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Green Light from the Fed

Green light from the FED

Pascal Blackburne & Luc Synaeghel 2019-04-01

The one central bank that had embarked on the monetary policy normalisation route has just stopped dead in its tracks. The US Federal Reserve’s March 20 decision not to hike interest rates at this point – nor indeed probably for the remainder of 2019 – and to go easy on balance sheet reduction provides a clear signal to financial markets: low yields are here to stay, so the risky asset rally is welcome to continue.

The Federal Reserve (Fed) attributed its change of course to economic concerns, notably the global trade slowdown, but we see it also as further evidence of the high-level monetary policy coordination in place since the great financial crisis (GFC) of 2008. To us, it is no coincidence that the US central bank decided to stop shrinking its balance sheet just after its European counterpart stopped adding to its own. Had the Fed not made this decision, global money creation would have shifted into negative territory – with serious implications for the cost of debt.

A basic economic tenet is that, over time and on a global scale, the pace of money creation should mirror that of economic growth. Put differently, money is the necessary fuel for the world economic engine to function. But when central bank balance sheets expand much faster than required by underlying economic trends, as they have since 2008, the surplus only serves to add to the pool of savings available for debt – pushing leverage up and market interest rates down.

Having fuelled a massive debt build-up in the economic system for several years – which is sadly ironic since excessive leverage was precisely what caused the GFC – central bankers are now effectively forced to admit that they cannot pull the plug. The world, especially the US, could not take in higher interest rates, be it in the corporate or public space. Falling asset prices would be similarly dangerous, via their impact on the pension schemes of ageing populations.

In fact, the mere shifting from an expanding to a flat money supply may already prove difficult for the global economy to absorb. Going forward, debt will only be able to grow in sync with savings. Not to mention the risk that the Fed’s about-turn could hurt consumer and business confidence (due to the typical “what is it that the Fed knows but we don’t?” question). But then again, any near-term economic slippage towards recession would probably lead to a reopening of the monetary spigot.

The positive news from an investor perspective is that financial market lights have been set on green for the foreseeable future. Bonds returns will remain at zero (in fact negative in inflation-adjusted terms) so there is no other option but to be invested in risky assets. Equity markets have upside – even from current generous valuation levels – and corporate bond spreads can further compress. Of course, portfolio allocation to these asset classes should still be decided in a wise and prudent manner, not forgetting to hold protections against the inevitable longer-term risks implied by prolonged dovish monetary policies.

The relationship between money creation and debt

Also well known to students of economic theory is the “savings = debt” identity: it is the part of national income that is saved (rather than immediately spent) that makes it possible to grant debt to households, businesses and governments.

Quantitative easing to the tune of what we have experienced over the past decade has resulted in money supply growth largely exceeding real economy needs. Just consider: the combined expansion of the Fed, European Central Bank (ECB) and Bank of Japan balance sheets has amounted to over USD 10 trillion since 2008, or some 13% per annum. With trend global growth in the 2-3% range, and money velocity flat to down, this means that massive amounts of centrally-created money effectively joined the savings pool available for debt. In turn, the cost of debt (i.e. market interest rates) fell across the maturity spectrum.


Source : Bloomberg

Think now what would occur if the money supply were to shrink – which would have been the case had the Fed maintained its balance sheet reduction program in the face of the ECB stopping monthly bond purchases. Given how unlikely it is that the global economy’s addiction to debt disappears overnight, matching the (lesser) supply of savings with (a still large) demand for debt would cause interest rates to skyrocket. Which is clearly an unsustainable prospect for highly leveraged governments and companies.

Central banks thus find themselves in a quandary. They know that money creation since 2008 has been excessive, with potentially dire long-term inflationary implications, but the risk of shrinking their balance sheets (i.e. removing liquidity from the system) currently appears even greater, in the form of economic slowdown and credit defaults. They have thus chosen a middle path, putting themselves in “wait and see” mode for the time being.

Mounting income inequality and social unrest

Why has excessive money printing by central banks not (yet) caused upward pressure on prices – other than in asset markets that is? We have written previously about how the corporate sector has captured an increasing share of national income since the start of this century, at the expense of labour. Globalisation and technological innovation have effectively combined to constrain labour’s bargaining power, preventing just about any gains in real wages and aggravating social inequalities.

We continue to believe that, with employment markets becoming tighter, particularly in the US, wage-driven inflation is a distinct possibility at some point in the future. Together with the risk of mounting social unrest due to the growing income divide, this might actually be why President Trump is so intent on keeping the oil price down – tweeting on this matter every other day.

Ultimately, there are only two ways to address the inequality issue: higher wages or a much more progressive tax system. The 2018 US tax reform did just the opposite, cutting taxes for the higher-income classes. And the fuel tax called for by French President Macron, while environmentally-friendly, also works against the lower-income classes – whose monthly budget is far more impacted. No wonder the “yellow vests” protests continue every Saturday…

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