Beware of hidden dangers ahead
Iain Stewart, Newton
The UK press has recently been preoccupied with the five-year anniversary of domestic interest rates being held at close to zero. They have had good reason to, as at no point in the previous 300 years have UK short interest rates been as low as they are today. After five years of low rates these are extraordinary times indeed.
This situation is even more unusual when set against the apparent transformation of UK economic prospects. In the current climate, market forecasters appear unanimously optimistic, the stock market has undergone a renaissance and the important UK residential property market is buoyant.
From a financial perspective what were once considered temporary (‘emergency’) monetary policy settings stand in stark contrast with what seem to be boom conditions.
This odd conjunction exists thanks to an ultra-loose monetary policy which has proved remarkably effective at boosting asset prices and holding down interest rates.
Rising asset prices are broadly seen as ‘leading indicators’ of improved economic activity and their momentum influences expectations and encourages extrapolation. But despite this emphatic ‘thumbs-up’ from markets, leading central banks still see the recovery as relatively fragile. We would agree. Where we part company with current orthodox economic thinking is in believing the policies used to manufacture growth run the risk of making matters worse, and of increasing, not reducing, this fragility.
Newton has long held the view that slower economic activity (particularly in advanced economies) follows logically from structural changes occurring in the global economy. We don’t believe monetary policy is likely to provide the answers to these structural issues. Instead, we fear the over-use of monetary levers, though well-intentioned, is setting the scene for the next destabilising boom-bust cycle.
In general, the theories and models that drive policymaking take no account of such changes in the structure of economies, and rely heavily on the concept of equilibrium. A particular bugbear is that policymakers operating in this academic and theoretical world see little need to include the influence of credit growth, or indeed financial intermediation (or the existence of a banking system), in their models. This partly explains why so few predicted the financial crisis and why some financial models even ruled out its possibility.
There also appears to be little emphasis on relatively straightforward analysis of the past. What is worrying is that the models that over-simplify the economy have not changed as a result of what happened in the last cycle, nor, broadly, have the people operating them.
In addition to these crucial drawbacks, policymakers work on the assumption that money is broadly ‘neutral.’ This means that when newly printed money enters the economy it will tend to affect all prices equally and any basket of prices should reflect the inflationary forces on households and business. This belief underlies the notion that, as long as headline inflation measures, like the core consumer price index (CPI), are well behaved, no amount of reflationary policy is too much.
In practice new money tends to benefit those who get it first. With quantitative easing (QE) directly targeting financial assets, financial markets have expanded to feed on state-sponsored largesse. We call this ‘financialisation’, by which prolonged and continuous monetary stimulus leads to a very large and over-geared financial system that tends to drive, rather than serve, economies.
As investors hunt for yield, and risk-asset prices rise, increasing amounts of leverage are being used. This is an important and dangerous by-product of increasingly policy-driven and financialised economies. In the present cycle, the principal driver of US share-price rises has been stock buy-backs, funded with debt. In credit markets leverage ratios are approaching those seen in the run-up to the global financial crisis. As in the last cycle, there is an unshakeable belief that the authorities will not allow bad things to happen to asset prices, encouraging some to speculate with cheap money.
As prices of risk assets rise, without a corresponding expansion in economic activity and profits, valuations have expanded markedly. In order to justify such valuations, expectations for growth and earnings seem to be diverging from reality. With interest rates close to zero, profit margins at record highs, governments fiscally stretched and the bull market already more than five years old, it is hard not to get the impression that we might be closer to the end, rather than the beginning, of the equity-market cycle.
Looking ahead, we believe unconventional monetary policy is unlikely to produce the sustainable growth sought by policymakers. Instead, this policy may actually be contributing to disinflation in consumer prices, while at the same time leading to dangerously speculative asset-price inflations.
A decidedly mixed economic global growth picture has been associated with broadly falling levels of CPI inflation in the major economic blocs. One reason why this intensely inflationary policy is not producing the ‘right’ kind of inflation is that it may be exacerbating the deflationary impact of globalisation.
Although the US Federal Reserve (Fed) sets policy for its domestic economy, the effects of that policy are undeniably global. Cheap US dollars flowing to the developing world have both directly and indirectly led to expansion of capacity and credit. In turn, the ebbing of that tsunami of foreign capital has coincided with a marked deceleration in emerging-market growth. Weaker emerging-world growth, allied with weaker currencies and significant overcapacity, is likely to continue to be deflationary for the West. Paradoxically, Japan’s mission to improve its competitiveness and create domestic inflation by devaluing its currency further may well exacerbate this trend. In a sense, Japan is attempting to export the deflation seen as the root of its economic malaise.
China may also be on the brink of becoming a deflationary influence on the world. In the wake of the global financial crisis China embarked on a credit-fuelled investment boom, the like of which the world has never seen. Total credit in the economy grew by some $11 trillion in the period of five years from 2009 (equivalent to the combined GDP of Germany, Japan and Canada), with much of this being financed by an unofficial shadow banking system which has very little rigour as to credit quality. With growth flagging and the authorities attempting to tackle corruption and speculative lending, the first defaults are appearing. The Western consensus, rather oddly for capitalists, likes to believe in the omnipotence of Chinese state planning; there is nothing they can’t fix!
Only time will tell how the next developments will play out in both China and more mature markets influenced by the current inflationary policies. But the potential risks are evident and we must hope a sustained ultra-loose monetary policy does not trigger a fresh boom-bust cycle.