The limits of monetary policy

there must be a way.

surely there must be a way that we have not yet

though of. – Charles Bulowski, The Crunch, 1977

Summary

One of the most anticipated policy moves of this year is the Federal Reserve’s decision to ease monetary policy by cutting interest rates at its meeting on 31 July (while later on in the year, to end its QT programme). Meanwhile, across the Atlantic, the ECB is expected to restart its asset purchase program in the months ahead.

However, “more of the same” monetary policy easing (i.e. artificially keeping interest rates low and injecting liquidity via asset purchase programmes) will not be able to avert the next economic downturn or market sell-off.

Further accommodative monetary policy will see an increasingly diminished return going forward in a) boosting real growth and b) providing progressively elevated support levels for financial asset prices.

The key forces that will put a limit on just how accomodative monetary policy can go (and for how long) are a) inflation and b) a reversal of the pro-corporate tailwinds that have been so beneficial for business profits since the end of World War II.

Faced with this reversal, more unorthodox ideas such as MMT (which does not come without its own risks – namely, the risk of inflation getting out of control or a loss of confidence in the currency or key institutions) are perceived to be the only tools left in the armoury of central bankers, suggesting that we are nearing the limits of [accomodative] monetary policy.

Therefore, in the next downturn, it will take a lot of cooperation on the part of politicians to come together and find pragmatic resolutions for the challenges that face our economy and society, given that central banks are running out of options.

Realism, not optimism

With the S&P 500 recently breaking through 3,000 for the first time ever, with $13.4 trillion of negative yielding debt globally and with 50.6% of European government bonds yielding sub-zero, market’s speculative behaviour seems to have no limits.

Source: The Atlas

The fuel behind this risk-on attitude, the fire that continues to burn through any level of technical resistance is hope – namely, investors’ hope that the Fed will cut interest rates, as well as for a resolution on the US – China trade dispute.

Source: CME Group, 28 July 2019

Cutting interest rates is not necessarily a positive sign – this is clearly iterated by Howard Marks in his latest memo, which you can read here. Additionally, John Hussman pointed out in his recent update to investors that “…with the exceptions of 1967 and 1996, every initial Fed easing (ultimately amounting to a cumulative cut of 0.5% or more, following a period of tightening in excess of 0.5%), has been associated with a U.S. economic recession.”.

Upper limits to monetary policy

When asset prices rise, it means that the present value of future cash flows that can be expected from holding these assets increases. This implies lower future returns as more of the anticipated economic value that the asset can deliver is baked in the current price.

That said, if we are in the early days of an economic cycle and, assuming a period of international peace on the horizon, rising asset prices may also signal that investors are optimistic about growth prospects and that they expect the future value of cash flows to also be higher. However, such optimism must be measured: too much optimism can result in having too high hopes about what assets can deliver at a certain stage during the economic cycle, i.e. it can cause an overvaluation of expected future cash flows.

It is no controversy to say that we are in the late stages of this economic cycle – indeed, as we will see below, many of the structural tailwinds that boosted economic activity, and thus corporate profits for the best part of the last few decades are now becoming headwinds. Thefore, higher asset prices today imply lower future returns. Below is a chart from Hussman Funds that illustrates this point.

Source: Hussman Funds

Another way to look at excesses in the stock market is showed by the chart below, from DWS. It shows that the valuation premium of growth stocks over value stocks is at record level. It illustrates the prevailing sentiment in the market today: hope for more of the same monetary policy against a backdrop of slower but steady growth.

Source: DWS

Yet another way to see just how much excess has been building in the stock market is illustrated below – the chart comes from Crescat Capital.

And it is not like the credit market is pricing risk more cautiously…

Source: Ardea Investment Management

For the economy and capital markets to work properly, the expected return of cash should be below the projected return on bonds, which, in turn, should be below the expected return on equities – the differences between these expected returns are called spreads and they provide the incentives for credit creation and production of goods and services.

As I explained in the Wealth Illusion, “Economic actors engage in transactions motivated by various self-interests (which can be rational, emotional or a combination of both). When these economic actors are free to make their own decisions, regardless of what the self-interests are, both buyers and sellers must believe that they will be better off as a result of completing the exchange (transaction), otherwise there will be no point in entering in one.”

The motivation to act in our self-interest and exchange money / credit for a different good / service is enticed by these spreads – if expected returns on cash are lower than those on bonds and stocks, than people borrow and invest in stocks and bonds. The projected return on cash is heavily dependent on the expected short-term interest rate (just as the current return on cash is linked to the prevailing short-term interest rate).

The expected return in the next 12 months for cash is below 1.6% in the USA. This may mean that the futures market is expecting the federal funds rate to be a lot lower going forward.

If there is a too wide-spread between the expected return on cash and that on bonds and equities, investors will borrow (which is a short-position on cash) and buy bonds and equities, boosting their prices and diminishing their expected returns relative to that of cash.

“The size of the spreads between the expected return of cash and the expected returns of risky assets will determine how much capital will move where and drive the movement of money and credit through the system.”, wrote Ray Dalio in December 2018.

If these spread become too narrow, the risk premia for holding riskier assets relative to cash also disappears, making these assets less appealing. This can trigger a relocation of capital out of stocks and into other (safer) assets, such as bonds and even cash. This, in turn, can kick off a chain of deleveraging processes across markets and the economy as financial assets are used as collateral: for example, as investors sell them to move into assets closer to the risk/reward profile of cash, the collateral value falls and margin calls require investors to put more (liquid) collateral aside, further forcing them to sell, adding more downwards pressure on asset prices, which leads to a self-reinforcing process.

Obviously, as interest rates go up, the cost of the massive pile of corporate and public debt denominated in that currency also increases, making it more difficult for the economy to service it and increasing the risks of forced deleveragings.

Source: Fred. Shows total US debt (public + private) = $28trn.
Source: Institute of International Finance

Therefore, the asset spreads puts a cap on how far interest rates can increase before we see a market correction and a wide-scale deleveraging. But do they put a cap relative to how low interest rates can go? As long as the central bank keeps funding costs low and there is liquidity in the system, asset prices can carry on rising. Indeed, as analysis from Hussman Funds demonstrates, there really is no limit to market speculation as long as there is a central bank (such as the Fed) willing to provide the markets with an accommodative monetary policy backdrop.

Therefore, the limit to how much accommodative monetary can become will likely come from the real economy.

Lower limits to monetary policy

There are two factors which will place a limit on how accommodative monetary policy can be kept and for how long – a) inflation and b) a deterioration of the pro-corporate environment that will likely contract profit margins.

Inflationary pressures

When I look at the economy I see two, interconnected ones: the nominal economy and the real economy. The former is the product of inflation, which, in turn, is always a monetary phenomenon. Meanwhile, the later represents the economic activity (the total of exchanges between all economic actors) adjusted for price changes. The basic equation that explains the relationship between the two is the monetary accounting function developed by Irvin Fisher: MV = PT. However, as I pointed out in The Wealth Illusion, we need to adjust this to include changes in asset prices (i.e. asset price inflation). Therefore, borrowing from the excellent work done by the MacroStrategy Partnership, the equation becomes: Asset velocity x Money velocity x Money supply growth = Asset inflation x Price inflation x real GDP.

Source: Fred

When the nominal economy grows faster than the real economy for too long, out-of-control inflationary pressures eventually manifest.

Here is how I think about inflationary risks. First of all, where inflation shows up is a by-product of what economic actors get to the cheap money / credit first. If the effects of low interest rates and liquidity injections trickle down to Main Street, given their propensity to spend, I would expect to see inflation appear across the broader economy in things such as consumer goods and services (broadly captured by the CPI). If Wall Street gets to that cheap purchasing power first, then I would expect to see a rise in asset prices (especially financial ones) and some gearing up on corporates’ balance sheets (the corporate debt in the US has gone from about $3.2trn in Q1 2007 to roughly $6.4trn in Q1 2019, based on data from Fred), before the CPI moves up too dramatically.

Based on traditional measures of inflation, such as the CPI, inflation has remained mostly below the “accepted” target of 2% across the developed world: the CPI in the US has averaged 1.7% per year between 2008-2018 and the same is true for the OECD block of countries, according to data from the IMF and the World Bank – although, as the chart below shows, it has been creeping higher in recent years.

Source: OECD, World Bank

The truth is that most of the inflation from ultra-low interest rates and liquidity injections has gone into financial assets. The chart below is just an example of many.

Source: Yardeni Research

When inflation manifests predominantly in the general economy (i.e. measured by CPI increases), the initial risk is a loss of purchasing power of that currency, which then lowers the living standards of people – if it persists for too long, inflation (turned hyper) can shatter the people’s trust in the currency and lead to challenging social, political and economic consequences.

However, if inflation gets concentrated into financial assets, then excesses (bubbles) form within financial markets, planting the seeds for the next correction (and potentially, economic downturn). This kind of inflation also risks increasing the wealth gap between those that own assets and those that don’t, creating a source for potential social and political risks, especially in difficult economic times. In other words, the way I see financial asset price inflation from a risk perspective is like this: as long as it doesn’t affect Main Street (too much) then the only ones that need to worry about this are the investors; however, when it does affect a large part of the population, then policymakers and regulators ought to take notice.

Today, the inflation in asset prices is affecting Main Street: it has contributed to a widening wealth gap which, when coupled with stagnant wages and an increase in working hours, it has created both a perception of and a factual reality of declining living standards for (too) many people who are now demanding things to change.

Nevertheless, the fact that the CPI has failed to surprise on the upside on a more consistent basis, given the tight labour markets observed across a number of key development economies, has led a number of commentators to suggest that the link between low unemployment and high inflation (the Philips Curve) is dead.

In fact, it seems that their interpretation of the Philips Curve is not entirely accurate. I was (probably too) curious to see where the Philips Curve comes from – so I read the 1958 paper entitled The relation between unemployment and the rate of change of money wage rates in the United Kingdom, 1861-1957, which is where the Philips Curve concept was born (I have to thank John Hussman for his insights into this as his analysis is what encouraged me to read the paper).

One does not have to go further than the title to see what the Curve is all about – the link between unemployment and wage inflation. This is illustrated in the chart below, which comes from the original paper.

So how is this relationship holding up today? Pretty well, the chart below suggests.

Source: Hussman Funds

In fact, even by the “conventional” interpretation of the Philips Curve (i.e. that of a relationship between unemployment and general price inflation), inflation seems to rear its head as unemployment moves lower.

Source: OECD

Given that labour costs remain one of the highest costs for corporations, the risk of cost-push inflation cannot be ignored: perhaps it is also important to look in what segment of the workforce real wage inflation occurs due to a tight labour market; the point being that the lower-paid, lower-skilled workers tend, overall, to have a higher propensity to spend than more affluent employees (CEOs etc.) that tend to invest their money in assets. Therefore, the Fed should think about inflation risks really hard before lowering interest rates – the US economy doesn’t warrant it.

From tailwinds to headwinds

Over the past decades, outsourcing labour to cheaper countries, like China, has been a substantial boost to corporates’ profit margins. Alongside the process of globalisation that kept labour costs down, corporations have also benefited from technological advancements that further reduced production costs, from a benign corporate tax environment, an openness to worldwide trade and a supportive mix of demographics.

Source: Yardeni Research, arrow mine

These tailwinds are now kicking into reverse, threatening corporate profit margins.

The world economic order that prevails today was built by the countries that won World War II and then, in 1989, the Cold War, i.e. by the United States and its allies. One of the core tenets of this global economic order was the liberalisation of trade, investment and finance, i.e. economic openness.

The idea of globalisation boomed in the 1990s – Thomas Friedman even wrote a book called The World is Flat, which talked about how national boundaries mattered very little (if at all) when it came to international trade and investment.

The chart below is a testament as to how successful the idea of trade liberalisation was for the past several decades. It shows exports of goods and services growing as a percentage of world GDP, almost uninterrupted until the 2008 financial crisis. After that traumatic event, globalisation seems to have peaked and with the trade war between the US and China still in its infancy, very probably it will decline from here.

Source: World Bank

A recent report published by The Economist entitled A slow unravelling describes how supply chains are undergoing some of the most dramatic changes in decades as “we are heading into a post-global world”. Inevitably, the trade conflict between the US and China was cited as one of the evidences for this claim.

However, the trade dispute between the world’s largest economies is not the only thing that flies in the face of a more global society. The socio-economic and, importantly, cultural developments of the past few years (Brexit, the election of Donald Trump, the rise of populism in a number of key European countries on both sides of the political spectrum, the yellow vests protests and, more recently, the loss of support for Angela Merkel in Germany) suggest that the overall attitude of people towards the establishment is shifting: away from the pro-globalisation narratives and policies and towards more protectionist ones.

The chart below shows that, in recent years, outward foreign direct investment as a percentage of GDP has also declined relative to average of the past 12 years for the major developed economies – perhaps another sign of a less connected world.

Source: OECD

In addition to a pro-trade, pro-investment policy agenda, corporates worldwide have also benefited from lower and lower taxes. This is illustrated in the chart below, which comes from Bridewater Associates.

A friend of mine called the Trump Administration the most corporate-friendly in America’s history. I agree. But can this downward trend in corporate taxes continue? We’ve already seen a growing backlash against the tax practices of technology companies in Europe and in the US, politicians like Bernie Sanders and Jan Schakowsky have proposed the Corporate Tax Fairness Act which aims to “to keep profitable corporations from sheltering profits in the Cayman Islands and other tax havens.  This bill also would stop rewarding companies that ship jobs and factories overseas with tax breaks”.

Another massive tailwind for corporations was the demographic makeup. However, “of the big lessons from the demographic history of countries is that population explosions are temporary.”.

Source: Our World in Data

A falling fertility rate and a rapidly aging population across the developed world may mean that the economic boost from demographics may be behind us: this can have serious implications because if these demographic forces turn out to be deflationary, the growing pension and healthcare liabilities that an increasingly aging developed world will want to claim may not be entirely met.

Finally, businesses have also benefited from lower cost of capital, thanks to the secular decline in interest rates across the developed world.

Source: Bridgewater Associates

From all of these tailwinds-turned-headwinds, monetary policy can only influence the cost of capital. In theory, central banks can maintain interest rates lower for as long as they want (sorry, for as long as needed). However, as mentioned above, inflation is the ultimate judge of how long interest rates can remain artificially surpressed. As such, it seems that moentary policymakers are trapped between keeping interest rates low for longer, risking to cause inflationary preasures that can spiral out of control or increasing interest rates, risking to trigger a market correction and a (massive) deleveraging. But there is a way out of this situation, and it is called COOPERATION.

The hidden risk

Mohamed A. El-Erian wrote in a recent column for Project Syndicate: “The Fed knew it had no power to promote genuine economic recovery directly via fiscal policy, ease structural impediments to inclusive growth, or directly enhance productivity. This was the preserve of other policy actors, which, lacking the Fed’s political autonomy, were sidelined by the inability of a deeply divided Congress to approve such expansionary measures. (These disagreements subsequently led to three US government shutdowns.)”.

The way I read the above statement is that the willingness of politicians to come together and work on practical resolutions for the challenges that are facing all of us is the key ingredient needed to prevent things from escalating into economic pain or social conflict.

Listening to Boris Johnson’s speech as the UK’s new Prime Minister, I realised a sad and alarming thing: we in the West lack real political leaders – those people in the public office that will serve the best interest of the people, even if doing so can cost them their political career. The speech was many things: an exercise in political rhetoric, with a certain amount of panache; a call to unite the country with fantastic broadband (finally!); an appeal to Brussels for a “new deal” based on an excitement partnership; etc. It was many things but one: pragmatic!

This is not a criticism addressed to Mr. Johnson or of support for the opposition – I doubt Mr. Corbyn (or any other politician – hence the problem) would have done a better job at convincing myself (and many other people living in the UK) that they are capable of doing their job of representing the best interests of those that elected them in a transparent and trustworthy manner.

Hannah Arendt, in the Origins of Totalitarianism, made a bold but, as far as I am concerned, true statement: “Those members of Parliament who had learned to regard politics as the professional representation of vested interests were naturally anxious to preserve the state of affairs upon which their “calling” and their profits depended.”

Rhetoric backed by actions builds trust. Rhetoric absent of actions shatters it.

Unless politicians demonstrate to us all that they are not regarding politics to be the “professional representation of vested interest”, the hidden risk remains a lack of coordination on their part and, as a result, a loss of trust in the political leadership and, more broadly, in the institutions of our democratic Western society.

Artwork from Hunaari.

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