on” side of future moves will likely be subdued and therefore attract its share of sellers looking to fund that protection. While it sounds like the only possible outcomes are slow and steady risk on or cataclysmic risk off, it’s the ebb and flow in expectations between the two that is likely to continue exacting the most pain.
About the Author For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis in the College of Engineering, as well as Behavioral Investing, at the University of California.
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management. As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
Bija Advisors LLC In publishing research, Bija Advisors LLC is not soliciting any action based upon it. Bija Advisors LLC’s publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, Bija Advisors LLC does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing on Bija Advisors LLC’s publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither Bija Advisors LLC nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, Bija Advisors LLC and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate. Bija Advisors LLC is not liable for any loss or damage resulting from the use of its product.