This is quite a technical note on monetary policy, but the key point is achingly simple.
Yet, it is something equity investors keep underestimating.
Back in January 2013, we wrote:
“We have compared conventional monetary policy (interest rates) to bows and
arrows at the zero-lower-bound. Quantitative Easing upgraded this to rifles and
pistols. Big new unconventional monetary guns are now being readied for action.
“We foresee comments of ‘too radical’, ‘too risky’ and ‘too reckless’ giving way to
shock and awe as the potency of this new weaponry dawns on investors.”
Heading into 2021: contrary to popular opinion ammunition for these weapons is NOT
exhausted – NOWHERE NEAR! However, firing them introduces increasing levels of moral
hazard and potentially serious future side-effects.
Let’s now look at this week’s announcement:
The Federal Reserve’s latest guidance is to expect zero rates until the end of 2023 and
that it does not expect to tighten monetary policy until inflation has been higher than 2%
“for some time”. This deftly unlocks the immense power of NGDP-targeting while
minimising the dangers of attempting a mandate shift during such perilous times.
IThere are formidable dangers associated with the ongoing acceleration of the
intertemporal, intergenerational, and inter-societal shift of wealth. On one level, Western
central banks have no credible alternative.
Afterall, which is preferable?
a)
Allow our fiat monetary systems to collapse under the growing weight of
outstanding debt
OR
b)
Prop-up nominal-GDP (NGDP) to a degree which – if something comes along to
restart productivity – will allow Western economies to grow and inflate their way back to
stability
The answer has to be (b). Hence the Federal Reserve’s unprecedented post-Covid-19
intervention. Measures to date are without precedent: 0–0.25% Fed funds rate, new
forward guidance that zero rates are here at least until end of 2023, additional QE
purchases, etc. Which comes atop expanded repo operations, increased lending to
securities firms, direct lending to US banks, invocation of Section 13(3) of the Federal
Reserve Act, back-stopping money market funds, buying commercial paper, relaxing
regulatory requirements, direct lending to major corporates via the PMCCF, supporting
loans to SMEs, direct lending to municipal administrations, and opening new FX swap
lines.
NGDP level targeting revolves around game theory and is consequently difficult to
model. However, being behaviourally based, its key strengths are intuitive, namely that
under NGDP targeting regimes – unlike current 2% inflation targets – the past becomes
relevant in a manner which increases the potency of current policy.
The process works like this:
Historically, the Fed would explain the circumstances surrounding past inflation misses,
commit to getting it back in line with its 2% target, and then basically just forget about it
and move on. Under the Fed’s new ‘soft‘ price-level targeting regime, it must now make-
up for at least part of past inflation misses to regain its pre-guided price-level path.
Incidentally, price-level targeting and NGDP-targeting are barely distinguishable in the
Fed’s case given its dual inflation/employment mandate.
In terms of specifics, the Fed has not guided a formal price-level path: it has
however taken a big step in that direction by guiding to expect no interest rate increases
until at least the end of 2023, while indicating it would not tighten monetary policy until
inflation had been higher than 2% “for some time”.
The necessary inflation catch-up element was strengthened by Powell’s comments on
Wednesday:
“This is all about credibility and we understand perfectly that we have to earn credibility, …..
This framework, we have to support it with our actions, and I think today is a very good first
step in doing that. It is strong powerful guidance.”
1.
Reinforce the USD inflation anchor: bond, stock, and FX investors, businesses,
households, and local authorities can now have a greater confidence that the Fed is
going to deliver its mandate in that going forward, it is at least partially committing
to make up for past inflation misses.
Don’t some argue that NGDP targeting risks de-anchoring inflation expectations?
This is theoretically possible to the extent that the Fed will be unable to clearly
communicate its new approach, a somewhat farfetched concern for an organisation
whose communication skills are second to none.
2.
It’s good news for US businesses, stocks, and the US economy: knowing that
inflation under/overshoots will be made up for later should increase confidence in
future US economic outcomes and thereby support the best possible allocation of
real resources to its economy.
Central bankers put it something like this: NGDP/Price-level targeting, far from
indicating an intention to tolerate inflation levels above declared inflation targets, is
another step towards a future where the path of nominal aggregate income
approximately equates to the levels anticipated by investors and borrowers at the
time they took on their existing nominal investments and loan obligations.
1.
While the idea of Price-level/NGDP targeting has been around since Irvine Fisher in
1911, it has never been tested in action. Partly because its side-effects cannot be
easily modelled owing to a lack of empirical data.
It would be reckless for the central bank of the world’s largest economy and global
reserve currency to be the first mover in this regard. In which light, the Fed’s small
steps seem prudent. Small steps which have hitherto included the Fed’s post-2012
upward reweighting of US unemployment in its mandate, albeit set within a
traditional Taylor type framework.
2.
NGDP targeting may not provide a reliable anchor in today’s productivity-
stalled/zero-r* environment, where it is no longer possible to accurately specify
future NGDP growth rates.
a.
Post-2000 improvements in technology have perversely reduced labour
productivity, increased the share of national income earned by capital,
and reduced the share earned by labour. This brings significant
uncertainty as to potential future NGDP growth dynamics, probably
why the Fed is emphasising the price-level aspects of its new policy.
b.
The effect of changing demographics on trend US GDP potential is
difficult to estimate.
c.
Potential US GDP growth rates are being influenced by unprecedented
EM competition for natural resources alongside unprecedented
opportunities for Western firms to access cheap foreign labour.
d.
The manufacturing sector has an infinite capacity to improve
productivity. When human brains can’t innovate any more, we can always
harness machines to do it for us. Not so for the service sector, a nurse
can’t treat infinitely more patients and a schoolteacher can’t teach an
unlimited number of kids. Replacing a local grocer with Walmart or
Tesco improves productivity but cannot do so ad infinitum. It is possible
that the increasingly service sector orientated US and Western
economies have squeezed out most of the possible service sector
productivity increases and now face an intractable problem.
e.
The influence on future NGDP growth and inflation of the 2000-2020
credit super cycle is hard to quantify.
f.
The output gap of a ZLB-trapped economy cannot be accurately
estimated. Especially within economies possessing an intangible output
gap such as Spain, the UK, Ireland, and even the US, where it is not solely
a question of revving up old businesses after a slump, but a matter of
deep reforms encompassing de-levering and a rebalancing away from
traditional industries including construction, finance etc.
g.
Behavioural-Econometric hybrid models like Eriswell’s in-house suite
have hitherto done a good job of explaining private sector savings
movements in conceptual terms. However, the ‘human anxiety’
parameter is hard to measure as little empirical data exists of ZLB
episodes where the savings rate flips from one stable savings surface to
another.
A prudent central bank may conclude, ‘Come back when you’ve sorted that lot out’ …to
which you may think, ‘Damn right!’ The Federal Reserve has instead chosen the lesser of
two evils: a carefully judged shift towards NGDP-targeting as opposed to risking a far
more damaging bout of entrenched deflation. The ECB, in time, must too decide
between NGDP targeting and a violent Supernova ending for the euro. We naturally
anticipate a similar shift.
Will stock investors believe the Fed? Yes, of course they will! We have previously
highlighted the way the Fed and other central banks now harness religious psychological
techniques for the purpose of encouraging investors, businesses, and consumers to
replace immediate personal experience with a passive belief in the infinite power and
wisdom of the central bank.
This is necessary because trapped at the ZLB, trouble beckons at the point we
collectively stop believing. We have previously explained the way subconscious Jungian
archetypes are routinely exploited in the advertising world. All of us have, from a very
young age, been bombarded with these archetypes until it becomes something we
instinctively recognise; something that strikes a deep chord within us. For example, The
Economist image below with the tagline “Into the unknown” strikes an emotional chord
because it speaks to our innate explorer and hero myths, and we have read/watched so
many hero myths in our life that we can readily accept the Federal Reserve as another.
Will households and businesses keep believing if a major recession hits? This is a trickier
question, and the Fed is already concerned about its inability to reach mainstreet and in
particular the poorest 50% of US households. This could contribute to a deep recession
if – having realised that the Fed can’t help them – the poorer US households choose to
increase their precautionary savings rate. The Fed will probably continue to find it easier
to influence investor behaviour than consumer and business sentiment.
This is the major risk as we see it, and while not quite imminent we need to start
thinking about how to navigate the ensuing recession.
Mark Page