Minack: If fiscal policy is dead, what does that mean for risk assets?

From Gerard Minack of Morgan Stanley (hat tip Scott):

The past two years have demonstrated the high cost of these policy errors. More to the point, the private sector now seems leery of debt and aiming to increase saving. This matters a lot, in our view. It means that monetary policy is battling two headwinds. The well-known problem is the ‘lower bound’: With inflation low, real interest rates can’t be reduced far enough to encourage demand.

The other problem – and we think perhaps the more telling one – is lower demand. An economist sees this as the demand curve for credit shifting down and to the left. Exhibit 4 suggests that this has happened. The scatter-plot tracks the real mortgage rate (vertical axis) against the net balance of bankers reporting stronger demand for mortgage finance, as reported in the Fed’s Senior Loan Officer Survey (horizontal axis). (Since mid-2007, the Fed asks separately about prime and other mortgages. We have averaged those responses.) The best-fit lines suggest a shift over the past four years: Households are less willing to borrow at any given level of interest rates. In other words, rates have to fall farther than usual – and farther than modeling based on history would suggest – to generate a given increase in credit demand. (As an aside, when we tried the same thing with demand  by large corporates, we couldn’t see a similar shift.)

Why does this matter? If the expansion continues – and our macro colleagues think it will – then it won’t matter: Policy will have done enough to support at least a tepid recovery in the developed world. But these issues will matter a lot if growth falters.

Our sense is that investors are more concerned now about the stretch in fiscal policy than monetary policy. Those concerns, and political factors, may limit the ability of fiscal policy to respond to renewed macro weakness in some developed economies. If investors also sense that monetary policy has lost its potency – or, put better, can’t single-handedly prevent recession – then risk assets will fall. More to the point, we think it means that investors (righty) will continue to focus on growth data, rather than rate or liquidity indicators.

One final point: The final step in Mr. Bernanke’s option list – the helicopter drop – clearly differs from the others. The difference is that instead of lowering the cost of borrowing money, policymakers are now giving it away. That, surely, would work. Of course, there are practical issues. This would effectively be fiscal policy (indeed, Mr. Bernanke didn’t really suggest helicopters – he suggested unfunded tax cuts), which means the central bank could not act autonomously. It also would increase the risk of the policy response to a deflation scare ending with inflation. We’ll write about this later.

What is Gerard saying?

1. Policy errors matter when the economy is at stall speed and any number of exogenous shocks can tip us into deflation and recession.
2. The credit demand curve has shifted downward wholesale. But, more than that the price inelasticity of credit demand is high. That means monetary policy will have a weak effect on end demand. Read: The Fed pushing on a string.
3. Investors are concerned about fiscal policy more than monetary policy. But fiscal policy is dead – if only for political reasons. Therefore, monetary policy has stepped centre stage.  For that, I refer you back to #2. This is bad for risk assets (high yield, emerging market bonds, and stocks – especially ones with high beta or in economically sensitive sectors)
4. The helicopter drop (crediting bank accounts with dollars) option is qualitatively different from all the others. But this would be a further move by the Fed into the fiscal arena.

My take: The helicopter drop option would only come after deflation has already set in i.e. after the depression becomes apparent in the form of a renewed drop in GDP, an increase in unemployment and a drop in risk assets. Don’t think the Fed will wade full-scale into the fiscal arena unless forced to do so. In the meantime, I expect almost no fiscal stimulus in the U.S. or anywhere else in Europe. Fiscal policy is dead until the next leg down. Monetary policy will be the stimulus drug of choice; But the drugs won’t work and we will probably get another leg down.

My hope is that job growth can pick up before any of this becomes axiomatic. But this is not what recent data in the US are telling us. The recent data say economic weakness is accelerating. If this trend continues, expect risk assets to be a poor medium-term bet.