This is an excerpt of the June 2013 Longbrake Letter. To read the letter in its entirety, click here.
With the notable exception of the European Central Bank (ECB), central banks in developed countries have been trying to ignite higher growth rates by purchasing large amounts of financial assets to drive down long-term interest rates. The theory is that lower interest rates, by decreasing the cost of capital and boosting the value of financial assets, will stimulate new investment and increase aggregate demand for goods and services. This, in turn, and over time, would create positive reinforcing feedbacks that accelerate growth and diminish more quickly the very large output gaps that prevail in many developed economies.
Monetary policy affects the cost of money and determines the extent of financial liquidity. It does not directly cause economic agents to engage in behaviors in ways that will change real economic activity; that is, it does not directly result in decisions to make capital investments or to increase purchases of goods and services. The transmission mechanism is indirect. Monetary policy is only effective if the lower cost of money and its greater availability induces economic agents to change behaviors in ways that boost real economic activity.
Because the linkage between monetary policy and real economic activity is indirect there cannot be certainty that current monetary policy will work as intended. In this sense current monetary policy is an enormous experiment. It is uncertain whether it will work as intended and it is uncertain what longer run impacts it will have on the economy. Some fear that it will lead to inflationary growth (see Section II 6 below for a discussion of how inflationary growth might occur) . But, a few fear that the experiment will fail to ignite sustainable growth and will end in a deflationary bust.
Policymakers could assure the intended impact of monetary policy is realized by increasing government investment in infrastructure projects and by directly or indirectly boosting government purchases of goods and services. But in the U.S. the exact opposite is occurring. Government spending is being reduced. This means that not only is monetary policy on its own in attempting to stimulate economic activity, it also has to contend with the negative impact of falling government spending.
This combination of easy monetary and tight fiscal policies implies a continuation of slow growth and only small reductions in the size of the output gap. This is exactly what has been occurring in the U.S. and more generally in other developed global economies.
As summer begins, economic activity around the globe remains sluggish. Although volatility in global financial markets has risen in the last month, this appears to be due mostly to technical factors, some of which are linked to Japan’s reflation policies, and to a tentative reassessment that growth prospects are improving in the U.S.
1. United States
While it is now clear in the U.S. that tax increases and spending cuts collectively are much greater than expected a few months ago, their negative effects, particularly the sequester, on economic activity don’t appear to be as great as feared and appear to being offset by rising consumer optimism and maintenance of consumer spending, which has occurred by virtue of decreasing the saving rate in the face of reduced disposable income growth. The favorable reassessment of growth prospects is rooted in an expectation that private sector improvement will continue in coming months while the negative effects of tax increases and reduced government spending gradually diminish.
Since early May ten-year U.S. Treasury note yields have jumped 60 basis points to 2.25%. Bank of America Merrill Lynch (B of A) believes two-thirds of the increase is the result of the market’s belief that economic momentum is improving and that the Federal Reserve will scale back (“taper”) asset purchases sooner. The remainder of the increase in rates stems from technical factors such as hedging convexity risk in mortgage backed securities, impacts of rising Japanese bond yields on carry trades, outflows from bond funds and underperformance of emerging market bonds and currencies.
Although much of Europe remains mired in recession, conditions no longer appear to be worsening and there is considerable hope that Europe will return to modest growth by 2014. French President, Francois Hollande, recently declared that Europe’s crisis is over. That pronouncement is decidedly dubious. Policy actions have limited investor risk, but the fundamental structural and governance flaws inherent in the European Union (EU) and Eurozone (EZ) have not been addressed. High unemployment is gradually undermining political stability. While the crisis may be in abeyance for the moment, it is certainly not over. Signs of political and social fragmentation continue to accumulate, all be it very slowly.
China’s economy is in transition from one in which investment and exports have driven growth to one in which domestic consumption will eventually dominate. Such a transition is typical in a developing economy as consumer incomes rise and a large middle class evolves. This transition is also necessary for sustaining social and political stability. However, the transition will result in a slowing in the rate of GDP growth. There are already early indications that a gradual slowdown in growth has begun. Most forecasters generally have not yet recognized that slower growth in China is at hand, so forecasts are likely to be lowered incrementally over time. As a greater proportion of the Chinese population benefits from a consumer-based economy, a slower rate of GDP growth is not likely to be problematic. While what needs to happen is clear, the new Chinese leadership will face formidable implementation challenges. This means that there will be plenty of bumps along the way and it is possible that the transition process will stall or move too slowly. The possibility of a hard landing, though unlikely, cannot be ruled out.
Growth in China’s demand for raw materials has already slowed. At the same time substantial increases in capacity to supply commodities are coming on line. Not surprisingly, prices of most commodities are falling. This is not a short-term phenomenon. Until recently rising prices for commodities partially offset powerful deflationary forces; falling commodity prices will now reinforce deflationary forces.
Recent Japanese data indicate that a strong cyclical economic recovery is underway. It is too early yet to know whether Shinzo Abe’s reflation policies will defeat entrenched deflation and result in sustained nominal, as well as real, GDP growth.
In the last few weeks the Japanese stock market has experienced a swift 20% correction and the exchange value of the yen has increased substantially. Both developments have blunted the “shock and awe” effects of Japan’s reflation policies on expectations. Changing expectations to accelerate investment and consumption has been an important part of the plan to defeat deflation. As described in previous letters, driving down the value of the yen helps Japan “export” its saving surplus to other countries. That, too, is a significant part of the plan to defeat deflation. The remaining necessary reflation policy, which has yet to be implemented, involve reforms that will increase the supply of labor, particularly women, and worker productivity. Apparently because of the difficulty in enacting far reaching reforms, Abe is waiting until the upper house elections has occurred later this summer before attempting to pass legislation. In the meantime his general commentary has lacked specificity and that fact may have also contributed to the recent setback in financial markets.
There appear to be some plausible technical reasons for the decline in stock prices, but sentiment is a fragile thing. First, the most obvious explanation is that rapid price appreciation, nearly 80% in the case of the Nikkei, eventually invite profit taking. Second, a less understood explanation, but a truly significant one, is that a significant portion of Japanese equities is held by Japanese trust companies. These trust companies have strict asset allocation guidelines. The rapid price appreciation in Japanese equities resulted in breaching the upper bound of the allocation guidelines and forced selling to rebalance portfolio composition. Third, Japan’s central bank botched its asset purchase program in the initial stages which created volatility. And, fourth, some increasingly began to question whether reflation policies would work as intended and whether there might be significant risks in the longer term. These worries were not helped by Abe’s recent speeches, which appeared to confuse matters more than clarifying them. This latter concern, if it comes to dominate thinking, would lead to a deflationary bust outcome.
My own sense is that the recent volatility in Japanese markets will diminish and implementation of reflation policies, including labor market reforms, will proceed. Japan is likely to experience a continuation of a cyclical recovery in growth and policies already implemented assure a return to a modest level of inflation, at least temporarily. What matters is whether the reflation policies can have a longer-term structural impact and permanently alter the way in which the Japanese economy works. I and many others have our doubts. Thus, the Japanese experiment entails high stakes and high risks. It’s possible failure, which will not be known for a long time, would have disastrous consequences for Japan and the rest of the world would not emerge from such a possible failure unscathed.
5. Deflationary Bust
What is occurring currently in the U.S., Chinese, Japanese and in many emerging economies is encouraging. However, the outlook for Europe remains bleak because, even if most European countries emerge from recession in coming months, the failure to address structural and governance defects, coupled with demographic trends, assures that at best growth will be very weak and at worst stagnation will occur.
So, economic momentum appears to be building slowly across the globe. To the extent this trend continues the world economy will strengthen gradually. However, the current extraordinary monetary stimulus might lead to another outcome, one that is not benign – a deflationary bust. How might that happen? The most articulate discussion of this possibility has been penned by Charles Gave.
Recessions occur when an increase in liquidity preference leads people to attempt to increase their savings by reducing consumption. Policy responses to combat recession are directed toward increasing demand through direct government purchases and by replacing lost spendable income through government transfers. Policy also attempts to stimulate demand by decreasing the attractiveness of saving by reducing interest rates. When nominal interest rates fall below the rate of inflation, real rates of return become negative and saving is discouraged.
But, remember, realized investment must equal saving. If saving is discouraged, realized investment must also fall. In the long run declining investment, as I have discussed in previous letters, depresses productivity growth and leads to lower potential real GDP growth. Unfortunately, this is exactly what appears to be happening in the U.S.
Private investment depends upon the availability of credit. The Federal Reserve can create liquidity through asset purchases but it cannot create credit. Creation of credit depends on the willingness of financial intermediaries to lend – to supply credit. Willingness to lend, while improving slowly, is still being held back by tight underwriting standards and conservative regulatory supervisory standards and increased capital requirements.
Demand for credit also depends upon the extent to which returns on investment are expected to exceed the cost of financing it. Demand for credit has been slack because of uncertainty about future growth. For example, the National Federation of Independent Businesses (NFIB) monthly survey continues to register high negative ratings about sales prospects; credit availability, in contrast, is not cited as a significant problem. In other words, very low borrowing interest rates appear to be insufficient to prompt investment in the face of enormous uncertainty. In short, investors prefer safe assets, even though they have negative real rates of return, than capital investments with uncertain returns, which could turn out to be even more negative.
Negative real interest rates pump up the value of financial assets and create the illusion of greater wealth. And for a while this feels good. But, artificially induced financial wealth must eventually be ratified by an increase in real wealth. If that does not materialize, a financial bubble builds. You will recall from the work of Hyman Minsky that financial bubbles occur when speculative forces predominate, which drive up financial valuations to levels that greatly exceed those justified by likely cash flows from real economic activity. Speculative activity can persist for a very long time and the risk in the present instance is that the Federal Reserve is feeding the beast with its large scale asset purchase policy. But, eventually bubbles burst and when that occurs, a deflationary bust follows.
This is not a foreordained outcome. It is possible that policies currently in place will lead to gradual strengthening in economic activity which would ratify higher financial asset valuations. As I explain in Section V, stock valuations appear to be reasonable at the present time and the equity risk premium is inflated, which is holding back potential further increases in stock prices.
Nonetheless, an economy whose real rate of growth is declining has a profound structural problem which over time could lead to an insufficient amount of real wealth creation to ratify the artificially inflated financial wealth. If that is the pathway we are really on, then the market will eventually realize that financial valuations are not supported by real economic growth. When, and if, this realization takes hole, a deflationary bust will unfold with a vengeance. Financial asset prices will decline precipitously as real rates of interest return to positive levels that are consistent with potential economic growth.
 Charles Gave. “More On the Deflationary Bust Risk.” GKResearch, June 10, 2013. This commentary is proprietary and is not available for distribution without permission by GaveKal.