Thank you very much.

It is always a pleasure to be able to speak to you at this event.

I have to tell you that Wade and I did get our wires crossed on this a bit.I had thought that he told me that I had two and a half hours for my presentation.I thought, “Finally I get a chance to talk about something really cool like Bitcoin.”But then he cleared me up on the time frame here and with 25 minutes I don’t think I’d even have enough time to get into the subject of blockchains.

Well, as Kurt Vonnegut would say, “So it goes.”

Let’s take a look at an overview of what I want to talk about this morning…

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If our economy could stay locked in place as it is today, we would be in very good shape.

I don’t know that we could really call it the best of times, but it is not a bad place to be … as long as we can stay there.

But, that’s not the way the world works – change happens. And, the change that brought us here will take us elsewhere …

Maybe that’s not to the worst of time, but I am sure we won’t like it nonetheless.

To tell this story, I’ll look at interest rates, price inflation, touch on some money issues and mention a bit on the monetary policy of the Federal Reserve.

I’ll pose 5 questions about monetary policy that I think deserves to be widely addressed, but really hasn’t been.

Then we’ll briefly look at the bigger picture of economic performance, which is the ultimate yardstick of measuring whether our policies are successes or failures.

Finally, I’ll off up my outlook for the coming year.

I was thinking about something referred to years ago as the “misery index.” This consisted simply of adding up the unemployment rate and the inflation rate.

There are problems with doing this, not the least of which is that it is a measure of how awful things are.

Well, I wanted to construct a similar index, but looking at this from a positive perspective. I have called my measure the “Economic Harmony Index.”

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The idea here is to identify a combination of outcomes that I think represent economic harmony with regard to 4 variables:

the unemployment ratethe rate of inflationthe prime rate of interestand, the growth rate in real GDP

I don’t identify specific outcomes, but rather ranges for each variable. I assign different weights to these variables and then identify values for these ranges. The optimal ranges are:

3% to 5% for unemployment-1% to +2% for inflation2% to 5% for the prime rate4% to 6% for growth in real GDP

I make an adjustment so that the worst outcome generates a value of zero, while the highest value is 565, as shown by the bold red line on the chart.

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For 2017, this value stands at 475 and you can see that not often has the economy been more in harmony, at least going back to 1949, which is the

first year for which I have a complete set of data. The previous higher values occurred in 1998-1999 and in the 1950s and early 1960s.

Over the first three quarters of 2018 we are at 515 and I expect the final value for the year to about that.

Indeed, if you look at this index on a quarterly basis, only three times since 1949 have we been at 565 – the maximum: in 1952, in 1955 and the 2nd quarter of 2018.

I think it would be fair to say that, yes, these are the best of times. Will they last? History says that they won’t.

There are 4 deep low periods on the chart:<<click – 1974>><<click – 1979>><<click – 1990>><<click – 2008>>

Interestingly, the recession of 2001 doesn’t stand out in this index, but then it was a shallow downturn.

Now, don’t going out and asking people if they’ve seen the Economic Harmony Index, because they haven’t … unless someone from one of the cable business news networks gets interested in it.

wink, wink, nod, nod …

So, let’s dig into the details here.

We’ll start our look with interest rates.

Here is the yield on the 10 year U.S. Treasury going back to 2000.

The shaded-in sections of the chart show periods of recession for us – 2001 and 2008 to 2009.

You can see that this rate fell during the last two recessions and then, more or less, leveled out.

For about a year and a half this rate has been rising as the Federal Reserve – the Fed – had finally begun to reverse its recession policies and push up interest rates.

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As of this past quarter, this rate stands at just a bit under 3%.

Let’s add in a longer term interest rate – here is the average 30 year fixed mortgage rate of interest.

You can see that it tends to be about 1.5 percentage points higher than the 10 year bond rate, reflecting, at a minimum, higher risk. There are other ways to compensate for risk – for example, not lending out to people with lousy credit and/or no proof of income. Since much of that kind of lending was taking place before the housing bubble burst in 2007-2008, you can’t use this gap as a reliable measure of increasing or decreasing risk.

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In the 3rd quarter, this 30 year mortgage rate was a bit over 4.5%, so still about, 1.5% above the 10 year bond rate.

We can add in another 30 year rate – this one for U.S. Treasuries.

What is interesting here – besides the break in the line when the federal government stopped issuing 30 year bonds – is that this rate was quite close to the 10 year bond rate going into the last recession. Then it diverged to become almost equal to the 30 year mortgage rate. But, it has since come back down to approximately the value of the 10 year rate.

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As of the 3rd quarter, this was just a little over 3%.

For many years Federal Reserve policy has been primarily aimed at the federal funds rate of interest, shown here, which it can control with some specificity.

This chart shows the effective federal funds rate going back to 1954, and how it has ranged from nearly zero to almost 20%, depending on our economic circumstances.

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As of last month, the effective federal funds rate was 2.19%.At the last meeting of the Federal Open Market Committee – just a week ago – the Fed decided to maintain their target for this rate at 2 to 2.25%.

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Aside from the rather peculiar long-run shape, there are two patterns that have emerged over the past 40 years, as shown by these red arrows. The Fed’s policy of pushing down this rate during, and following a recession, in order to stimulate spending has reached what is known as the “zero lower bound” – that is, you can’t force interest rates into negative territory.

Equally troubling is that the length of time which the Fed has kept interest rates low has gotten enormously long. Following our last recession, not only were these rate targets lower than they’ve ever been before – nearly zero – but the Fed kept them there for more than 100 months.

If we can characterize monetary policy as “accommodative” when the Fed pushes this rate down – meaning that the Fed is trying to accommodate an increase in spending and if we can think of these low rates as some kind of ceiling that the Fed wants to impose until it feels that rates can be allowed to rise, we are indeed in totally new territory. Here’s a chart to show this dramatic change in the state of policy.

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By my definition, there have been 14 accommodative periods since the mid-1950s. The red line shows the ceilings to which the Fed pushed down rates. For example, in 1967, the Fed pushed rates down below 4% and kept them there for 6 months. The blue line, measured against the axis on the right-hand side, shows the length of time the rate was below the ceiling.

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What we see is that over the past three recessions, the interest rate ceilings have come down while the length of time rates are held low have risen in dramatic fashion: – below 4% for 16 months starting in 1992 – below 2% for 36 months starting in 2001 – below 1% for 104 months starting in 2008

Can this continue? I think not. Is it a big deal? I think so. How many times did this come up during the last presidential election? Of course the answer is zero.

Let’s turn to prices for a moment. We generally track inflation based on the percentage change in the Consumer Price Index. Here is a chart showing the 12 month percentage change going back to 1990. It peaked back then at about 6%. During our last recession we actually had measured deflation – a falling average price level – to the tune of almost -2%.

Since 2015, the rate has steadily risen until it is now over 2.5%. In fact …

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For the last quarter this 12 month rate stands at 2.6%.

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Since 2012 the Fed has set an inflation target of 2%. Ben Bernanke, Janet Yellen and now Jerome Powell keep telling us that this is consistent with the Fed’s mandate to “maintain price stability and maximize employment.” But, did I miss the national debate about this? When did we decide that price stability means 2% inflation?

I’m not the only one to find this a disturbing feature of Fed policy. Robert Heller was a member of the Federal Reserve Board of Governors in the 1980s. In 2015 he wrote the following:

“The term “stable prices” is self-explanatory: a bundle of goods will cost the same ten, 50, or even 100 years from now. By contrast, if a country experiences 2% inflation over a ten-year period, the same items that $100 can buy today will cost $122 at the end of the decade. After 100 years, the price tag will be a whopping $724.”

Well, that’s not the only oddity about monetary policy.

Let’s take a closer look at what the Fed has done to the monetary base.

As we began the last recession, the monetary base stood at about $800 billion. The Fed then engaged in a number of policies that have come to be called “quantitative easing” such that by 2014 this monetary base was over $4 trillion.

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As of the last quarter, it was a bit over $3.6 trillion.

So, what was the purpose in doing all of this? Ben Bernanke, then chairman of the Fed, believed that more money needed to be injected into the financial sector to insure against bank failures and to stimulate additional spending to promote our recovery from the recession. Quite simply, it didn’t work out too well, but Bernanke kept pushing.

Many economists, myself included, thought that this would trigger an explosive inflationary episode. Yet, it hasn’t. But, I’m not convinced that we are free from this threat.

So, why haven’t we seen noticeable inflation? Because most of this growth in the monetary base is sitting idle in the banking system.

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Until the recession, American banks kept very little of their reserves at the Fed. Year in and year out this was less than $20 billion.

And, since the recession you can see that this grew to nearly $3 trillion.

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And, although it has come down a bit, it is still almost $2 trillion.

So, most of this increase in the monetary base has become bank reserve deposits at the Fed.

As if this isn’t strange enough, the Fed is paying interest on these reserves which it created in the first place. It has been paying the federal funds rate. Well, when the federal funds rate was about zero, nobody was taking notice. But, now it is up to 2%. Will anyone take notice now? What about if rates go up to 5%?

To highlight another aspect of this I’ve just subtracted the bank reserves from the monetary base to get what I’ll call the “net monetary base.” As you can see it is pretty much a straight line and it shows that monetary policy has been rather ineffective.

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For those of you familiar with the components here, this $1.69 trillion left over is the value of circulating currency.

To give a little more perspective, let’s pull this back to 1990.

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As you can see, these bank reserve balances were practically non-existent prior to the last recession. And, my “net” monetary base is rising only on a slightly higher trend line than pre-recession.

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There is one final story of the Fed’s activities that continues to hang over us. As noted, the Fed has increased the monetary base dramatically. It does so by buying securities which become part of its assets. Until the last recession, that would be U.S. Treasury Bills, Notes and Bonds.

This chart shows the size of the assets that the Fed owns. You can see that this was about $1 trillion in 2008 and grew to almost $4.5 trillion.

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It hasn’t fallen much, and now stands at $4.24 trillion dollars.

But, starting in 2008-2009 the Fed also started buying a new asset - mortgage-backed securities. And, they bought a lot.

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The Fed’s holdings are currently at $1.7 trillion.

By way of contrast, we can note that the entire commercial banking sector of the U.S. owns only a little more than this -- $1.8 trillion.

It is unclear how the Fed can possibly shed itself of these financial instruments without totally wrecking the market. But, what will they do during the next recession? Will they buy up student loan debt? Auto debt? Municipal debt? We don’t know and nobody seems concerned.

To wrap up this section I would like to pose to you 5 questions about monetary policy. Not only do we not have good answers to these questions but the larger problem is that we aren’t even seeking to ask them. At least, not in the popular press. All of these questions may indicate to us that, indeed, these are, if not the worst of times, then the times just before the worst.

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My answer to these questions is “No, no, no, no, no” and if I had 3 more questions I would start to channel Freddie Mercury.

Is there a solution? I think that the only viable long-run solution is to adopt a new monetary regime. For example …

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Bitcoin. But, unless you want to stay for another two and a half hours, you’ll have to take my word on that.

As if these monetary issues weren’t problems enough for us, consider the bigger picture of economic growth.

This chart shows the annual growth rate in Real GDP going back to 1990. I separated them out by the level of growth …

<<click>> One year (1984) growth was above 5% - in fact it was above 7%.

<<click>> 8 years growth was between 4% and 5%, the last time being the year 2000, 18 years ago.

<<click>> 7 years growth was between 3% and 4%, the last time was 2005, although I think we’ll be there this year.

<<click>> 9 years growth was between 2% and 3%, more than half of those years since the last recession

<<click>> 7 years growth was between 1% and 2%, with six of the seven since 2000.

<<click>> And, finally, 3 years had negative growth, indicating recession years.

Here is the same data, but expressed in annual terms by quarter.We can mark each recovery, or growth, phase of the business cycle by the presidents in office at the time.

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Here is how long each recovery phase lasted:

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Our current recovery has lasted 37 quarters. By next summer we will have passed the length of the recovery we had in the 1990s.

Here is the aggregate growth in real GDP over each of these recovery phases:

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As you can see, we’ve barely outpaced the last recovery, yet ours has lasted 50% longer.

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And, here is the best numerical representation of this disturbing trend – the average annual growth rate over the past 4 recoveries has steadily gone down, from over 4.1% to 3.7% to 2.8% to 2.3%. If this is the “new normal” I think it is worth significant discussion and, to my mind, it should be the single most important issue that concern voters. But, of course, it isn’t.

Here’s another representation of these 4 recovery periods. As you can see, our current recovery badly lags these others.

Now, there is an adjustment we can make here. Some of this growth really just catches up to the previous peak. So, here’s what this looks like if we subtract out this “catching up” growth …

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The past 3 recoveries only took one or two quarters to catch up to the past peak. Our current recovery took an amazing 7 quarters to accomplish this!!

So, we may say that we are now 30 quarters into a higher growth path. Where do we stand relative to these past episodes at this stage of growth?

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We’ve barely matched half of the 1980s recovery.

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We’ve matched almost 60% of the 1990s recovery.

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And, we’ve barely surpassed the recovery from the 2000s, even though we’ve had an additional 7 quarters.

Summary

Before I turn to my outlook, let’s first look at just some of the threats that hang over us. This could be a very long list, but I’ll just briefly mention four (threats/items/??)

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The Fed has been able to maintain its bloated balance sheet for many years. That can’t last.

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The stock market seems more volatile as of late. If that continues into the new year I feel quite sure that the Fed will stop, and may even reverse, its interest rate increases.

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The federal government deficit is projected to be almost $1 trillion next year. This is still a train wreck waiting to happen.

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And, what of a divided government, with the Democrats now in control of the House of Representatives. Conventional wisdom is that this will be good for business, because nothing bad will get passed through Congress. Of course, nothing good will get passed either, but I think we can be cautiously optimistic that business will be good in 2019.

In general I think next year will be a little better than this year. More specifically:

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I think that GDP growth will be a little higher next year than it will be this year. I don’t think we’re going to top 4% but I think we’ll be close.

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I think that the Fed will want to continue to raise rates but I’m not sure that they will be convinced to do too much in this regard. Maybe by the end of the year the target federal funds rate is 2.5% to 2.75% or maybe even 2.75% to 3%, but I am not expecting anything over 3%.

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Inflation has been creeping up for a couple of years now and I think that will continue. We may have measured inflation at or above 3% for the first time since the last recession. But, I have a wide range here of 2.5% to 3.5%.

As you know, we have a new Fed Chairman. Jerome Powell had been a member of the Board of Governors since 2012 when President Trump tapped him to succeed Janet Yellen as Chairman this past February. Although his term is not even a year old yet I would say that he has flown under the radar, at least insofar as the public goes. In the last 40-50 years I can only think of one other Fed Chairman that has been more inconspicuous.

Anyone want to hazard a guess as to who I mean?

G. William Miller was nominated by President Carter to replace Arthur Burns and served as Chairman for less than a year and a half in the late 1970s.

So, I was thinking about what Chairman Powell can do to become more of a prominent figure to the public, which leads us to …

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Today’s Top Ten.