The Federal Reserve has spoken, and it seems certain they will maintain increasing accommodation via quantitative easing for the remainder of the year and likely beyond. In back to back speeches by New York Federal Reserve President William Dudley and Chairman Ben Bernanke, they stated that IF the economy strengthens AND they think it is sustainable they will begin to taper quantitative easing. However, neither condition is close to being satisfied as recent data suggest a continued muddle through with downside risk. Both men indicated any improvement would require months of better data before improvement and sustainability were assured. Bottom line, the Fed will not be taking away the punchbowl prematurely – or likely even on a timely basis. They will be very sure they are too late because they will not be blamed for causing the next recession. Meanwhile, they also noted further deterioration in inflation or economic growth could extend the period of open ended quantitative easing, implying an increase in the monthly amount of QE was also unlikely. In our view this leaves us in a status quo of steady $85 billion securities purchases by the central bank for many more months as labor market slowly improve.
What happens if you use too much QE? No one really knows, but watch what is happening in Japan as they conduct the first experiment in over the top bond buying. Japan is buying $70 billion in securities a month in an economy just one third the size of the US. Their stated goal is 2% inflation. They hope for an economic double whammy from both consumers shifting spending forward to beat inflation and increased export sales due to a weaker currency. Unfortunately, financial markets move much faster than the real economy, and so far what they have is rapidly rising interest rates as the bond market prices in the expectation of higher inflation. Ten year yields have doubled from 45 basis points and are testing the 1% barrier. Finance Minister Kuroda, who first promised bond buying would lower interest rates, is backpedaling quickly citing a Government study which suggests that Japan is safe with bond rates up to 3%.
How is the market to interpret this in any way other than to assume 3% is the Government’s target, especially given the 2% inflation pledge? Anyone who has to mark a portfolio to market faces serious capital losses, putting banks at risk and killing the entire idea of fresh bank based lending to generate inflation. It is not easy to raise interest rates when there is an entrenched investor group holding 200% of GDP in government securities that stands at risk from this policy. Indeed, many of Japan’s cash rich companies are major holders of JGBs. These are the same companies the government expects to increase investment and generate new jobs. Bottom line, you cannot pull the money veil over their eyes. If Japan’s economy is to improve, it must be through changes in fundamental policies on immigration, farm subsidies, service regulation etc., which will enhance productivity growth. These changes were to be new Prime Minister Abe’s “third arrow”, but it still appears to be in the quiver.
The Squeaky Wheel
A central bank is in control of one – and only one – very blunt weapon, the ability to change the size of the economic pie that competitors are fighting over. How the new pie is allocated is a function of the imbalances in supply and demand – and hence prices – which led the central bank to inject liquidity into the system in the first place. Those prices are determined by the market or by the government when it interferes with free enterprise through subsidies, taxes or regulation. There is obviously a deep connection between central bank injections of liquidity and inflation. If greater liquidity does not result in a more efficient allocation of resources – and more output – you end up with more money chasing the same amount of newly produced goods and services or existing assets. Bottom line, increased liquidity allows all prices to adjust, but it is the effectiveness of markets which cause prices to rise fastest for those things people want the most, calling out new production.
When central banks pump up the money supply, it is typically the squeaky wheel that gets the grease. In the 1970s, when the US used inflation to simultaneously finance the war in Vietnam and the war on poverty, the two major economic imbalances were: 1) the baby boom entering consumer markets; and 2) the advent of much higher OPEC determined prices for oil. The combination of these forces meant that the world needed to produce a lot more stuff – houses, cars, furniture etc. – at the same time that existing factories were made unprofitable by the oil shock. A complete rebuilding of global manufacturing infrastructure was needed, and prices soared to call out new supply of both consumer and capital goods. Financial asset prices suffered during this time, as interest rates rose with a lag to inflation and real returns were poor for a decade. However, home prices did well as they provided both a hedge against inflation and baby boomers needed housing.
Today, quantitative easing in the US is producing rapid growth in available liquidity, but it has yet to produce much inflation in the prices of goods and services. It has resulted in a sharp rise in asset prices for stocks, bonds and real estate. Unlike in the 1970s, what the world needs now is not more stuff – but rather the world wants more “stores of value” that can be sold to buy stuff a decade from now, primarily for medical care as the baby boom ages. Because the squeaky wheel is medical care a decade from now and there is no market which allows you to efficiently pre-buy those goods and services, prices are rising for the next best alternative – existing assets (especially for health care stocks). Despite the rise in asset prices, investors are not yet cashing in, because what they want most is still not available and they fear that medical care prices will be much higher in a decade given the pre-Lehman historical trend. True, recent medical care inflation has slowed substantially along with other prices, but fear takes a long time to abate.
Unfortunately, the Federal Reserve’s stated objective for QE is a stronger labor market, which is to say greater production of current goods and services – apparently not what the consumer currently wants. Thus, accommodation will have to keep rising until asset prices get high enough that consumers are certain they can afford future medical care. Only when that squeaky wheel is adequately greased will further money growth generate either the stronger output of goods and services the Fed wants or inflation in consumer prices. In either case, quantitative easing would end.
So when will asset prices be high enough that consumers are confident they have enough for future outlays? Obviously, it will not be the same level for all participants, so we should look for behavior suggesting the leaders have shifted from accumulating to spending their wealth. At the very top of the income spectrum this is already apparent as prices for luxury goods & services and alternative investments like artwork are once again frothy. Indeed, a common complaint among investors is that inflation is quite high – and it is for the goods and services they want most since they are in competition with other buyers who also have large capital gains. These higher prices only reinforce the wealthy’s fear about future medical costs and increase investors’ desire to save. None of this suggests an early end to the Fed’s dilemma, as aging consumers are very unlikely to spuriously begin spending without much greater confidence about their economic security in retirement.
A Long and Winding Road
The combination of continued QE and government grid lock suggests that while the economic pie gets bigger, the beneficiaries will remain the same for a while – until policies change. Among the biggest winners are major corporations, who have seen their market capitalization soar, and who can use their shares as currency to acquire what they want most. This bodes well for mergers and acquisition activity and ultimately fresh investment in the real economy. The question is in whose real economy? Multinationals are more likely to expand operations in the emerging markets as they exploit lower labor costs, lower taxes, and less regulation. This will narrow the gap between the developed world and the emerging markets – but that remains an enormous gap. Thus, the Fed strategy of trickle down wealth effect stimulus has a massive hole in it due to globalization. While risk takers invest abroad, that flood of QE created dollars will return to the US as increasingly wealthy foreigners seek the safe haven and diversification of US financial markets and real estate. Increased economic efficiencies abroad will likely export deflation to the US while reducing demand for more expensive US labor. In aggregate, the US and the world will get a higher standard of living while working less – continuing the trend of the past four centuries – but we see no return to the labor market conditions that prevailed pre-Lehman. Those that benefitted most from the pre-Lehman US-centric investment boom in housing and small businesses are likely to be permanently disadvantaged, though some will adjust to the brave new world.
In essence, US QE is the equivalent of the post-WWII Marshall Plan, when the flow of dollars into the world economy accelerated the rebuilding of global infrastructure. Back then, dollar loans provided access to US made capital goods – the only source of such production at the time. Without the Marshall Plan, a lack of dollar financing would have bottlenecked global development, because US banks were not yet major international lenders and the current deep US financial markets were not yet developed. Both of those successes were results of the Marshall Plan’s path breaking effort. Currently, international (and especially European) banks are being cautious about lending in the emerging markets, where risks are naturally higher. However, cash rich corporations – empowered by QE fueled equity gains — are filling the void. They can use their existing cash or issue dollar denominated stock, which foreign investors want for diversification, in return for local currency to builds plants and hire labor. China is adding to this global trend by funding development in many nations where the US will not tread.
In previous newsletters we have argued that the current economy is most similar to the early 1900s or 1930s. Both were periods where government intervention favored lower income spenders. We believe the post-Lehman decade will have similar results – but the low income earners who benefit may primarily be in emerging markets as US QE has a global effect. The invisible hand that seeks to efficiently allocate scarce resources will find the path of least resistance when confronted by barriers like government interference or monopoly control. It is never stymied, and though it may not precisely repeat past history (as model makers would wish) – it often rhymes. A global economic recovery based on the emerging markets converging with the developed world was likely never on the Fed’s agenda when they debated QE. However, given that financial markets have expanded beyond national control that appears to be the economic outcome that is most likely to occur. Slow progress in repairing US labor markets should keep QE pumping out ever more monetary accommodation – and so long as the policy settings in the emerging markets allow them to absorb the dollars and generate real economic growth, dollar based inflation will remain at bay. So far, so good. Meanwhile, it is how effectively US politicians embrace the Fed enhanced global convergence — via free trade agreements, immigration reform, taxes, tariffs, subsidies etc. – that will determine whether US consumers enjoy the full benefits of the ongoing growth in the global economic pie.