A debt/asset value/IR bounded endogenous monetary chokehold: Comments on “Patience is a Virtue When Normalising Policy”

The primary interest rate conflict is not between inflation and growth, but between asset prices and a potential asset price shock to growth and the financial system.  Increasing income inequality and weak wage growth keeps the US and other economies within a debt/asset value/IR bounded endogenous money supply chokehold.    A successive series of debt/asset bubbles and interest rate lows are not a succession of unrelated incidents but a tightening of an extremely dangerous grip.

In the most recent Federal reserve Bank of Chicago Missive,  Patience Is a Virtue When Normalizing Monetary Policy, much interesting information was imparted on employment trends…but  there was little comment about interest rates and their relationship with the build up of asset focussed money supply growth……this build up of broad MS was and still is reflected in highly valued asset markets and global debt accumulation.  Its magnitude can be gauged by the large surge in broad MS growth over and above nominal GDP growth.

“With the economy undershooting both our employment and inflation goals, monetary policy does not presently face a conflict in goals;

I foresee a time when a policy dilemma might emerge: Namely, we could find ourselves in a situation in which the progress or risks to one of our goals dictate a tightening of policy while the achievement of the other goal calls for maintaining strong accommodation.

So what happens when a conflict emerges?”

The 2007/2008/2009 crisis, IMO, came back through the banking system precisely because of the inflated valuation (and supply) of assets and the tie between these asset values and the debt used to finance asset purchases…as well as,of course, the impact of debt on the level of consumption and hence revenue underpinning cash flows supporting asset valuation (inflate on the way up, deflate on the way down). 

Asset values were inflated by excessive broad money supply growth and debt accumulated, as a consequence, tied these assets values to the economic framework.  

It is worth pointing out the difference between asset value bubbles caused by an increase in the demand for an asset class within the market portfolio from asset value bubbles financed by excess debt/endogenous MS growth in low interest rate environments.  The collapse of the former may impact a small % of current demand but the collapse of the other can, as we have seen, have significant impact on consumption and investment.  I think it important that we appreciate the difference; debt financed asset and consumption booms leveraged by low interest rate environments devised to stimulate economic growth are incredibly dangerous.

I feel that this, the debt/asset value dynamic, is still the biggest risk to the financial and economic system, yet it is a relationship that is not even worth a mention in this Chicago Fed communication.   The primary interest rate conflict is not between inflation and growth, but between asset prices and a potential asset price shock to debt and hence growth and the financial system. 

Yes, at some point obviously, inflation will rear its head again; at some point output constraints will cross below demand capacity, and years of below average human and capital investment will show its consequence; we could even easily have short bursts of inflation if and when GDP growth ratchets up…but this is not the preeminent imperative.

We have spent pretty much most of the last 20 or more years (and some argue further) in a Central bank mode focussed on supporting growth that has required ever lower levels of interest rates and that has become ever more sensitive to interest rate changes and asset prices.   When we moved from an “interest rates are falling as a response to declining post 70s/80s inflation” to “interest rates are declining because we need to stimulate growth at risk in a low inflation environment” is a moot point.

However, every significant threat to asset prices and growth has been met with interest rate cuts and asset price support…all the way from the LTCM, the Asian crisis, to the bear market of the early 2000s..to the current point in time.  We have not allowed the system to reset….

We have also been within a financial framework that has become ever more liberal, corrupt and risk taking, and within a financial engineering mind set that favours short term asset price returns to long term capital and human investment, key to supporting long term income growth.  Note my last blog on share buybacks which includes references to a number of opinions on the subject.

Low interest rates have the effect of reducing the discount rate on future returns on capital/assets.  Depending on certain assumptions about cash flows from these assets, the physical valuation framework raises the valuation of assets as interest rates fall.   While for those who hold the assets have gained financially from the adjustment, those who need to buy the assets benefit from no such adjustment, and much of the debt we have seen accumulated is a consequence of this…in a strict interpretation of the discounted present value model, the difference in discounted cash flows (new rate flows less old rate flows) is added to the price….what this does is lock in the interest rate regime to the asset value and debt framework.  If enough debt is accumulated by asset purchases at this interest rate structure, a rise in interest rates locks in a present value demand shock….this is especially so if rises in asset prices have been used to fund expenditure via secured loans.

While interest rates have fallen, we have also seen a weakening of real cash flows, and hence an accumulation of greater risk and hence uncertainty around those weakened cash flows.  Yet, asset prices have still risen to historically high valuation levels….Quantitative easing has increased liquidity in the system (skewed the portfolio allocation decision), made certain assets relatively scarce and compounded the historical asset focus of broad money supply.  The discounted present value model only really works within a closed system, without endogenous money supply growth, and certainly is not meant to accommodate squeezed demand for yield.  DPV arguments supporting high asset prices at low interest rates are IMO invalid.

Many academics view the lack of demand as being due to excess saving and the failure of low interest rates to be able to stimulate consumption or investment (whether it be in human or physical capital).  That is people are cutting consumption and saving too much, yet with interest rates (short term rates) already close to or at the zero bound in the US (i.e next stop negative rates for the Us) interest rates are no longer effective at stimulating consumption….a lower rate than the zero bound would be needed to stimulate borrowing.

In truth low interest rates are as much a characteristic of an upper limit debt constraint, in the sense that for a given level of income growth the sensitivity of consumption expenditure to debt interest payments and capital repayments forces interest rates to remain at low levels.  Repeated boom busts that have resulted in higher debt amidst a weakening growth dynamic and weakening income growth has placed an interest rate constraint on the economic framework….interest rates are low not because most people are saving too much but because most people could not accommodate a higher rate of interest and still maintain current consumption expenditure.  Without a rise in income growth to adjust for a drop in asset valuations and higher interest rate payments, interest rates cannot rise…the drop in asset values relative to debt levels would crystallise a demand shock… 

In a sense we are constrained not because we are spending too little but by having too much debt and too little income growth.   Moreover, from such a low interest rate regime a rise in interest rates would have significant negative impact on wealth and likely expenditure, with further loop backs to the core financial system.  

We are constrained in one sense by the lower interest rate bound because the central bank accommodation of the last 2 or more decades has no further room to move and by the rise in debt and asset values as a result of a) low interest rates and b) asset focussed money supply growth and c) QE.   The mix has been accentuated by low income growth, increasing income inequality and by a depreciation of labour and physical capital. 

Yes, there are enough assets to fund consumption, if these were sold to fund consumption, but only at present demand for asset levels…essentially we would shift asset focussed money towards consumption….but with wealth and income inequality in favour of those who are not interest rate/debt constrained, this would seem unlikely.

Rising asset values have coincided with falling wage growth and increasing income inequality and the rise in debt used to finance assets has gone hand in hand with the rise in debt used to finance consumption…it is odd that as median income growth relative to GDP has tailed off that household expenditure growth to GDP has exploded…so it is difficult to believe that we are in an excess saving environment…possibly an income inequality environment with the imbalance allocated to wealth accumulation as opposed to consumption, yet nevertheless overall, household consumption has exceeded GDP growth…

So prior to the crisis, we were in a situation where the nominal returns (cash flows) to capital had been falling and for a while real economic growth remained relatively stable as debt finance supported consumption and wider economic activity (note the impact on residential construction and financial sectors).   But this broke as the crisis hit and as interest rates started to rise in the Western developed world between 2004 and 2006. 

The way out of the crisis has been to support asset prices and to promote loan growth.  Any significant rise in debt growth (i.e. relative to income growth) is going to expose the economic structure to greater interest rate risk and effectively bind it even more closely to a zero or negative rate structure.  We remain in a dilemma that few see… Pushing asset prices up via QE liquidity to fund loan growth is an extremely dangerous exercise in the absence of income growth as it links debt to over valued asset prices.  In the absence of any other policy options there was clearly a need to support asset prices during 2008 to 2010, but sustained asset price support risks creating a further financial shock from which it is difficult to see how global economies could recover while keeping debt structures intact. 

Fed concerns over being forced back into the zero lower bound would be better applied to the asset value/debt/IR chokehold than to inflationary risks.   

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