The world’s QE bet is all about closing the potential output gap, and for many this accumulated gap, built up over the last 5 years is pretty large. Not large enough however to soak up all that cash the Fed has injected, but the Fed wants to deal with this crisis later.
OK, we have lots of unemployment, weak capital investment and poor consumption growth, so one way of looking at all this is to say, we only need worry about inflation once we have caught up with all the unemployed and those who have left the work force, got back to sensible capital investment levels and consumers are once again able to spend comfortably. Inflation remember occurs when output growth is above its natural rate of growth with demand exceeding the ability of an economy to meet supply: we are not there yet and will not be for a while say the Fed, in between the lines.
In such a scenario taxes will eventually rise, government support can be cut back and eventually the Fed can think about starting to withdraw all this excess cash. Oh, and the banking system will be stronger and better able to lend and the whole engine will be back working.
Letting the economy while away at stall speed risks the economy settling in at a lower nominal GDP growth path – there is still too much debt for this scenario to be acceptable. Debt and asset values need to correctly discount future real growth and if the two are overvalued relative to future real output growth, the crisis that started in 2007 would continue. This is what the Federal Reserve is worried about, because there would be no way out with potential GDP permanently fixed at a lower band.
But why do we have a lower rate of economic growth and why are we operating on a lower nominal GDP band?
Well, we know that debt became an important source of economic growth on both the demand and supply sides in the lead up to 2007.
Debt availability impacted the supply dynamics of the domestic and global economy: housing supply increased in the US and other countries, the domestic PCE/domestic production and investment balance changed, the trade deficit swelled and globally important emerging economies like China became heavily dependent on such structural imbalances, and many other similar effects.
Debt allowed consumers to increase expenditure above levels that their income growth was able to provide, pushing economic growth above levels the demand side of the economy could support and national savings levels collapsed. When the whole dam broke, debt could no longer be relied on to finance consumption and income levels were not sufficient to do the job on its own.
The level of global economic demand shifted below the amount of global economic supply and supply shifted down to meet the new demand paradigm. Indeed, you could argue that with high debt levels, low interest rates, weakening income and ex debt fuelled dynamics that future growth of real GDP should be much lower until the large emerging economies were able to exert their own consumption dynamics on global supply. This lower future real growth did not equate to the current value of both debt and assets in the economy, so global growth crashed. The shift down to a lower GDP growth bound was an accurate reflection of the economic risks and imbalances in global and domestic economies.
The question is, was supply too high, or was demand too high? You know the growth of supply should ultimately influence the growth of demand, so the two should be related.
I think it is more complex than assuming that supply and demand pre crisis were evenly balanced and that it was the financial shock that interrupted their relationship. I think the distribution of the components of demand (income distributions) and supply (domestic and global imbalances between consumption, investment, saving and production) were overly skewed. They still are skewed, unfortunately and I cannot see a speedy resolution to the problem.
Supply/demand structural imbalances are therefore likely to be the main drivers of growth and not monetary policy for some time. Unfortunately, monetary stimulus will likely have significant short term impact on asset prices and risk, in other words they risk a disconnect between risk and return implied by prices and the risk and return implied by fundamental economic dynamics. Investors are likely to be impacted for a third time (2000, 2007, and 20xx).
Time frames are indeterminate, but if China’s growth slows, Europe’s stagnates then US structural imbalances will continue to pose a risk to US economic growth no matter how much QE occurs. One thing is clear, the longer the current process of structural realignment continues and the greater the disruption in Europe and China and elsewhere, the earlier will you see serious inflation problems arising in the world economies. The lower the growth rate of supply relative to money supply, the greater the eventual inflationary impact.
The vista for bonds under the current aggressive monetary stimulus/weak global growth regime is for lower and upper bound outcomes of default and inflation.
The vista for equities is for significant valuation risk on the one hand if growth remains slow and the global supply outlook weakens and for significant valuation risk as inflation kicks in much earlier than expected.
If the Fed are right and rising asset prices can feed directly into increased consumer demand, without risk and the creation of further structural imbalances, then there is a significant risk to asset prices as vast monetary stimulus must be necessity be withdrawn from the system.
Ben is like a chimp on a production line: his job is to produce goods at a certain rate per hour, irrespective. His job is not to accept risks to the system, but to find a way out, and he is trying to find an escape route for the US economy as the mountain collapses upon him.
My view is that potential nominal GDP growth has a very low trend growth rate and it is not in the nature of current relationships for supply growth to naturally rebound back to its previous trajectory, irrespective of how much help is given.
And, as I have said many times, ordinary individuals with risk investments are tied to this ship whether they like it or not. If everyone tries to get out of risky assets, the ship goes down, if everybody hangs in we might stay alive long enough to be rescued, but we will be forever impacted by the experience.