Friday, April 7, 2017

The Federal Reserve's Recovery Playbook - a Theory

After spending more than 8 years arguing and providing data to back up my view that there has been no discernible economic recovery in the US (of the traditional "escape velocity" variety), I've decided to stop my focus on this subject and move on to other issues. Thankfully I'm no longer making these charges on my own. As such I'm going to let the far more eloquent and technical writers like Jeff Snider from Alhambra Partners continue the fight to hammer that message home.
Despite the clinging narrative, the "economic recovery" is not one of the main drivers behind the stock market's meteoric rise to record highs, although the 'green shoots' story did start the rally ball rolling in March 2009.
Similarly, earnings, expansions in PE multiples, the recovery in housing, rising wages and the falling unemployment rates have also all been offered up as reasons to explain the stock market's rise at one time or another over the last few years. While all of these measures have seen increases or improvements, none have been consistently strong enough to be thought of as the main underlying support system in the market since the end of the Great Financial Crisis.
One theory that I will expand upon in this post relates to my view that the Federal Reserve is actively using the US stock market as a policy tool to impact and influence consumer sentiment. By increasing consumer sentiment (through a rising stock market), the Fed believes there will be an increase in consumption expenditures that would be more significant than leaving sentiment to run on its own merits.
First - we need to take a close look at the historical and recent correlations that exist between Consumer sentiment and the S&P 500. In this example I've used both the University of Michigan Consumer Survey as well as the Conference Board's Consumer Sentiment Index.

As you can see from the charts below, while there is a marginal correlation between consumer sentiment and the markets over the entire history of these measures, the correlation in BOTH surveys from March 2009 to today (2017) is almost perfect.

The Conference Board's Consumer index shows a similar pattern:

Given the work above - there should be absolutely no debate that from March 2009 to today, consumer sentiment is greatly influenced by the rises and falls of the S&P 500.
Now that we've established that this close relationship exists, let's review research written by the Federal Reserve on the subject of consumer sentiment to gain insight into how they feel sentiment relates to future consumption:
Research Review -
1993 - "What Role Does Consumer Sentiment Play in the U.S. Economy?" 
By Federal Reserve Bank of Boston Economist Jeffrey C. Fuhrer

Key quotes:

"The economy is mired in recession. Consumer spending is weak, investment in plant and equipment is lethargic, and firms are hesitant to hire unemployed workers, given bleak forecasts of demand for final products. Monetary policy has lowered short-term interest rates and long rates have followed suit, but consumers and businesses resist borrowing. The conditions seem ripe for a recovery, but still the economy has not taken off as expected. What is the missing ingredient? Consumer confidence.

Once the mood of consumers shifts toward the optimistic, shoppers will buy, firms will hire and the engine of growth will rev up again".
"In its most recent publication (1992), the Survey research Center (SRC) at the University of Michigan is careful to point out that the important of the Michigan Surveys derives from the

"important influence of consumer spending and saving decisions in determining whether the national economy slips into recession or is propelled toward recovery and growth". They argue that consumer's optimism or pessimism primarily affects the timing of decisions to purchase homes, vehicles and other durables".

June 1998
"Does Consumer Confidence Forecast Household Expenditure? A Sentiment Index Horse Race" 
by Jason Bram & Sydney Ludvigson

Key quotes:
"Household sentiment has been cited as one of the leading causes of the 1990-91 recession"

"In response to the widespread belief that consumer's opinions and expectations influence the direction of the economy, a growing number of studies have set out to analyze the relationship between consumer attitudes and economic variables"
"Our empirical analysis suggests that consumer sentiment can help predict future movements in consumer spending"
.."our results suggest that consumer confidence can help predict consumption, and that consumer attitudes may also act as a catalyst for economic fluctuations".

September 2006
"Stock Prices, News and Economic Fluctuations"
by Paul Beaudry and Franck Portier

Key quotes:

"There is huge literature suggesting that stock price movements reflect the market's expectation of future developments in the economy"

"There is also a huge literature, and a long tradition in Macroeconomics (from Arthur C. Pigou, 1927, John Maynard Keynes, 1936, to the survey of Jess Benhabib and Roger E. A. Farmer, 1999) suggesting that changes in expectation may be an important element driving economic fluctuations."

"In particular, our evidence suggests that business cycles may be driven to a large extent by TFP (total factor productivity) growth that is heavily anticipated by economic agents, thereby leading to what might be called expectation driven booms.

May 2009
"Trends in Consumer Sentiment and Spending"
by Maude Toussaint-Comeau and Daniel DiFranco

Key quotes:

"Consumer sentiment is one of the many macroeconomic indicators tracked by policymakers. It is seen as an important barometer of economic activities - an indicator of the way people plan to spend their income."

"Research has shown that consumer expectations align more closely with spending during periods of weakness in the economy, and the forecasting contributions (or predictive power) of consumer sentiment appear to be wrong when the economy is weaker. During times of greater economic uncertainty, as consumers perceive greater risk, they tend to accumulate precautionary savings to insure against a sudden loss in income. For example, even if a consumer's financial position remains unchanged, the precautionary motive for saving will affect his discretionary consumption, i.e. spending on nonessential goods and services, in the present."

"We find that the condition of the macroeconomy has a strong influence on consumption spending. Consistent with the implications of precautionary motives, the impact of consumer sentiment on spending decisions is stronger among those with greater constraints in income and liquidity."

"The stock market index may affect consumer confidence in two ways: An increase in stock market prices may increase wealth and directly boost confidence, or rising stock markets may act as an indicator of higher expect labor income, which would also increase confidence and hence consumption spending."

November 2010
"Confidence and the Business Cycle"
by Sylvain Leduc

Key Quotes:

"Indicators of consumer confidence have been at depressed levels in recent months. Business sentiment is also low, reflecting uncertainty about U.S. fiscal policy and the perception that economic weakness may be prolonged. This lack of confidence raises the risk that pessimism can become entrenched and self-reinforcing, further dampening the nascent recovery".

"The boom-and-bust cycles in the United States and other parts of the world over the past two decades and the stock market collapses in 2000 and 2008 have prompted macroeconomists to take another look at the extent to which confidence, optimism, and changes in expectations may drive and amplify business cycle fluctuations. Recent empirical work indicates that these sentiments contribute significantly to economic ups and downs. Typically that means monetary policy remains accommodative when weakness in confidence becomes entrenched".


So, based on research produced by the Federal Reserve over the last 25 years, we know that consumer sentiment is thought to have a very large and measurable impact (positively and negatively) on the underlying economy. One report in particular attempts to calculate exactly how much consumer confidence can add or take away from economic activity.

April 1995
"Consumer Confidence and Economic Fluctuations"
by John G. Matsusaka & Argia M. Sbordone

Key Quotes:
"The pattern is striking; all recessions were preceded by a fall in confidence, and all major falls in consumer sentiment were followed by a recession (except in 1965 which, while not in recession, was the so-called "growth recession")."

"In a multiple-equlibria model, output responds to fundamentals, but in addition there can be fluctuations as the economy shifts between equilibria. Perhaps the most intriguing feature of these models is that output can fluctuate simple because everyone expects it to. Put differently, expectations can be self-fulfilling in that if people expect bad times they get them."

"... the evidence that movements in consumer confidence precede movements in output can be interpreted in two ways. Either consumer sentiment causes GNP or it simply anticipates GNP." [emphasis theirs]

".. changes in consumer sentiment have a statistically significant effect on output fluctuations. In other words, we find evidence of Granger-causality running from consumer sentiment to GNP".

[Granger-Causality definition from Wikipedia: The Granger causality test is a statistical hypothesis test for determining whether one time series is useful in forecasting another, first proposed in 1969.[1] Ordinarily, regressions reflect "mere" correlations, but Clive Granger argued that causality in economics could be tested for by measuring the ability to predict the future values of a time series using prior values of another time series. Since the question of "true causality" is deeply philosophical, and because of the post hoc ergo propter hoc fallacy of assuming that one thing preceding another can be used as a proof of causation, econometricians assert that the Granger test finds only "predictive causality".[2]]

"Our second finding is that while sentiment is not the most important factor in GNP fluctuations, it plays a quantitatively significant role: between 13 percent and 26 percent of GNP innovation variance can be attributed to innovations in consumer sentiment."

[referencing Oh and Waldman research (1990, 1993)] "Their key insight is that if there is an announcement that the economy is about to boom and everyone believes it then future output should be high, even if the announcement is based on false information".

"This paper explores the possibility that the economy's total output occasionally varies not in response to a shift in fundamentals but in response to a shift in consumer sentiment. Specifically the paper asks whether and to what extent exogenous declines in consumer confidence cause recessions, and conversely whether and to what extent bullish consumers drive economic growth."

"There are two inspirations for this research. The first is the fact that something called "consumer confidence" plays an important role in popular explanations of the business cycle and in the public statement of business and political leaders. The second purpose of the paper is to provide some evidence on the rich collection of macroeconomic models with strategic complementaries that have been developed in recent years. All these multiple-equilibria models have in common that expectations are self-fulfilling - because agents must expect to be in a particular equilibrium before the economy can move to it, either expectations in a sense cause the movement to the equilibrium.

"An implication of these models, then, is that after controlling for movements in economic fundamentals, changes in consumer sentiment lead to changes in GNP".

Based on the examples and statements above, it is clear that the Federal Reserve views consumer confidence as a very important and influential component that impacts the broader economy (either positively or negatively). Now to be thorough, let's look at two simple examples where consumer confidence has had a measurable impact on an economy.

Example one -

The U.S. recession of 1990-91 -
"A Better Economic Mood; Many Say the Gulf Crisis Shook Confidence and Foresee a Recovery as Hope Revives" by Sylvia Nasar, The New York Times (April 3, 1991)

Key Quotes:

"The current recession may be the first in memory that can be attributed to a case of nerves. And now that confidence has come roaring back, signs are that an economic recovery is not far behind."

"Pinning hopes of an economic revival on the recovery of nerve makes sense for the great many who believe that when the economy stumbled, psychology was the main culprit".

"Confidence Indexes Show Brighter Consumer Outlook" by Sylvia Nasar, The New York Times (March 21st, 1992)

Key Quotes:
"To economists, improvement in the confidence indexes is critical evidence that the recent jump in retail sales was not a fluke and that the economic recovery is not necessarily doomed to fizzle."

"Economists had worried that consumer's pessimism could turn into a self-fulfilling prophecy. A DRI/McGraw Hill calculation showed that if consumers remained deeply worried, retail sales would be $20 billion lower, and 100,000 fewer cars and 40,000 fewer houses would be sold this year".

Example two:

The economic impact of the D.C. Sniper attacks of 2002

"DC economy suffers in wake of Sniper attacks" By Jeremy Raelin, The Heights, Volume LXXXIII, Number 25, 5 November 2002

Key quotes:

"While the sniper was at large, the Washington Post reported that retailers in Montgomery County MD, were suffering a 50 percent drop in sales. People were afraid to leave their homes, fearing assassination while doing even the most trivial tasks such as pumping gas, playing at recess and walking to a car".

"Retailers have lost money in one of the biggest shopping months of the year. Anirban Basu, chief economist at Towson University's Regional Economic Studies Institute, which tracks the Washington area's economy, said in an interview with the Washington Post. "It's never a good time for a sniper, but this is really not a good time. If it persists, if people do not come out of their houses to shop, the effects are going to be more permanent".

While there are many more examples where consumer confidence has impacted an economy, for the sake of keeping this post at a reasonable length, I will move on.

Thus far we have established two incontrovertible facts:

1. After a tremendous amount of research, the Federal Reserve is convinced that high or rising consumer confidence will help boost & support the economy and keep it out of recession.
2. The correlation between the S&P 500 and consumer confidence has increased substantially since the bottom of the Great Financial Crisis (March 2009).

Correlations between the stock market and consumer sentiment are now running at 88% to 97% (depending on which survey is measured). Given the Federal Reserve has not admitted to explicitly supporting the stock market in an effort to help the economy recover, we must therefore use our research and the information available to draw inferences that suggest this is exactly their strategy.

The first hint came during an unprecedented interview with then Fed chairman Ben Bernanke on 60 minutes on March 15th, 2009 - right at the bottom of the crisis.

The first few minutes of this interview have Ben Bernanke suggesting that the crisis will only stop when the financial system is stabilized. Then, at the 12:05 mark, Bernanke makes a pledge that the Fed will backstop ANY problems that arise in the banking system.

Scott Pelley: "Are you committing in this interview that you are not going to let any of these banks fail? That no matter what their balance sheets actually look like, they are not going to fail?"

Ben Bernanke: They are not going to fail. But, what we can do should it be necessary, is try to wind it down in a safe way".

Part Two also contains provides us with some excellent insight into Fed thinking:

9:50 in to the second half of the interview -

Scott Pelley: "There's an argument made today that that's not what the problem is. The problem isn't that there's too little money in the system, the problem is that there's too much fear in the system. That with these companies being propped up by the government, no one on Wall Street can tell who's solvent and who's not, and therefore business does not move."

Ben Bernanke: "Well I absolutely agree that confidence is key. People don't know what's happening and they're afraid and they're not sure whether or not the system is going to recover. Umm so how do you get confidence, that's the question. And I think the way that you get confidence is to show progress."

Bernanke then goes on to explain all of the various areas that he's seeing improvement - many of which are within the financial arena. As we know, the market started it's current rally a week prior (many, myself included think the bigger catalyst was the changing of FASB 157, but that is certainly open to debate). A few years later, Ben Bernanke made is first formal reference that associated the rise of the stock market to the US economy.

The date was January 13th, 2011 and Ben Bernanke was part of a panel hosted by the FDIC on the subject of "Overcoming Obstacles to Small Business Lending", the event was moderated by CNBC's Steve Liesman.

During the event, the following discussion took place:

Mr. Liesman: Chairman Bernanke, I have to ask you this question. Since you guys have launched QE2, rates have gone up. The stock market's gone up too. We did a poll of CNBC market participants and they said that QE2's responsible for a higher stock market, but also higher commodity prices. That does not seem to be something that in general is helping small business".

Chairman Bernanke: Well, how much time have you got to answer this question?

Mr. Liesman: As much time as you have sir.

Chairman Bernanke: First of all I do think that our policies have contributed to a stronger stock market, just as they did in March of '09 when we did the last iteration of this. The S&P 500 is up about 20 percent plus. The Russell 2000 which is about small cap stocks is up 30 percent. I think a stronger economy actually helps small business more than it helps even larger businesses. Yes, it is contributing to the stock market. Interest rates are higher, but I think that's mostly because the news is better. It's responded to a strong economy and better expectations.

The most interesting commentary about the Fed's attempt to push the stock market higher came from former Fed member Richard Fisher who in March 2016 said,

"I like to say that we injected cocaine and heroin into the system and now we are maintaining it on Ritalin"

So to summarize, given the volumes of research published by the Fed over the last 25 plus years, we can safely assume they were very concerned that, if left unchecked, consumer confidence could have become increasingly negative during the sub-prime crisis, making any form of future economic recovery impossible. To combat this potential danger, Fed Chair Ben Bernanke took the nprecedented step to address Americans directly via an interview with 60 minutes. In that interview he pledged that no other US bank would fail under his watch. He then suggested that the market would recover when progress was made and the financial system was stabilized.

A few years later, Bernanke cited the level of the S&P 500 and Russell 2000 as "proof" that the economy was positively responding to a stronger economy thanks to Fed policy. Further, whenever the US stock market experienced a significant correction (for example during the European debt crisis, the recession scare of 2011, the Brexit vote, etc), Fed members would make dovish statements suggesting that monetary policy would continue to be extremely accommodative (and therefore support stocks). These messages of assurance helped stocks rebound in kind, which in turn helped preserve positive consumer sentiment.

I personally do not think that the Fed is secretly "buying shares", although I am aware of theories to this effect. Instead I believe the Fed is simply sharing it's playbook with Wall Street and allowing them to act on this information.

Interestingly, it has come to light recently that in 2012 then Richmond Fed President Jeffrey Lacker leaked secret, market sensitive information to an analyst at Medley Global Advisors. But Lacker's leak is not the only example of a seemingly cozy relationship between Wall Street and policy markers. Some will recall then Treasury Secretary Hank Paulson setting up a meeting with some of Goldman Sachs' board members in Russia just as the crisis was unfolding in 2008, or Timothy Geithner's alleged leaking of policy to Ken Lewis, then CEO of Bank of America. 

So, by allowing Wall Street in on the strategy to boost the stock market, the Fed expects consumers to be relatively more optimistic than they would be on their own. As discussed in the research above, 

"if there is an announcement that the economy is about to boom and everyone believes it then future output should be high, even if the announcement is based on false information".

We can see that some of the foremost thinkers in the economics field are starting to be aware of the Fed's reliance on confidence and 'narratives' to generate optimism. Below are two very recent examples from some of the US's most influential economists: Mohamed El-Erian and Robert Shiller.

America's Confidence Economy - by Mohamed El-Erian

Key quote:

"The surge in business and consumer sentiment reflects an assumption that is deeply rooted in the American psyche: that deregulation and tax cuts always unleash transformative pro-growth entrepreneurship. (To some outside the US, it is an assumption that sometimes looks a lot like blind faith.)

Of course, sentiment can go in both directions. Just as a “pro-business” stance like Trump’s can boost
confidence, perhaps even excessively, the perception that a leader is “anti-business” can cause confidence to fall. Because sentiment can influence actual behavior, these shifts can have far-reaching impacts."

"Narrative Economics" - by Dr. Robert Shiller

Key quotes:

"This address considers the epidemiology of narratives relevant to economic fluctuations. the human brain has always been highly tuned towards narratives, whether factual or not, to justify ongoing actions, even such basic actions as spending and investing. Stories motivate and connect activities to deeply felt values and needs. Narratives 'go viral' and spread far, even worldwide, with economic impact. The 1920-21 depression, the Great Depression of the 1930's, the so called "Great Recession of 2007 and the contentious political-economic situation of today are considered as the results of popular narratives of their respective times".

"When in doubt as to how to behave in an ambiguous situation, people may think back to narratives and adopt a role as if acting in a play they've seen before. the narratives have the ability to produce social norms that partially govern out activities, including our economic actions.'


Considering all of the research and examples discussed above, it seems entirely reasonable to assume that a portion of the Federal Reserve's strategy to help stimulate the economy is to keep consumer confidence as high as possible. This would insure that pessimism would never have a chance to permeate the consumer's psyche, while also opening the door to a possible 13 to 26 percent bump in GNP than would not be forthcoming otherwise.

We can see these expectations for a jump in consumer expenditures by the Fed (given a rising stock market) contained in a few comments by Fed officials recently. First we have Janet Yellen responding to a question from Binyamin Appelbaum from the New York Times on the apparent lack of concern by the Fed to excessively elevated equity prices. 

(apologies but C-SPAN doesn't allow me to embed into Blogspot - so the picture will take you to the clip) - here is the link just in case:

Key Quote:

Chair Yellen: "the higher level of stock prices is one factor that looks like it’s likely to somewhat boost consumption spending"

Secondly we have this story in Bloomberg,
"How the Yellen Fed Got Religion Over the Stock Market and Policy" by Matthew Boesler

Key quotes: 

" In February 1998, Dudley and his team at Goldman took a cue from then-Fed Chairman Alan Greenspan, who had just testified before Congress that although inflation-adjusted interest rates had risen, “in virtually all other respects financial markets remained quite accommodative and, indeed, judging by the rise in equity prices, were providing additional impetus to domestic spending.” Two years later, the technology bubble burst."

 "Ultimately, the Fed’s response to easier financial conditions should hinge on whether or not that boost in business sentiment translates to an actual acceleration in consumption, said Freedman.

“Stock markets go up. That in itself is not relevant,” he said. “What is relevant is its effect on people’s willingness to spend.”


If we consider all of the material covered above, and put two and two together, I think it is very easy to come to the conclusion that the Fed has been attempting to use the stock market as a policy tool to help the US economy recover. By informing Wall Street of its intentions and going out of their way to keep the market stable and elevated, consumer sentiment remains high, which in turn could add several valuable percentage points to economic growth. This potential 13 to 26 percent swing in GNP could, for example, have been the difference between the 'near miss' recession in 2011, and another full blown recession.

While this is the third longest expansion in U.S. history, it is also the weakest in the post world war II era. For reasons I've laid out in my larger macro thesis (The View from 30,000 feet: the US economy was sick before the Great Financial Crisis), the consumer has been mortally wounded and as such should not be expected to bounce back in the same fashion that they have from previous recessions. It appears as though the Fed continues to be bewildered by the lack of increased consumer expenditures in the face of a rising stock market and high confidence.

It is my sense that the Fed is now backing away from trying to push the market higher as they realize the gap between stocks and the underlying economy is at a very critical and dangerous level. By raising interest rates at this point, the Fed is attempting to slowly deflate the asset bubble they've created, while simultaneously trying to preserve consumer confidence and the forward progress they've made in the economy. Given the Fed's track record at deflating bubbles, I am not optimistic that they will be successful in their attempts. Time will tell.